You may probably come across Smoothed Moving Average (SMMA) along your trading adventure. Because of its capacity to confirm current market patterns that aid in the generation of buy/sell signals, it is a useful indication tool to be aware of.
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| SMMA plotted on NEPSE Chart |
What is the Smoothed Moving Average?
The smoothed moving average is simply a moving
average that assigns weight to price data points over a long period. Traders
use it to gauge market trends according to a series of averages taken over a
given period. As more data becomes available, they recalculate the averages to
accommodate newer periods. That’s why we call it a “moving” average.
Think of the SMMA as a hybrid of its better-known
siblings — the simple moving average (SMA) and the exponential moving average
(EMA). The SMA looks at the price of a traded asset and divides it by the given
period to be studied, but it all looks at all periods equally. Unlike the EMA,
which places more emphasis on recent data.
The smoothed moving average provides a broader view of
things by ‘smoothing out’ short-term market fluctuations. This added accuracy
helps traders confirm market trends quicker.
The chart below shows the Microsoft (MSFT) stock chart with
the SMA (blue), EMA (red), and SMMA (green). All trendlines were plotted within
the same period, and yet they show different results on the chart.
Calculating the Smoothed Moving Average
Because it is a combination of both the EMA and the SMA, the
formula for calculating the smoothed moving average might come off a
bit complex.
The good news is that the SMMA indicator is available by
default on most trading platforms. So you don’t have to worry about the actual
formula or calculation; you can just set it up on your charts with one click.
Nevertheless, let’s walk through the formula anyway. It
doesn’t hurt to know how to calculate it. Plus, on the off chance that the SMMA
indicator is not readily available on your trading platform, this knowledge
will come in handy.
The formula for calculating the smoothed moving average is:
SMMA = (SMMA# – SMMA* + CLOSE)/N
Where
SMMA# – the smoothed sum of the previous bar
SMMA* – the previous smoothed moving average bar
CLOSE – The closing price at the time of calculation
N – the number of smoothing periods
The first period is an SMA.
By smoothing out the data over a given period, traders and
analysts have a more comprehensive overview of the trend minus the deviations
attributed to short-term volatility. Additionally, since it gives equal weight
to data from past periods, the SMMA can represent economic conditions
better than its non-smoothed counterparts.
SMMA Trading Strategies
The SMMA indicator plays a vital role in many trading
strategies. As a lagging indicator, it’s excellent for confirming
prevailing trends, whether upward or downward, in the market. This crucial
insight into market behavior helps traders identify entry/exit points.
Here are some common SMMA trading strategies:
Trend Following
The trader buys an asset whose price is already on the rise
and confirmed to be trending upwards in trend following. They also short the
asset when the price is already falling and confirmed to be trending downwards.
The beauty of this trading strategy lies in its simplicity.
It’s only common sense to buy an asset when you’re confident that the price
will go up, giving you a nice profit. The smoothed moving average line serves
as a guide for identifying when to buy or sell based on the current market
trend.
For instance, the SMMA line will usually remain slightly
above it when the asset price trends downward. Once the trend is about to end,
the price and SMMA lines will start to draw closer to each other, signaling
that a trend change is imminent.
Trend following with the smoothed moving average indicator
works across every traded asset class.
Reversals
Identifying potential reversals in price action is a massive
opportunity to enter or exit a position. A reversal is when the current trend
comes to an end, and a new one begins in the opposite direction.
For example, if you spot a bullish reversal about to start
in a down-trending market, you take a long position and wait for the reversal
to occur so you can ride the resulting price rise to accumulate profits.
One of the most effective ways to use the SMMA in
trading reversals is when used with another moving average line measured over a
different period. The idea is to be on the lookout for crossover between both
trendlines.
If the crossover occurs after a strong upward trend, a new
bearish trend is likely gathering momentum. On the flip side, if the crossover
occurs after a definite downward trend, it signals a possible bullish trend on
the horizon.
The 50-day and 200-day SMMA indicators are the most common
periods in use here. These are also known as the golden cross and
death crosses. It’s a golden cross when the two SMMA lines make a bullish
crossover. And it’s a death cross when the lines form a bearish crossover.
Current Price Concept
In this trading approach, you’re looking at the current
price and comparing it to the SMMA indicator line. If you’re just starting your
trading day and are looking for great entry points, this strategy can help you
make an informed choice.
If the asset’s current price is trending above the SMMA
line, it’s a signal to buy. When it goes down below the SMMA line, you exit the
position. The reverse is the case when in a short position. You sell when the
current price goes below the SMMA line and exit the position when it
rises above it.
Setting Up the SMMA on Your Trading Chart
Simply find the SMMA indicator among the list of built-in
indicators and strategies on your trading platform. Click on it, and the moving
average line will appear on the chart. You can then edit its parameters based
on your analytical preferences.
Like all types of moving averages, it’s up to you to decide
the period for which to analyze. There is no standard recommended period.
That being said, most short-term traders typically calculate
averages over 14- and 28-day periods. Long-term traders tend to favor the 50,
100, and 200-day periods when plotting SMMA.
Smoothed Moving Average vs. Other Moving Averages
As you use smoothed moving averages for trading, it’s
important not to confuse it with other types of moving averages. Though they
all tend to follow similar trend directions, the kind of data they reveal can
be pretty different from one another. The primary reasons are the differences
between the weighting factor and the length of the average we’re analyzing.
To understand these variances better, let’s compare the SMMA
to the SMA and EMA.
SMMA vs. Simple Moving Average
The most significant difference between an SMMA and an SMA
is the time frame involved when calculating the moving average. An SMA
generally uses a shorter period when generating the average.
One of the most significant drawbacks of this approach is
that with a short-term trendline comes the possibility for false signals. A
long-term trendline can provide a stronger signal, but there will be a lag.
Traders have to wait until the price action is confirmed
before making their moves in the market. In so doing, they might miss out on
some prime trading opportunities when the trend began. The SMMA helps
avoid this issue by covering an extended period, thereby removing short-term
fluctuations. And because it is smoothed out, traders can easily view the
trend.
SMMA vs. Exponential Moving Average
The EMA is an advanced form of the SMA and can help traders
confirm the prevailing market trend much faster. The underlying reason is that
the EMA places more weight on recent data, making it more sensitive to changes
in price movements.
However, this sensitivity to recent volatility is also its
main drawback. For example, if the market experiences a sudden spike, the EMA
line will reflect that change. Suppose the trader is not using another
indicator to confirm the trend and the strength behind it. In that case, they
could act based on the false signal generated by the short-term volatility.
The smooth moving average helps prevent this because it also
considers past data in generating the average instead of emphasizing more on
recent data. It enables a more accurate and relevant average that is not easily
swayed by short-term volatility.
So, at the very least, consider using both the EMA and SMMA
when making trading decisions.
Final Thoughts
Becoming a successful trader requires you to understand how
to utilize technical indicators. Whether you’re just starting out or you’ve
been in the game for a while, the smoothed moving average is a tool that should
be in your trading arsenal.
For all its benefits, however, keep in mind that the SMMA
only works well under certain conditions in the market. These are upward and
downward trends. If the price is trending sideways, the SMMA can’t provide a
lot of valuable data. That’s why it’s important to mix it up and not stick to
only one tool. Some technical indicators that work well with the SMMA include
Bollinger Bands, Price Channels, and Stochastic Oscillator, to mention a few.
