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Moving Average (MA) Explained

Moving Average (MA) Explained

The Simple Moving Average is arguably the most popular technical analysis tool used by traders. The Simple Moving Average (SMA) is often used to identify trend direction but can be used to generate potential buy and sell signals. The SMA is an average, or in statistical speak – the mean. An example of a Simple Moving Average is presented below:

Example:

The prices for the last 5 days were 25, 28, 26, 24, 25. The average would be (25+28+26+26+27)/5 = 26.4. Therefore, the SMA line below the last days price of 27 would be 26.4. In this case, since prices are generally moving higher, the SMA line of 26.4 could be acting as support

 

Moving Average Acting as Support – Potential Buy Signal

When price is in an uptrend and subsequently, the moving average is in an uptrend, and the moving average has been tested by price and price has bounced off the moving average a few times (i.e. the moving average is serving as a support line), then a trader might buy on the next pullbacks back to the Simple Moving Average.

Potential Sell Signal At times when price is in a downtrend and the moving average is in a downtrend as well, and price tests the SMA above and is rejected a few consecutive times (i.e. the moving average is serving as a resistance line), then a trader might sell on the next rally up to the Simple Moving Average.

The 3 Simple Moving Average method could be interpreted as follows:

  1. The first crossover of the quickest SMA (in the example above, the 10-day SMA) across the next quickest SMA (20-day SMA) acts as a warning that prices might be reversing trend; however, usually a trader would not place an actual buy or sell order then.
  2. Thereafter, the second crossover of the quickest SMA (10-day) and the slowest SMA (50-day), might trigger a trader to buy or sell.

There are numerous variants and methodologies for using the 3 Simple Moving Average crossover method

  • A more conservative approach might be to wait until the middle SMA (20-day) crosses over the slower SMA (50-day); but this is basically a two SMA crossover technique, not a three SMA technique.
  • A trader might consider a money management technique of buying a half size when the quick SMA crosses over the next quickest SMA and then enter the other half when the quick SMA crosses over the slower SMA.
  • Instead of halves, buy or sell one-third of a position when the quick SMA crosses over the next quickest SMA, another third when the quick SMA crosses over the slow SMA, and the last third when the second quickest SMA crosses over the slow SMA.

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