Lesson 1 of 5
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Simple moving averages (15 mins)

Phillip Konchar

Lets get straight into moving averages:

 

The moving average indicator

The moving average is a lagging indicator used by traders to confirm the existence of a trend over a predetermined number of periods.

Simple moving averages (SMA)

The formula:

 SMAn = ( price1 + price2 + … + pricen ) / n 

An example:

Prices
Monday 10
Tuesday 12
Wednesday 13
Thursday 9
Friday 11
SMA5 Friday = 55 / 5 = 11

For a worked example please go to the lesson materials section.

How the SMA reacts to price

When a new period’s price is recorded the oldest piece of data is removed from the calculated, remember the formula is looking at a set number of periods.

SMA5 Friday SMA5 Monday
Monday 10
Tuesday 12 12
Wednesday 13 13
Thursday 9 9
Friday 11 11
Monday 25
SMA5 55 / 5 = 11 70 / 5 = 14

This has the effect of smoothing price action. The more periods in an SMA calculation, the more it will smooth the price action. In practice, it is a balancing act for traders: too few periods and there is too much noise, too many periods and confirmation being sought will take too long.

Limitation of the SMA

The SMA weighs each data point equally, in practice traders place more weight on the most recent prices.

Key Learning Points
  • The moving average is a lagging, trend following, indicator.
  • Traders use it to confirm the direction of the trend.
  • When adding a moving average indicator, traders set how many periods they want it to look back over.
  • Moving averages smooth out the price action.
  • Because each period is weighted equally, the SMA formula places the same weight on the first and last periods.

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