Many people get into investing without really knowing much about it. They may watch the financial news programs, talk with friends, make their own independent analysis and make decisions from there, but knowing some of what the talking heads are talking about before you invest can be both instructive and illuminating. So it is for the Simple Moving Average (SMA). But what is a Simple Moving Average? How do Simple Moving Averages work? Isn’t the math behind Simple Moving Averages complicated? Let’s investigate.
What is a Simple Moving Average: To get right to it, the math for a Simple Moving Average is not complicated at all; it’s simple. It’s even in the name. So before you go running to your old high school graphing calculator or your geek nephew for help, just relax a second. As discussed on Invesopedia.com “a simple, or arithmetic, moving average…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.” So if you have Stock-Z whose closing price over five days has been $1.25, $1.40, $1.33, $1.51, and $1.48 what do you think the five day Simple Moving Average would be? We would say that the five day Simple Moving Average of this stock would be $1.39 (actually $1.394, but we round down). “$1.39!” you may say, “but that stock was at $1.51! We shoulda sold there!” And yes, you should have. But what can we learn about this particular example? Stock-Z’s price is higher on day 5 than on day 1, right? And the 5 day Simple Moving Average is higher than where the stock was at the beginning of the week, right? So we’d have to deduce from this short term analysis that the momentum is on a strong upward curve. That’s good, right? But to really understand how a stocks been doing, we need to draw from a larger sample.
Simple Moving Averages: Longer Terms: Okay so the five day Simple Moving Average is at $1.39, trending upward from where it had been on day one to day five. But what do traders look for in Simple Moving Averages? Again from Investopedia.com, “traders watch for short-term averages to cross above longer-term average to signal the beginning of an uptrend.” So if the five day Simple Moving Average is at $1.39, the fifteen day Simple Moving Average could be $1.45 and the fifty day Simple Moving Average could be at $1.80. So by looking at the longer term picture, even though this upward trend is good, the value of the stock on a longer term picture is still depressed. Professional investors may look at this one of three ways; they may think that at this price, the company is a good value, they may think that the Simple Moving Average is still too low for them to go near, or they may have to wait for more information. You need to decide what kind of an investor you are, how long you plan to hold on to this stock, and where you’d like to get out.
Simple Moving Averages: Conclusion: The Simple Moving Average is actually something you should definitely know about your stock, before you get invested in a particular security. Even if you’ve got “a feeling” about a stock’s potential direction, these feelings can often be premature if not totally wrong. So get hip, use the tools available to you from your broker, chart your stocks yourself, and get familiar with your stocks Simple Moving Averages before you plunk down one penny.