How to use the simple moving average indicator to time your trades
Summary: The simple moving average (SMA) is an indicator that can help you time your trades and set limits to protect your drawdowns. SMAs provide a simple methodology for identifying support/resistance levels and entry/exit levels, and you can easily apply them to SaxoTraderGO's integrated charts.
What is the simple moving average?
The simple moving average (SMA) is a technical indicator that represents the average price of an instrument over a specified period, such as 50 days or 200 days. This rolling arithmetic average line smooths out day-to-day price changes and you can use it to identify support/resistance and entry/exit levels on any asset class.
The SMA is ‘simply’ calculated by taking the ‘average’ closing price for a chosen time period. For instance, the 20-day SMA is the average closing price of the past 20 days. The indicator is referred as ‘moving’ because the first data point rolls off as the next day is added.
The optimal time period depends on your investment horizon. 200 and 100 days are commonly used for long-term trends, 50 days for mid-term trends and 10-20 days for short-term trading.
You can use the SMA as resistance in a long-term downtrend and as support in a long-term uptrend. Therefore, you could place your stop-loss and take-profit using the SMA, putting your stop-loss just below the support/SMA in an upward trend or, alternatively, placing your take profit at the resistance/SMA in a downward trend.
As illustrated in the chart below, the Apple stock reversed three times after running into SMA100 (resistance) before breaking out mid-March. Following the trend correction in early April, the SMA turned into the support that was tested four times without any breakthroughs until the end of June.
Crossovers (trading signals)
Most investors use the SMA in their strategy to identify crossovers and thus their entry and exit points. A crossover can refer to 1) the price crossing the SMA or 2) an SMA crossing another SMA.
A price crossover may imply a reversal of the price trend and thus a trade signal; a bearish signal if the price crosses through the SMA (support) downwards and a bullish signal if price breaks through the SMA (resistance) from below. The chart below shows that the Amazon stock crosses through the SMA100 at the beginning of September, which was indeed a bearish signal as the negative trend continued for several days. However, at the end of September, the price crosses again, which indicated the trend reversal.
As an alternative trading strategy, you could use multiple SMAs with different time periods. When a shorter SMA crosses above a longer SMA, it could signal that the trend is changing towards the upside, possibly indicating a good entry opportunity. Alternatively, a bearish trade signal could appear when the shorter SMA crosses below the longer SMA, indicating that the price may change direction, which could be a good time to sell/short. These crossovers are known as Golden Cross and Death Cross respectively and are mostly applied using the 50 and 200-day SMA. The chart below illustrates the price development of the SPY-ETF. The SMA50 crossed above the SMA200 at the beginning of July, which was followed by an upward trend. However, the SMA50 crosses below the SMA200 at the beginning of September, followed by a downward trend. Finally, we see another Golden Cross at the beginning of October.
Be aware that the SMA indicator only uses historical data and does not account for fundamental changes in the instrument nor market developments. Moreover, the SMA indicator lags behind the price movement as it only appears after the fact. Hence, it's important to monitor the price development when the SMA is approaching the price or another SMA. The larger the time period, the larger the lag. Using a different kind of MA (WMA or EMA) reduces the lag to some extent. Finally, a choppy price development could generate multiple trade signals, meaning it’s sometimes better to just use another indicator. However, adjusting or enlarging the time frame could resolve this problem.
How to apply SMA in SaxoTraderGO
As shown below, you can insert the SMA indicator into your charts by selecting it from the indicator tab.