Technical indicators use historical price and volume data to predict future prices. Investors use indicators to time market entries and exits, get a sense of short- and long-term trading ranges and detect turning points. The simple moving average, or SMA, is the average closing price of a stock over a specific number of days. For example, the 50- and 100-day SMAs are the average closing prices over 50 and 100 consecutive trading days, respectively.
The SMA calculation removes the closing price of the oldest day and adds the closing price for the newest day. For example, if the closing price of a stock over three consecutive days is $10, $11 and $12, the three-day SMA is $10 plus $11 plus $12, divided by 3, or $11. However, if the price of the stock is $13 on the fourth day, then the new three-day SMA is $11 plus $12 plus $13, divided by 3, or $12.
A buy signal occurs when a stock price closes consistently above the SMA, while a sell signal occurs when the price closes below the SMA. The SMA tends to react slowly to price changes; this is especially true for longer SMAs. For example, a 100-day SMA will not move very much even if there has been a sharp correction in the stock price recently. Short-term traders would find 15- or 50-day SMAs more useful for making investment decisions. However, 100- or 200-day SMAs provide better indications of the long-term price trends. Investors can use SMAs of different periods together. For example, they can overlay the plots of 50- and 200-day moving averages to assess the short- and long-term price trends.
A positively sloping SMA is generally a bullish signal because it means that prices have been steadily increasing, while a downward-sloping SMA is a bearish signal. A flat SMA usually indicates that prices have been in a tight trading range. Crossovers occur when the graphs of two or more SMAs intersect and move in different directions. A bullish crossover occurs when the shorter SMA crosses above the longer SMA. For example, if a stock's 50-day SMA moves above its 100- or 200-day SMA, it means that prices have been rising recently, which could be a buy signal. A bearish crossover occurs when the shorter SMA crosses below the longer SMA. For example, if a stock's 50-day SMA moves below its 100-day SMA, it means that the stock has been losing steam recently, which could be a sell signal.
Investors should remember that SMAs and other technical indicators do not provide any insight into why prices are changing. For that, they should analyze business and industry fundamentals using information provided on corporate websites and in industry and business media reports.
- Drawing a stock graph image by Allen Penton from Fotolia.com