Sma and the Trend
In my last article - Do you know the trend ? - i talked about the famous words "The trend is your friend" and why we see this words everywhere. In there, i talked about determining the trend using trend lines. But there are several ways to determine if we are in presence of one trend or not and with trend lines we can get easily false breakouts (price crossing the trend line). We can see that in image 2 taking as reference the pink line there. With this breakouts we may think about trend change but don't is what happens. In this article i'm talking about using a indicator (well, to be correct, same indicator three times) to help us in trend determination. The indicator we are going to use is the SMA - Simple Moving Average.
What is SMA ?
SMA refers to "Simple Moving Average" and is one of the simplest "Moving Averages". "Moving averages" are one way to "smooth" the price action (price flow) along the time. This "Moving averages" can be of two major types: Simple and Exponential. In "Simple Moving Average" - SMA - we use the price as is without modifications for a determined number of periods (can be one of Open price, Low price, Higher price or Close price of each period). On Exponential Moving Average - EMA - the more recent one type (as refered before) prices in the number of periods considered are changed to take more weight, and the latest less weight. But we must stick with the theme, and in this case is with SMA. It's easy to calculate the SMA value. SMA is calculated adding each of the prices of X periods and after divide the result by X. We can see in next image the formula for SMA and example of it's calculation.
Image 1: SMA formula and example of calculation for 5 periods (SMA 5).
The setup for trend determination.
For this setup that can be applied to all time frames we use:
- SMA with period 30 applied to close price - green color
- SMA with period 50 applied to close price - red color
- SMA with period 100 applied to close price - blue color
Of course you can use other settings you think more adequate for your setup. One frequent SMA used is SMA(200) and we find it in a great number of analyses out there. With this setup we can determine if we are in presence of a trend, its strenght and the end of it.. In the following image we see a "downtrend" where the prices are getting low and low.
Image 2: Downtrend with 3 SMA lines, some rules and indications present in image are explained below
To consider that we are in presence of a healthy trend, the following conditions must meet:
- all SMA lines are in order
- all SMA lines are pointing the same direction
- all SMA lines are parallel whithout crossing over
- price remains on correct side of 50 SMA
- price never stays near 100 SMA (B area)
- Price swings gets out of 30/50 SMA area (A area)
1- taking the price bar as point of reference, the first line near the bar (except in cases were the price bar crosses the lines) must be the lower SMA, followed by middle SMA and far away the greatest SMA.
2- All three SMA lines must be pointing the same direction. That means up for uptrend and down for downtrend.
3- All SMA lines are parallel without crossover. May occur lower SMA touch middle SMA, but never occur a cross between them by the rule, but i have see some short crosses without meaning the end of the trend.
4- Price bars must be bellow middle SMA for downtrend or above for uptrend. Price bar staying in the A area or crossing of middle SMA line in one way and back next one or two bar don't mean the loss of strenght of trend.
5- Price never stays near the higher SMA, and never stays in B area.
6- Price bars can stay in A area, but not for long, only as a result of a swing.
Trading the trend
If all of this conditions meet, we are in presence of a strong and healthy trend, and as usual we can take benefit of it. Also we can use this setup if we are on a healthy trend to trigger entries for trades. This entry points are indicated by green arrows in image 2 and 3. We can setup SL (Stop Loss) near (in B area if we are conservative) or after higher SMA (more agressive). We can also setup TP (Take Profit). The greater the angle of SMA lines(taking a horizontal line as reference), the greater that TP can be because the trend is moving more quickly. If we are in presence of a consolidated trend we can also setup a TS (Trailing Stop). TS is a exit point for the trade if the price goes against our trade in a predefined percentage or pips. This stop changes if the price goes in our favor on direction of the trade, but don't change the value if price goes against our trade. If the price goes this percentage or pips against or trade, we get out of this trade with the profits at that moment. That way we can benefit of all trend after entry point till the end of it where a reversal in price or trend occurs and the TS is triggered.
Image 3: Uptrend with 3 SMA lines and it's exaustion and reversal. Some rules and indications are explained below.
Trend exaustion or reversal
If any of the conditions referred before is no longer true we can be in presence of trend exaustion (the prices are getting "sideways") or trend reversal (the prices taking a diferent direction). The signals are:
- the price bars keep crossing middle SMA more than two bars.
- the price bar stays in B area (1 on last image).
- the lower SMA line indicates other direcction (2 on last image).
- the SMA lines crosses one another - as expected lower SMA with middle SMA first (3 on last image)
- price bar crosses higher SMA
- the SMA lines are getting flat losing their angle.
You can also check higher time frames to confirm the exaustion or reversal of the trend with same SMA setup. It's possible with that way to avoid some "false breakouts" as the trend can get back in it's flow.
When any of this happens, that's time to "get out" if we have trades running and get the possible profit.
Remember that SMA indicator is a lagging indicator that reflects past average price actions. Don't forget, as always, to trade with SL to avoid fast price moves against your trade.
The great the period we consider for SMA, if we are using one line in the main chart to represent it, the far way this line stays taking as reference the price bars if the price flow is in a trend. Also, with greatest SMA periods, greatest the time to this line to reflect price action changes. Price bars crossing SMA lines means at least we are in presence of trend end, we don't be in a presence of a trend or in presence of new trend beginning.
If your trading style is "trend following" next image maybe represents your nightmare. :)
Image 4: Sideways trend or price bouncing
In current times with great volatility and instable economy it's hard to find a great trend as we can find in some years before the end of 2008. In that times is easy to follow the trend. Now we need to work with lower time frames to see them. Hard times for currency traders.
I hope you find any usefull information in this article. Please comment your toughts or opinions as they can be important to our community.
Trade well and good luck.
Final note: I want to express my gratitude to all community members who made possible my classification on last month contest. Also i want to thank to Dukascopy Contest Team for the kind words on review and of course their classification. I'm expecting to be on top 10 but not in first place. Once again, thankyou!