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Confirming the Trend with the Simple Moving Average Indicator

Simple Moving Average

This article will discuss how to use a simple moving average (SMA) as a guide to identifying, confirming, and following a market's trend. As a trend indicator, an SMA is a good all-round tool and one that every trader really should have some familiarity with. First things first, what is a simple moving average?

Simple Moving Average Definition

A simple moving average is the simplest form of a moving average. A moving average is a mean value calculated over a specific number of recent data points. This value is periodically re-calculated, kicking out the oldest value in favour of the most recent period. Let's take a look at a simple example in order to illustrate how to calculate an SMA.

How to Calculate a Simple Moving Average

We calculate values using the simple moving average formula:

SMA = (Sum of price values for n periods)/n

Let's use some sample prices to show a simple moving average example. Let's say we want to calculate the 10-day SMA using daily closing prices, and let's say that the closing prices for the last 10 days are as shown in the following table:

Day Number

Example Closing Price

1

24

2

26

3

23

4

28

5

30

6

26

7

22

8

19

9

24

10

20


The simple moving average period, n, is 10 in our example. So we total our 10 closing prices and divide by 10. Easy!

The sum of our values = 24 + 26 + 23 + 28 + 30 + 26 + 22 +19 +24 + 20 = 242

The SMA = 242/10 = 24.2

The next day we would discard our old Day 1 value and instead include the newest day's closing price in our calculation, hence giving us a new average value. The value of the average therefore changes as time progresses, which is why it is called a moving average.

To find a simple moving average is not fairly simple, as you can see. Indeed, even long before computers became commonplace trading tools, analysts would work out daily moving averages doing the calculations manually. If you are calculating for a large number of periods, or if your periods are short time frames, the work involved can be very laborious, however. This is why we let computing power deal with the simple moving average algorithm, so that we can focus on the results of the calculations rather than the calculations themselves.

Using the SMA Indicator in MT4

A moving average tool comes bundled with the platform as one of the core indicators, meaning you don't have to make a separate simple moving average indicator MT4 download. You will find the Moving Average indicator listed in the Trend folder within MT4's Navigator, as shown in the image below:

Moving Average

Image source: MetaTrader 4 platform, November 2017

As you can see from the image, the moving average indicator in MT4 offers you a choice of more than one type of method. Naturally for an SMA, you choose Simple as the method. The SMA settings that you need to decide on are the values for Period, Shift, and Apply to.

The Period is the same as N in our SMA formula. It is how many periods we include in our average. The greater the value for N, the smoother our moving average line will be, but the slower it will react to changes in the price. Smaller values for N will produce a faster-moving SMA line. This will react more quickly to changes in the price, but will be less smooth. Ideally, we are looking for a happy medium that will be smooth enough to allow us to see beyond short-term volatility and instead focus on genuine trend, but fast enough to give us timely signals.

It can be instructive to compare a faster (i.e., shorter period) SMA with a slower (i.e. longer period) one, as we shall see later on in the strategy section of this article.

The Shift is the least important of the SMA settings here. The value entered displaces the SMA in time along the time axis, a positive value shifting the SMA to the right and a negative value to the left. Shifting with a negative value is only useful as a tool for looking at historical data. If you are looking for an SMA for the current period with a negative shift, it is not possible – you would need a value for a period that has not yet occured in order to complete the data set. Using the default value of 0 is recommended as a good place to start.

The Apply to menu gives you seven choices. These are:

  1. close;
  2. open;
  3. high;
  4. low;
  5. median price, which is (high + close)/2;
  6. typical price, which is (high + low + close)/3;
  7. weighted close, which is (high + low + close + close)/4.

The default setting applies the SMA to close and, once again, this a good place to start. Naturally, some experimentation will help you decide on the best simple moving average settings.

In the image below, I have added a 50-period SMA chart indicator to an hourly chart of the GBP/USD:

50-period SMA chart indicator to an hourly chart of the GBP/USD

Image source: MetaTrader 4 platform, price data from Admiral Markets, GBP/USD H1 chart, 14 November 2017 to 21 November 2017

What does the simple moving average tell you? Primarily, the SMA allows you to see beyond short-term price fluctuations and thereby better-perceive the underlying trend of the market. Notice how the Forex SMA indicator smooths out the market movement. The upward trend of the market, in this case, is more clearly seen when reading a simple moving average rather than looking at the price alone.

