A simple moving average (SMA) is a popular, easy to use technical - it is the average value of the price of a stock, over 15, 50, 100 or 200 days. To calculate a 15-day moving average, one has to add up the closing prices of the stock over all the past 15 days and divide it by 15. These technicals are readily available on online charts.
The SMA comes in two kinds - the short term or the long term. You can compare the stock over its short term (15, 30 or 50 day) performance or its long term (100 or 200 day) performance (see SMA screeners).
Why is this useful?
The SMA tells you for instance, if the stock’s current price is too cheap or expensive - if the price is above or below its average. And the interesting thing about these kinds of technical indicators is that if a lot of people are using the same technical strategies to invest, they become self-fulfilling, because everyone considers them important.
How does looking at technicals compare to fundamentals? Some investors insist that looking at technicals for investing is superficial, and that the real value of investing can only be realized if you are looking at company quality, not just the market roller-coaster.
The upside of technical indicators
The effect of fundamentals can stretch over a long period of time. Often, a cheap but promising stock may continue falling in price after you buy it, before fundamentals catch up to the price. Or a rising stock which has given enough profit can continue to rise beyond our expectations, before it peaks. Technical analysis therefore acts as an additional filter after you have looked at the fundamentals, allowing you to pick the right buy or sell price.
Looking at the tech indicators can therefore make you more disciplined in your exit and entry strategies and take the ‘gut feel’ out of your decision making.
Coming back to the Simple Moving Average
The moving average ticks all the right boxes: it is a simple technical tool, very easy to follow. It shows you a readable +positive or negative trend, especially when tracked for days at a time. And it is the most commonly used metric.
Using the SMA to find a bullish or bearish stock
There are two kinds of strategies that can be used to find a bullish or bearish stock, which I’m illustrating here with examples:
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Crossover strategy 1: When the price of a stock crosses an SMA:
If the price of stock is above the moving average over a time period, the stock is trending up, and if the stock price is below the SMA over a time period, the stock is trending down. A stock above the SMA200 means that the stock now has a price that is above its yearly average, and is over-performing its long term average. A stock above its SMA30 is outperforming from a short term perspective.
A significant ‘crossover’ happens when a stock price has gone above or below a longer time period SMA. This may be a trigger point to buy or sell a stock you have already been planning to buy/sell after looking at the fundamentals. For example, Mahindra & Mahindra fell below its 200 SMA on October 17, and it has been trading around or below the 200 day SMA since (Chart 1). While the fundamentals for the stock are good, Chairman Anand Mahindra said on October 15 that the firm may be divesting its stakes in key listed companies. Investors may have grown cautious with the stock until the company clarifies its next move.
Chart 1: Mahindra and Mahindra moves below its 200 day SMA
2) Crossover strategy 2: When an SMA crosses other SMAs:
Another strategy for identifying exit and entry points for a stock is to add two SMA lines to a stock chart, one longer and one shorter. When the shorter MA crosses above the longer term MA it indicates the trend for the stock is shifting up, on strong positives.This is known as a "golden cross".
If you hold ICICI Bank in your portfolio, for example, it’s interesting to note that the SMA50 line of the stock crossed above the SMA200 line on 20 July - a Golden Cross - and has been trending upwards since (see Chart 2).
Chart 2: Golden cross for ICICI Bank stock
When the shorter SMA crosses below the longer term SMA, it's a sell signal as it indicates the trend for the stock is shifting down. This is known as the "death cross". Bharti Airtel for example, which is facing stiff competition from Reliance Jio for market share since September this year, saw a death cross for the stock - the SMA50 line crossed below SMA200 - on October 4. It’s been trending downward since (Chart 3)
Chart 3: Death cross for Bharti Airtel stock
A couple of cautions: Moving Averages are calculated on historical data, and the calculation is not predictive. Bharti Airtel stock may for example, quickly recover on aggressive company moves. In a turbulent market or industry, the SMAs swing back and forth. Still, they are a good gauge of market sentiment and overall trend for a stock.
Keep in mind the magic number in trading: Trading strategies based on technical and fundamental trends can give you a 40% average success rate, and it’s unlikely to go higher than that with the exception of the rare lucky periods that every investor knows and remembers forever.
