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How to use Simple Moving Averages in trading
Investors and traders are in constant search of tools they can use to gain any possible advantages from shifting markets. Technical indicators are especially vital parts of any trader’s kit, and few indicators are as consistent (and dependable) as moving averages.
A Simple Moving Average (SMA) is a technical indicator that can help traders determine whether a bull or bear trend will continue or reverse course. It typically adds up closing prices for a given time period, then divides that figure by the number of time periods used for the average.
Depending on the trader’s goals, a simple moving average can be calculated for the short- or long-term. The shorter a SMA’s time frame, the quicker the response to price shifts. Longer time frames react more slowly to fluctuations, delivering a flatter reading. This makes long-term SMAs strong baseline by which to measure short-term behavior, smoothing out daily ups and downs.
A single simple moving average can quickly identify the upwards or downwards trajectory of a specific asset. Combining two moving averages of different lengths allows traders to view crossovers for an asset.
Simple moving averages are effective in their simplicity, but their efficacy is most closely tied to how they are used. By giving equal weight to each data point, SMAs can limit bias towards any specific point in a specific time period. Some traders argue that this is also a negative, however; equal reliance on data from all points in time means an SMA does a poor job of truly reflecting a security’s most-current behavior, thus limiting its predictive potential. Many traders still find ways to trade effectively with a SMA, especially used in conjunction with other tools.
Two basic crossover signals – the Golden Cross and Death Cross – have strong predictive track records. The Golden Cross is a breakout candlestick pattern formed when the short term 50-day moving average for a security exceeds its long term 200-day average, backed by high trading volumes. Investors typically interpret this crossover as a harbinger of a bull market, and its impact can reverberate throughout index sectors.
The Golden Cross’ inverse is the Death Cross: a chart pattern occurring when a security’s short-term moving average crosses underneath its long-term counterpart, typically followed by an increase in trading volume. A death cross, which like a golden cross most commonly uses long-term 50-day and 200-day moving averages to detect the pattern, usually signifies an incoming bear market to traders.
Death crosses are most accurate when short- and long-term moving averages are trending downwards – there is less cause for concern if one line is falling while the other is rising. Research indicates that death crosses signal lasting declines once a market has lost 20 percent of its value. A death cross best serves as an alarm of a slowdown, not a death knell, for a bull market. Savvy traders can even use a death cross as a signal to buy on the dip (or purchase a stock after a price decline).
If you're following a security's simple moving average closely, and the price is showing an established uptrend, look for instances when the securities' price dips below the moving average but then closes for the day above the moving average (as seen on the chart). That could be a sign of more upward price momentum ahead for the security, meaning that the trader could consider going long the security or exploring call options.
The opposite could also apply. If the simple moving average is in an established downtrend, and the price moves above the moving average but then closes for the day below it, that could be a sign of more downward momentum ahead. The trader may consider selling the security, looking at put options, or shorting it.
Moving averages are flexible, proven tools for identifying asset trajectories and possible behaviors. Whether mitigating risk or providing evidence in support of (or opposition to) a trading decision, moving averages can help traders navigate the ups and downs of the market and maximize their results.
They may not be perfect – no tool is – but moving averages are an important part of any informed trader’s bag of tricks – especially when combined with artificial intelligence tools that can help locate these patterns for traders to capitalize on. There are myriad ways to use technical analysis in trading, and which indicator or methodology a trader decides to use usually depends on their experience, skillset, and the quality of the tools (A.I.) available to help them find trade ideas.