The Simple Moving Average (SMA) is an average price calculation over a specific time period. SMA is calculated by dividing the sum of the closing prices of the stock through the time period of interest by the number of these time intervals.
For example, if you want to have a 20-day simple moving average on the daily chart, you will add the closing prices for the previous 20 days and then divide by 20 to get your 20-day moving average.
Traders use moving averages to help determine trend direction and strength. They can also act as support and resistance in a strong trend and is where a lot of traders look to enter and exit trades. Below is an example of the 8- and 20-day SMA where you will notice prices tend to respect the moving averages. One strategy day traders look for is the moving averages to “cross-over.”
You will notice the circle on the chart marks where the 8-day SMA crosses over the 20-day SMA, marking a possible turning point in the trend and good place to look for a trade entry. Moving Averages are just a guideline and shouldn’t be treated as a hard entry or exit point. Sometimes markets can chop out and will just go back and forth with the moving averages flat-lining.
Keep in mind that moving averages can be customized for any length of period that you want. The 8 and 20 tend to be the most popular for day traders but really any length can be used based on your trading style and personal preference. There are two popular patterns that happen with longer time framed moving averages, usually on daily charts, and that is when the 50-day SMA crosses over the 200-day SMA.
When the 50-day SMA crosses to the upside, it is called a Golden Cross and is generally a bullish pattern as long as prices are able to hold the 200-day SMA. When the 50-day crosses below the 200-day, it is called a Death Cross and is considered a bearish pattern where prices are expected to continue to the downside.
Golden/Death Cross Examples
Above is an example of a Golden and Death Cross on the Apple (AAPL) daily chart. The red moving average is the 50-day SMA and the yellow is the 200-day SMA. Notice how prices continued on their trend after breaking through the 200-day SMA in both directions. As long as they are holding the 200-day SMA in their perspective direction, then price action should continue to follow the trend.
There are also Exponential Moving Averages that tend to be more popular for day traders due to their faster moving characteristics