Finance

Simple moving average (SMA)

Simple moving average (SMA)

Moving Average (MA) is a commonly used technical analysis and is a stock indicator. The reason for calculating the moving average of a stock is to help smooth out the price data over a specified period of time by creating a constantly updated average price. There are two types of moving averages. They are simple moving average (SMA) and exponential moving average (EMA). The longer the time period of the moving average the greater is the lag. A 100-day moving average would have a greater lag than a 10 day moving average.

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What is a simple moving average?

A Simple Moving Average (SMA) calculates the average of a selected range of prices (they are usually the closing prices) by the number of periods in that range. SMA is basically a technical indicator that determines if the asset price will continue or if it will reverse a bull or bear trend. A higher version of the simple moving average is the exponential moving average (EMA). EMA is more heavily weighted on recent price actions.

How does this indicator work?

A Simple Moving Average (SMA) is an arithmetic moving average that is generally calculated by adding recent prices and then by dividing it by the number of time periods for the calculation of average. You could add the closing price of a security for a number of time periods and then divide this total by that same number of periods. Short term averages respond quickly to changes in the price of the underlying security but the long term averages are slower to react as compared to short term averages

How it is calculated:

It can be calculated by the following formula.

SMA = A1 + A2 + A3……..+An
n

n = the number of total periods

An = the price of an asset at period n

Suppose you have security with the following closing prices over a 15 days period.

Week one: 20, 22, 24, 25, 23

Week Two: 26, 28, 26, 29, 27

Week three: 28, 30, 27, 29, 28

You need to calculate SMA for the first 5 days.

SMA = 20 + 22 + 24 + 25 + 23

5

SMA = 22.8

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Uses in trading and its Interpretation:

Technical traders often use the Simple Average Model to time their buy and sell trades. Traders perform their analysis by looking at when the stock price line intersects the SMA line.

When the price intersects and falls below the SMA line, it is a downward trend in prices, which can also be a good indicator for the investors to sell. Investors must also be careful when trying to time the intersections because SMA is based on historical information and lags behind real-time data.

Bottom Line:

One of the benefits of using moving averages needs to be weighed against the disadvantages. Moving averages are trend-following, or lagging, indicators that will always be a step behind. This is not necessarily a bad thing though. But, SMA is slower to respond to a rapid price change that often occurs at market reversal points.

Author: Saachi Lodha

About the Author – A passionate professional with knowledge of Accounting and Finance and currently exploring Financial Risk Management (FRM) to gain knowledge and exposure. As a part of the FRM course also writing blogs to explore the field more and deep dive into the content.

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