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The simple moving average (SMA) is anything but simple, yet it is still the most basic moving average in trading nonetheless. Before tackling on its more complex siblings—Displaced Moving Average, Exponential Moving Average, and Triple Exponential Moving Average—it would be best to gain understanding of the least difficult of them all.

In Investopedia’s definition, SMA is an arithmetic moving average calculated by adding the closing price of the security for a number of time periods and then dividing this sum by the number of time periods which gives the average price of the security over the time period. In simpler terms, the SMA is the average price of the given time period, with equal weighting given to the price of each period.

But what significance does the SMA, or the moving averages in general have?

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Their importance lies on being an analytical tool used to pinpoint current price trends and the possibility for a change in an established trend or simply, a reversal. The simplest form of using an SMA in analysis is using it to swiftly identify if a security is in an uptrend or downtrend. It also measures the strength of an asset's momentum and identifies possible areas where an asset will find support or resistance.

SMA smoothens out volatility, and makes it easier to see the price trend of a security. An SMA pointing upwards means that the security's price is increasing, and vice versa. The longer the timeframe for the moving average, the smoother the SMA is. A shorter-term moving average is more volatile; however its reading is closer to the source data.

Several traders monitor short-term averages to cross above longer-term averages to indicate the start of an uptrend. Short-term averages can act as levels of support when the price experiences a pullback.

In theory, there is an endless number of SMAs. The following are the most commonly used SMAs in the market:

·         5 – SMA: For the hyper trader.  This short SMA will always give you signals.  According to TradingSim, the best use of a 5-SMA is as a trade trigger in conjunction with a longer SMA period.

·         10 – SMA: prevalent with the short-term traders, as claimed by TradingSim. Great swing traders and day traders.

·         20 – SMA: this is the end for short-term traders, as beyond 20-SMA you will be looking at primary trends.

·         50 – SMA: used in measuring mid-term trends.

·         200-SMA: used by long-term trend followers.  Most investors will look for a cross above or below this average to signify if the stock is in a bullish or bearish trend.

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(chart taken from onlinetradingconcepts.com)

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(chart taken from onlinetradingconcepts.com)

The basic rules for trading with the SMA do not involve trading SMA crossovers and getting instant profit, as that strategy is heavily inaccurate. Oftentimes stocks will tick over or under moving averages to only continue in the primary direction.

One of the many ways in earning profit by trading with the SMA is simply going with the primary trend. Look for stocks that are breaking out up or down strongly, then apply the common SMA periods to see which is covering price the best.

After identifying the correct SMA, wait for the price to test the SMA successfully and look for price confirmation that the stock is continuing the direction of the primary.

Keep in mind, however, that the SMA is not an indicator you can use as an individual trigger.  Nevertheless, that doesn't mean it can't be a nifty tool for watching the direction of a trend or assisting you in determining when the market is getting tired after an impulsive move. The SMA could be described as a basic compass.  Other tools and indicators are needed for detailed coordinates, but an SMA will shed some light for you to have at least an idea of where you are going.

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