SMA (Simple Moving Average): Definition, Calculation and Application in Crypto Trading
Simple Moving Averages (SMAs) are fundamental tools in the world of technical analysis, providing traders with a clear understanding of an asset's trend direction and potential support and resistance levels. Widely used in various markets, including the ever-evolving cryptocurrency market, SMAs offer an accessible and straightforward method for interpreting price movements. In this article, we will explore the history and rationale behind Simple Moving Averages, their definition, and how to use them effectively with other technical analysis indicators to enhance trading signals in the crypto market.
The History of Simple Moving Averages
The concept of moving averages dates back to the early 20th century when statisticians and mathematicians first began analyzing financial markets. Simple Moving Averages, as the name suggests, are the most basic form of moving averages, and their application in financial markets has a long-standing history. SMAs have become a staple in technical analysis, offering an easy-to-understand method for tracking price trends across various markets, including stocks, commodities, and cryptocurrencies.
The Definition of Simple Moving Averages
A Simple Moving Average is the arithmetic mean of an asset's price over a specified period. To calculate the SMA, the closing prices of the asset for the given period are summed up, and the total is divided by the number of periods. For example, a 50-day SMA would sum up the closing prices of the past 50 days and divide the result by 50. The SMA is then plotted on the price chart, creating a line that follows the asset's price movements, highlighting the overall trend direction.
How to interpret the Simple Moving Average?
The primary rationale behind SMAs is to smooth out price fluctuations and provide a clearer picture of an asset's overall trend direction. By averaging past price data, SMAs filter out the noise of daily price movements, helping traders identify patterns and anticipate potential trend changes. Furthermore, SMAs serve as dynamic support and resistance levels, offering insights into potential entry and exit points for trades.
On the chart above, we are comparing the evolution of the price minute per minute to the 99 minutes Simple Moving Average in yellow. The first thing that we can notice is the smoothing power of the Simple Moving Average. The white line of the price is spiky while the yellow Simple Moving Average is smoother. We can see that the Simple Moving Average lags way behind the price when the trend is bullish. After the spike, the market is slightly bearish and the price tends to fluctuate below the Simple Moving Average.
Now, as we have seen, the curve of an asset's price shows variations. It is sometimes better to compare the positions of a short and a long Simple Moving average to evaluate trends with more security.
On the example above, we can see the price candles, a 7-period Simple Moving Average in yellow, and a 25-period Simple Moving Average in blue. We can see that the price of the asset frequently drops below the two Simple Moving Averages. But, if we look at the two curves, we cans see that the 7-period Simple Moving Average does not clearly fall below the 25-period Simple Moving Average. It seems to bounce on the blue curve. The 7-period SMA follows the price more closely that the longer SMA, which indicates the general trend: a strong bullish one. However, at the end, the 7-period SMA clearly drops below the 25-period SMA, indicating a clear trend reversal. The market is now bearish.
How to calculate the Simple Moving Average?
The calculation of the Simple Moving Average consists in adding up the different closing prices of the stock studied and dividing them by the number of periods. Thus, if the period chosen is fifty hours, we will have to add the fifty closing prices of the stock, before dividing the number obtained by fifty. In this way, we will obtain the Simple Moving Average.
You may find below an example of the Simple Moving Average calculation.
| Close price | 5-period SMA |
|---|---|
| 132 | Not enough periods |
| 134 | Not enough periods |
| 129 | Not enough periods |
| 139 | Not enough periods |
| 149 | 136,6 |
| 135 | 137,2 |
| 138 | 138 |
| 131 | 138,4 |
| 130 | 136,6 |
| 127 | 132,2 |
| 124 | 130 |
| 125 | 127,4 |
| 123 | 125,8 |
| 119 | 123,6 |
Technical Indicators using Simple Moving Averages
As one of the most popular technical analysis indicators, many indicators are built upon simple moving averages. Here is a non-extensive list of of them:
- Moving Average Crossover: This indicator is used to identify potential buy and sell signals by comparing two or more moving averages of different time periods. When a shorter-term moving average crosses above a longer-term moving average, it is considered a bullish signal, and traders may interpret it as a signal to buy. Conversely, when a shorter-term moving average crosses below a longer-term moving average, it is considered a bearish signal, and traders may interpret it as a signal to sell.
- Moving Average Ribbon: This indicator uses multiple moving averages of different time periods to identify support and resistance levels. It can be used to identify potential trend reversal and confirm the direction of the trend.
- Moving Average Envelope: This indicator is used to identify overbought and oversold conditions by plotting two moving averages with a certain percentage deviation from the moving average. When the price moves outside of the envelope, it can indicate that the market is overbought or oversold.
- Bollinger Bands: Bollinger Bands are used to measure volatility by plotting a moving average and two standard deviation lines above and below it. The distance between the centerline and the upper and lower bands varies depending on volatility. When the price is moving inside of the Bollinger Bands, it can indicate a continuation of the trend, and when the price is moving outside of the Bollinger Bands, it can indicate a potential reversal.
Crypto Trading Strategies Using Simple Moving Averages
Simple Moving Averages (SMAs) are versatile and accessible tools that can be utilized in various trading strategies within the cryptocurrency market. Here are some popular trading strategies that incorporate SMAs to help traders make informed decisions:
Moving Average Crossovers
A moving average crossover occurs when a shorter-period SMA (e.g., 10-day SMA) crosses above or below a longer-period SMA (e.g., 50-day SMA). This crossover can signal a potential change in trend direction. When the shorter SMA crosses above the longer SMA, it generates a bullish signal, indicating a possible uptrend. Conversely, when the shorter SMA crosses below the longer SMA, it generates a bearish signal, suggesting a possible downtrend.
