Simple Moving Average (SMA) is one of the most powerful analysis tools used by technical traders. This indicator is often used to identify the trend direction. Typically, traders also use SMA to determine the buy and sell signals.
SMA is calculated by adding the recent closing prices of a security and then dividing that, by the number of periods in the calculation average. Long term averages react slowly to the price changes, whereas short term averages respond quickly.
How does SMA work?
Simple Moving Averages are used to filter out the minor price fluctuations and determine the direction of the trend. If the SMA is moving upward, then we can say that the trend is up. Likewise, if SMA is moving downward, we can say that the trend is down. There are infinite numbers of moving averages in the market. Some traders believe that they can beat the market with some weird number of SMAs, like 77. However, that’s not true. One cannot generate accurate trading signals using a single indicator.
Some of the common and widely used SMAs by the traders
A 200-bar SMA is common for long term investors, whereas the 50-bar SMA is used to gauge the momentum of the intermediate trend. Shorter period SMAs like 13-bar is used to measure the intraday trend.
If you use a longer period SMA, you will get a smoother result. But there will be a lag between the SMA and the price. When SMA is crossing the price, it is often used to trigger the buy/sell trades. When the prices cross above the SMA, it’s a buy signal, and when it is crossing below the SMA, it’s a potential sell signal.
Below are some of the critical SMAs used by traders according to their trading styles.
- 5-period and 10-period SMAs – These SMAs work the best for hyper traders and scalpers. Day traders also use these SMAs at times. It generates a lot of buy and sell signals on lower timeframes, but not everything will be genuine. Hence traders need to filter out these signals to save themselves from losing trades.
- 20-period SMA – This SMA is a last stop shop for the intraday traders.
- 50-period SMA – Traders use this SMA to gauge the mid-term trend changes.
- 200-period SMA – The investors and trend following traders uses this type of SMA. Most of the investors look for a cross above or below the price to identify the bullish and bearish trend changes.
Installing the SMA Indicator in MT4 (Step-by-step process)
Simple Moving Averages will be available in your MT4 Terminal by default.
Open your MT4 Terminal and click on Insert > Trend > Simple Moving Average.
You can change the SMA period according to your style of trading. If you are an intraday trader, go for a smaller period. Make sure to filter out the signals because lower periods often generate fake signals. But if you are an investor and want a smoother ride, go for the longer period SMA.
As you can see in the image below, the default SMA is applied to the EUR/USD 60-minute chart.
SMA – Trading Strategies
Simple Moving Averages alone can be a great tool to trade the market. In fact, many traders use moving averages alone to generate buy and sell signals. However, we suggest that you combine this study with some other reliable indicators or use multiple SMAs to generate more accurate signals with extra confirmations.
Two Simple Moving Average Crossover Strategy (Short Term)
This is a common strategy used by many of the traders in the market. Select the two moving averages; let’s say 10 and 20 SMAs.
The strategy is to detect when the short-period moving average is crossing the long-period moving average. If the short-period MA is crossing, the long-period MA from below, it can be considered as a buy signal. In the below image, you can take buy trades every time the smaller SMA crosses the larger SMA from below.
Here, if the short-period MA is crossing the long-period MA from above, it can be considered as a sell signal. In the below image, you can take sell trades every time the smaller SMA crosses the larger SMA from above.
Short-period period SMAs often generate a lot of false signals. So it is recommended to also look at the candlestick patterns and price action before placing buy/sell trades.
Two Simple Moving Average Crossover Strategy (Long Term)
For long term investors or higher timeframe traders, 50 and 200 SMA works the best. When the 50 SMA crosses above or below the 200 SMA, buy/sell signals are triggered.
In the below EUR/USD chart, on a weekly chart, the market generated a buy signal in 2003, and for the next four years the market goes straight up. That’s precisely what investors are always looking for in the market. Then after 2009, the market turned into a range and gave them plenty of buy/sell signals. Some work and some do not.
SMAs work well in a trending market. In a ranging market, traders seek other methods such as Oscillators (stochastics, Williams %R) or support-resistance analysis, since the SMA gives mostly false signals.
If you still want to use them in the ranging market, make sure you are getting an extra confirmation by pairing them with other indicators, candlestick patterns or price action in order to filter out the genuine signals from the false ones.
Double Moving Average + RSI Divergence
RSI is an oscillator which is quite popular in the trading world. Know more about this fantastic indicator in our detailed article on RSI. The strategy here is simple. Look out for the RSI divergence here. If you are wondering what divergence is, it is a situation where the price is printing lower lows or higher highs, but our indicator (in this case RSI) fails to print the lower lows or higher highs. In this strategy, we are using 10, 5-period moving averages, and the default RSI values, to identify the signals.
Note – This strategy works the best only on lower timeframes.
When you observe a divergence on the charts, see if the lower moving average is crossing the higher moving average. If yes, that is a perfect time to take the trade.
In the below chart, we can observe a clear divergence when the price was printing lower lows, but RSI is clearly not. Also, we can see that the lower SMA is crossing higher SMA from below. Hence it is a definite buy signal for us.
In the below chart, it is a clear divergence when the RSI was at the overbought area, and the price is printing a lower low. Then when the lower moving average crossed the higher moving average from above, it is a clear sell signal.
Simple Moving Average is one of the most popular indicators in the market. It works on every timeframe, and because of that, all types of traders, such as intraday traders, scalpers and even investors, use this indicator to make their trading decisions.
Moving averages are based on the past data of the market, and it shows the average price over a specific time period. The only drawback of this indicator is that, in shorter periods, it often generates a lot of false signals. It works the best in longer periods if you want to catch long-term moves.
As we always say, to get more accurate signals, never use any one indicator alone. Combine them with other reliable indicators, price action, candlestick patterns etc. Happy Trading!