If you're an independent investor, get to know your stocks better by doing some basic chart analysis. By understanding indicators such as the simple moving average, or SMA, you can follow the price trends of your securities. SMA is a simple arithmetical equation that calculates an asset's price over a certain time period, which can help investors identify whether the price stays constant, increases or has potential to reverse.
SMA is calculated by adding closing stock prices over a period of time and dividing the sum by the number of days during the same time period.
Creating a Definition of SMA
The SMA is the sum total of the stock price over a specified period of time, divided by the number of days in that stretch. When analyzing stock charts, a little history comes in handy: specifically, the recent trend in price, which the simple moving average will reveal
To get a 20-day simple moving average, for example, you add up all the price closings over the last 20 days and then divide by 20. The result is a number that might be above or below the current price of the stock, and which trends in the general direction of that price.
Implications of Rising, Falling and Steady Charts
When the SMA is rising, then the stock price is going up, generally. Although it might have dips and swoons from day to day, investors in general are showing optimism. When the SMA is falling, then the stock has been pulling back. SMAs smooth out the price action and give you a little clarity.
The most important consideration for investors is not what happened in the past -- they want to know the future. For this, two different SMAs can be plotted on the same chart.
The Significance of Crossovers
Plotting a long-term SMA (100 days, for example) alongside a short-term line (20 days) gives you parallel indicators that from time to time will cross over each other. To experienced investors, the SMA crossover provides a flashing mathematical beacon that shows a (possible) change in price trend.
When a rising short-term SMA dips across the long-term and heads downward, the stock migh be reversing its upward trend. However, trading on that signal alone is hazardous. You should always take into account factors that have nothing to do with the fundamental financial well-being of the company, such as market trends, speculative selling, or macroeconomic news that might be coming into play.
Evaluating SMAs and EMAs
As long as you're delving into SMA and other financial acronyms, consider the related EMA indicator. The exponential moving average uses the same basic calculation of the SMA, but it gives greater weight to the more recent closings. (Most investor charting software will display these averages with a click on a pull-down menu, with the user providing the desired time periods).
The EMA line tends to track the current price more closely. For both indicators, the shorter the time period you use, the faster the change in direction. The longer the period chosen, the smoother the line.
Always calibrate moving averages to your investing time horizon, which you can measure in hours, days or years.
- Hand on stock page with chart drawn image by Allen Penton from Fotolia.com