Price and Moving Average Crossovers
In this strategy, traders look for instances when the price of an asset crosses above or below an SMA. A bullish signal occurs when the price crosses above the SMA, indicating a potential uptrend. Conversely, a bearish signal is generated when the price crosses below the SMA, suggesting a potential downtrend. This strategy can be used in combination with other technical analysis tools to confirm the signals and filter out false breakouts.
Moving Average Bounce
Traders can use SMAs as dynamic support and resistance levels to identify potential entry and exit points. In an uptrend, the price of an asset may retrace and "bounce" off an SMA, providing a buying opportunity. Conversely, in a downtrend, the price may encounter resistance at an SMA and reverse, offering a potential selling opportunity. This strategy works best when the market is trending, and it is essential to use other technical indicators or price action analysis to confirm the bounce signals.
Multiple Moving Averages
Using multiple SMAs with different periods can help traders gain a more comprehensive view of the market's trend strength and direction. For instance, a trader could use a combination of a 10-day, 50-day, and 200-day SMA on their chart. When all SMAs are aligned, with the shortest period above the others in an uptrend (or below in a downtrend), it indicates a strong trend. When the SMAs start to converge, it may signal weakening trend strength and a potential trend reversal.
It is important to remember that no single trading strategy is foolproof, and the effectiveness of SMAs may vary depending on the cryptocurrency, timeframe, and market conditions. To enhance the accuracy of these strategies, traders should combine SMAs with other technical analysis tools, such as RSI, MACD, or candlestick patterns, to corroborate the signals and filter out false breakouts. By doing so, traders can optimize their decision-making process and minimize risks in the volatile cryptocurrency market.
How to use Simple Moving Averages with other technical analysis indicators to improve signals?
Using Simple Moving Averages (SMAs) in conjunction with other technical analysis indicators can provide a more comprehensive market analysis, helping traders filter out false signals and make better-informed decisions. Here are some ways to combine SMAs with other technical analysis tools to improve trading signals:
SMA and RSI (Relative Strength Index)
The RSI (Relative Strength Index) is a momentum oscillator that measures the speed and change of price movements, helping traders identify overbought and oversold conditions. When the RSI indicates an overbought or oversold market, traders can use the SMA as a confirmation tool to validate potential trend reversals. For example, if the RSI signals an oversold condition, and the price bounces off the SMA support level, it could confirm a bullish reversal.
SMA and MACD (Moving Average Convergence Divergence)
The MACD (Moving Average Convergence Divergence) is a popular trend-following momentum indicator that can help traders identify potential trend changes by tracking the relationship between two moving averages. When the MACD line crosses above the signal line, it generates a bullish signal, and when it crosses below the signal line, it generates a bearish signal. Traders can use SMA crossovers or price and SMA crossovers as additional confirmation of the MACD signals to ensure the trend change is genuine.
SMA and Bollinger Bands
Bollinger Bands consist of an SMA and two standard deviations that create upper and lower bands. These bands help traders gauge volatility and identify potential breakouts or trend reversals. When the price touches the upper or lower Bollinger Band, traders can use the SMA as a confirmation tool to determine if the trend is likely to reverse or continue. For example, if the price breaks through the upper Bollinger Band but remains above the SMA, it could suggest a strong uptrend.
SMA and Candlestick Patterns
Candlestick patterns, such as Doji, Hammer, or Shooting Star, can provide valuable insights into market sentiment and potential trend reversals. When a reversal candlestick pattern occurs near an SMA, it could indicate a high probability of a trend change. For instance, if a bullish engulfing pattern forms near the SMA support level, it could confirm a potential trend reversal to the upside.
SMA and Trendlines
Trendlines are diagonal lines drawn on price charts to identify the direction and strength of a trend. When a trendline break coincides with an SMA crossover or price and SMA crossover, it could signal a higher probability of a trend reversal. Combining trendlines with SMAs can provide additional confirmation for trend changes and help traders make more informed decisions.
Remember that combining SMAs with other technical analysis tools is not a guarantee of success, but it can help filter out false signals and improve the overall accuracy of trading strategies. Experimenting with different indicators and timeframes can help traders find the most effective combinations for their specific trading styles and market conditions.
Frequently Asked Questions about Simple Moving Averages
1. What is the difference between a Simple Moving Average and an Exponential Moving Average?
A Simple Moving Average (SMA) gives equal weight to each price data point in the calculation, while an Exponential Moving Average (EMA) assigns more weight to recent price data. As a result, EMAs react more quickly to recent price changes, making them more responsive to new information than SMAs.
2. Which SMA period should I use for crypto trading?
The choice of SMA period depends on your trading style and objectives. Shorter periods, such as the 10-day or 20-day SMA, are more sensitive to price changes and suitable for short-term trading strategies. Longer periods, such as the 50-day or 200-day SMA, are less sensitive to price fluctuations and more suitable for long-term trend analysis. It is essential to experiment with different settings to find the one that works best for your trading approach and risk tolerance.
3. How can I use Simple Moving Averages to identify support and resistance levels?
SMAs can act as dynamic support and resistance levels, providing traders with potential entry and exit points. When the price of an asset is above the SMA, it may serve as a support level, indicating a potential buying opportunity. Conversely, when the price is below the SMA, it may act as a resistance level, suggesting a potential selling opportunity. It is important to note that these support and resistance levels are not absolute; price can break through them, so it's crucial to use other technical analysis tools to confirm the signals.
4. Can Simple Moving Averages be used in different timeframes?
Yes, SMAs can be applied to various timeframes, such as hourly, daily, or weekly charts, depending on your trading style and preferences. Short-term traders may find SMAs more useful on shorter timeframes, like hourly or 15-minute charts, to capture quick price movements. On the other hand, long-term traders might prefer using SMAs on daily or weekly charts to identify broader market trends and potential trend reversals.