Moving averages are one of the most popular and easy to use tools available to the technical analyst. They smooth a data series and make it easier to spot trends, something that is especially helpful in volatile markets. They also form the building blocks for many other technical indicators and overlays.


Simple Moving Average (SMA)

A simple moving average is formed by computing the average (mean) price of a security over a specified number of periods. While it is possible to create moving averages from the Open, the High, and the Low data points, most moving averages are created using the closing price. For example: a 5-day simple moving average is calculated by adding the closing prices for the last 5 days and dividing the total by 5.

10 + 11 + 12 + 13 + 14 = 60
(60 / 5) = 12

The calculation is repeated for each price bar on the chart. The averages are then joined to form a smooth curving line - the moving average line. If the next closing price in the average is 15, then this new period would be added and the oldest day, which is 10, would be dropped. The new 5-day simple moving average would be calculated as follows:

11 + 12 + 13 + 14 +15 = 65
(65 / 5) = 13

Over the last 2 days, the SMA moved from 12 to 13. As new days are added, the old days will be subtracted and the moving average will continue to move over time.



Moving Averages are Lagging Indicators

All moving averages are lagging indicators and will always be "behind" the price. If price is trending down, but the simple moving average, which is based on the previous 10 days of data (10 day SMA), remains above the price. If the price were rising, the SMA would most likely be below. Because moving averages are lagging indicators, they fit in the category of trend following indicators. When prices are trending, moving averages work well. However, when prices are not trending, moving averages can give misleading signals.

Study the graphic below... Prices are trending well to the downside however, a false signal was produced when price rose up through the moving average flagging a buy signal.