A simple
moving average is the simplest type of moving average (DUH!). Basically, a
simple moving average is calculated by adding up the last "X"
period's closing prices and then dividing that number by X.
Confused???
Don't
worry, we'll make it crystal clear.
If you
plotted a 5 period simple moving average on a 1-hour chart, you would add up
the closing prices for the last 5 hours, and then divide that number by 5.
Voila! You have the average closing price over the last five hours! String
those average prices together and you get a moving average!
If you
were to plot a 5-period simple moving average on a 10-minute chart, you would
add up the closing prices of the last 50 minutes and then divide that number by
5.
If you
were to plot a 5 period simple moving average on a 30 minute chart, you would
add up the closing prices of the last 150 minutes and then divide that number
by 5.
If you
were to plot the 5 period simple moving average on the 4 hr. chart... Okay,
okay, we know, we know. You get the picture!
Most
charting packages will do all the calculations for you. The reason we just
bored you (yawn!) with a "how to" on calculating simple moving
averages is because it's important to understand so that you know how to edit
and tweak the indicator.
Understanding
how an indicator works means you can adjust and create different strategies as
the market environment changes.
Now, just
like almost any other indicator out there, moving averages operate with a
delay. Because you are taking the averages of past price history, you are
really only seeing the general path of the recent past and the general
direction of "future" short term price action.
Disclaimer: Moving averages will not turn you
into Ms. Cleo the psychic!
Here is
an example of how moving averages smooth out the price action.
On chart
above, we've plotted three different SMAs on the 1-hour chart of USD/CHF. As
you can see, the longer the SMA period is, the more it lags behind the price.
Notice how
the 62 SMA is farther away from the current price than the 30 and 5 SMAs.
This is
because the 62 SMA adds up the closing prices of the last 62 periods and
divides it by 62. The longer period you use for the SMA, the slower it is to
react to the price movement.
The SMAs in this chart show you the overall sentiment of the market at this point in time. Here, we can see that the pair is trending.
Instead
of just looking at the current price of the market, the moving averages give us
a broader view, and we can now gauge the general direction of its future price.
With the use of SMAs, we can tell whether a pair is trending up, trending down,
or just ranging.
There is
one problem with the simple moving average and it's that they are susceptible
to spikes. When this happens, this can give us false signals. We might think
that a new trend may be developing but in reality, nothing changed.
In the
next lesson, we will show you what we mean, and also introduce you to another
type of moving average to avoid this problem.
