This is the second article in our SMA series. If you haven’t already we suggest that you check out the first article about the SMA Indicator. In that article, we covered the background of the “Simple Moving Average”, or “SMA”, indicator, how it is calculated, and how it looks on a chart. The SMA was designed to smooth out the effects of price volatility and create a clearer picture of changing price trends. Traders use an SMA, sometimes in concert with another SMA for a different period, to signal confirmation of a change in price behavior.
The benefit of the SMA indicator is its visual simplicity. Traders can quickly assess the prevailing trend of price behavior from the direction of the SMA. Care must be taken since the SMA is a lagging indicator and may not adjust rapidly to volatility in the market. If shorter periods are chosen, then the weakness is that not enough pricing information is included in the indicator’s makeup.
How to Read an SMA Chart
The SMA works best when there is a strong trend present over a long period as in the above “GBP/USD” 15-Minute chart. The SMA “red” line follows the upward trend, lagging below and forming an angled support line until the trend begins to reverse its direction. The “lagging” tendency of this indicator is emphasized in the latter portion of the chart when prices fell very quickly. The period setting is “28” in the above chart. Shorter settings can be used, but the tendency for false signals also increases in reverse proportion.
The key points of reference are when the SMA crosses over the pricing candlesticks. If prices are going up and a crossover occurs, that is viewed as a “Buy” signal, and vice-versa. An SMA is often “teamed” with a faster or slower SMA. In these cases, the crossovers of the SMA lines become a key point of reference.
As with any technical indicator, an SMA chart will never be 100% correct. False signals can occur, but the positive signals are consistent enough to give a forex trader an “edge”. Skill in interpreting and understanding SMA alerts must be developed over time, and complementing the SMA tool with another indicator is always recommended for further confirmation of potential trend changes.
In the next article on the SMA indicator, we will put all of this information together to illustrate a simple trading system using SMA analysis.
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