Thursday, November 20, 2008

A Note On SMAs

I use the phrase SMAs an awful lot, don't I? But I've realized that I have never explained why I use them so much or why I think they are so effective. To that end I have added this explanation. Warning: there is some math involved.

"SMA" is "simple moving average." Here's a working definition:

A simple, or arithmetic, moving average that is calculated by adding the closing price of the security for a number of time periods and then dividing this total by the number of time periods. Short-term averages respond quickly to changes in the price of the underlying, while long-term averages are slow to react.

I use the 10, 20, 50 and 200 day SMAs. So in real time the lines are a two week line (half a month), a four week line (one month), a two and a half month line and the line everybody uses to differentiate between bull and bear markets.

SMAs are like line charts for prices. But because they are averages they smooth the price action which helps to block out the day to day noise. This is what makes them incredibly valuable. They allow us to see what the overall trend is in a variety of time frames.

There are two very significant developments regarding SMAs.

1.) When a shorter SMA crosses over a longer way in either direction (either up or down). Let's think this through. Suppose the 10 day SMA crosses below the 20 day SMA. That means the two week average price moves below the one month average price. What do you think that means for the one month average price? It's going lower. Why? Consider the math involved. The numbers used to calculated longer SMA contain the shorter SMA. So as the shorter SMA decreases the longer SMA decreases by simple definition.

So a cross-over not only means short-term prices are moving lower, it also means prices for the next higher time frame are moving lower. The reverse of this is also true.

2.) Where are the shorter SMAs in relation to the longer SMA? A phrase that I write a great deal is something like, "the shorter SMA is below the longer SMA." Why is this important? Remember -- the longer SMA contains the shorter SMA, so if the shorter SMA is below the longer SMA that means the longer SMA is probably moving lower. The reverse is also true.

These two reason are the primary reasons I rely so heavily on moving averages in my technicla analysis.

Hope this helps.