In the world of trading and investing, there are literally hundreds of technical indicators that have been developed over the years by a variety of people, fascinated by the markets. All the indicators have three things in common. Firstly they were developed as a silver bullet to tell you exactly when to open or close a position, secondly, they are all based on lagging information, and thirdly they all work some of the time!
The only indicator that I use in my daily trading is the simple moving average or SMA. They are the most basic and simple indicator of all, and whilst they are a fairly blunt tool in our tool kit, they do offer a very basic overview of what is happening on the chart, and provide simple guidance as to the possible future direction of prices.
As the name suggest a simple moving average is simply that – so a 20 day SMA is the last 20 days prices added together and divided by 20 to arrive at an average. I did say it was simple. That is all there is to it! – I only use 2 to keep the screen uncluttered and these are a 50 day and a 200 day. When you listen to commentary on the markets on the financial news stations, or on TV you will hear them refer to these figures – i.e.: ‘a commodities price has crossed below its 200 day moving average’ – so even the professionals use them! The reason that I only use two is that they give me a slightly different view of prices over different timescales, and the screen remains clutter free.
The significant points are where the averages cross one another, and it is at these points which we must pay attention, and try to draw some conclusions from the price action. The crossover point can represent the change in sentiment from rising prices to falling prices (or the other way round) but be careful – when you watch these averages they will often cross over and return on their original path, so they are not a reliable indicator and remember also they are lagging. So treat them purely as a rough guide to what is happening – not a hard and fast rule. They are there to give an early warning to pay attention – nothing else!!
In summary, a simple moving average is an early warning systems of POSSIBLE future changes in direction. Read them in conjunction with your candlesticks and volume interpretation to see if the alarm can be validated by your analysis from the chart readings. Do not use them in isolation, or try to use them as some sort of indicator – you will fail! They are a rough guide ONLY – no more no less.