Also note how the price remains above the SMA line for the vast majority of the trend. Herein we have a couple of key points for how to trade with the SMA indicator. First, we can use price crossing above the moving average as an entry signal to buy. Second, the price remaining above the moving average is confirmation of an uptrend.

The converse is also true: we can use price crossing below the SMA as a sell signal. The price remaining below the SMA is a confirmation of a downtrend. So let's now talk a little about how to use these concepts as part of a simple moving average trading strategy.

Trading Strategy: SMA Crossover Indicator MT4

The simple moving average crossover strategy is a fairly basic trend-following system. It looks at two price series and gives a trading signal when one crosses over the other. In our image above, we saw price crossing above a 50-period moving average. As an alternative, we can also use another moving average instead of price.

The key is that the direction of the signal is given by the direction of the cross of the faster-moving price series over the slower one. So, for example, you might use a 20-period moving average as the fast series and a 50-period moving average as the slower one. If the 20-period MA crossed above the 50-period MA, it would be a buy signal. If the 20-period MA crossed below the slower MA, it would be a sell signal.

Following such signals is effectively an example of simple moving average forecasting. We are using our moving average as a likely guide to the future performance of the market. Of course, such simple moving average forecasting relies on a key assumption – namely, that future data values will tend to follow the trend.

As we all know, historical values may not accurately predict future values, and there may, in fact, be many times when the trend breaks down. Historical data is an imperfect guide to the unknown of tomorrow, therefore, but remains one of the few guides available.

When looking at historical data, there is a pertinent question of how much historical data to incorporate. Do we consider all previous data as relevant? Or do we decide that only the most recent data is of any bearing for what will happen next? Moving averages attempt to provide a simple, but effective rule of thumb to the problem, considering the mean value over a certain window of observation.

We can come up with other trading strategies by combining the MT4 slope indicator with other trading tools. One way to do this is to use an SMA as a trend filter and use another indicator for the trading signals. For example, you could use Keltner Channels for entry signals, buying when the price breaks above the Keltner Channels or selling when it breaks below the envelope. The filter comes into play by only following signals that agree with the direction of the larger trend. That is to say, we can only buy if the market price is above our SMA and only sell if the price is below our SMA.

Keltner Channels are just one of the many additional tools that you gain with MetaTrader Supreme Edition. MT4SE is a custom plug-in for MetaTrader that greatly expands the functionality of the platform – and it is free to download.

Download MT4 Supreme Edition - Forex trading platform

Simple vs Exponential Moving Average

As we saw from the Type dropdown in MT4, there are several types of moving averages available. The two most common are Simple Moving Average and Exponential Moving average (EMA). As we have seen, an SMA has no weighting – all data points are treated equally when calculating the mean value. With an EMA, weighting is applied, with more recent data values carrying more weight when calculating the average.

Because moving averages look back and incorporate older data points, they are inherently lagging in nature. Changes in a moving average will occur after the market price has already started moving. This is why a chief use of a moving average is as a trend-confirmation tool. Weighted moving averages attempt to mitigate the lag by focussing more on recent data points, assuming that more recent data is more relevant for predicting what might happen next. An exponential moving average weights previous data with a weighting that exponentially decreases with time. There is a trade-off, though, in that it may not smooth out price fluctuations so well.

When comparing an SMA to an EMA, one is not inherently better or worse than the other; it is more a question of understanding the difference and using what better suits your requirements. Probably the best way to work out what works for you personally is to go ahead and give them both a try. Using a Demo Trading Account will allow you to do this as many times as you need without risking any money on trial and error.

The Simple Moving Average Model: Summary

We have looked at how to find the simple moving average by summing all the data points within a given number of periods and then dividing through by the number of periods. We've also see how using a simple moving average smooths price fluctuations and makes the trend clearer. Moving averages can be used for all instruments – a stock SMA indicator will work just as well as a Forex one. It is, therefore, a versatile tool with a variety of uses for informing us about the market trend.


We hope you enjoyed this discussion of Simple Moving Averages. You might also be interested in our article on the Most Important Forex Indicators.



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