Trading101
Article #1: How to use 200 SMA as Support and Resistance
If you have been in the trading world for a while now or if you are still a beginner making his first steps into this astonishing world filled with graphs, statistics, investments and much, much more, you probably have heard the term Moving Average. In this short guide, I would like to familiarise you with the advantages and disadvantages of using the moving average indicator and specifically the Moving Average with 200 periods setting.
First of all lets’ say a few words about what is a Moving Average and how it works. This is a widely used indicator in technical analysis. The indicator helps in filtering out the random moves on the market and is good to assess the current trend. The Moving Average is a lagging indicator which means that it is based on past prices. The indicator defines an average of the past closing prices of the candles on your graph and moves with it. For example, if you are using a Moving Average with a 10-period setting, the indicator will filter the last ten closing prices and will produce an average which will be the starting point. After that, with each candle, the indicator will create an average of the new candle and 9 candles back. As I stated the moving average is a good indicator that helps you define the current trend and also it can help you define support and resistance levels. But first lets’ examine how the Simple Moving Average (SMA) works mathematically and see the advantages and disadvantages of using it as a sole signal in your trading technique.
Mathematically the SMA is expressed by the following formula:
If we say that all the previous days are marked with N and each following day closing price is marked with Pm, Pm1 …. PmT the formula of how it is calculated can be expressed as follows:
Psma = Pm + Pm1 … + PmT / N
Just want to add here that the formula — Psma = Pm + Pm-1 … +Pm — (n-1) / N — represents the adding of one new candle each time, so the above formula is more simplified for a certain period of time, but still does the trick if you do not forget to remove one closing price from the start whenever you add a new closing price.
Lets’ give it an example so it would be better understandable:
We are using the 10 period SMA on the daily chart in our example:
- Day 1 closing price: 1
- Day 2 closing price: 2
- Day 3 closing price: 3
- Day 4 closing price: 4
- Day 5 closing price: 5
- Day 6 closing price: 6
- Day 7 closing price: 7
- Day 8 closing price: 8
- Day 9 closing price: 9
- Day 10 closing price: 10
So our first point for the SMA would be Psma = 1 + 2 + 3 + 4 + 5 + 6 + 7 + 8 + 9 + 10 / 10 = 55 / 10 = 5.5
Whenever a new daily closing price is added we continue with the same formula so if the closing price for Day 11 is 11, we add 11–10 at the end of the formula, but we still divide by 10 periods, without getting in to account the closing price of Day 1, or we get Psma = 2 + 3 + 4 + 5 + 6 + 7 + 8 + 9 + 10 + 11 / 10 = 65 / 10 = 6.5. This value would be the next point of the Moving Average. Add those points to the graph and connect them with a line and you should get something like this:
Of course, this is just a simple example and as you probably already know the market is not moving always in just one direction, but you got the point.
As you have probably guessed it is quite impossible to predict the next closing price using this indicator or it might be in theory, but this would most likely take years of research and an extremely in-depth understanding of mathematics, so lets’ just say it is impossible.
So what are the advantages and disadvantages of using the SMA in your trading strategy:
- Advantages:
- It can give you a better view on what the current trend is on the different time frames.
- You can adjust the period setting in a way to help you gain a better edge over the market according to your preferred trading style — short or long-term trading.
- It can be used to define previous turning points on the market and evaluating support and resistance levels.
- Disadvantages:
- The main disadvantage of the SMA indicator is that as a lagging indicator it gives you information about the market that is already there without giving you any certainty for the future price movements.
- It can not be used as a sole signal for entries, so I don’t recommend that, as it can lead to substantial losses in the long run.
Now lets’ see how you can use the SMA and especially the “200 period” SMA not only to define support and resistance but as a main support or resistance. First of all, I want to add here that the 200 SMA is best to be used on the higher time frames as it can give you better results in the long run. Any time frame from H4 up is a good time frame. You can experiment and use it on lower time frames, but the results might be fluctuating and not satisfying. Don’t say I did not warn you… Lets’ get it on with the examples and how the 200 SMA worked as a resistance and after that as a support.
- 200 SMA — Resistance:
In this case, you have to look for a spot where the 200 SMA is above the candles you see on the graph which confirms the current downtrend. Next thing you will have to wait for the price to form a correction reaching to the 200 SMA, it would be best if the price touches the Moving Average. This is the point where you will have to add a second confirmation signal so you can be sure that the 200 SMA will hold as a resistance level. This second signal can be some price action indication, candlestick formation or another indicator. After you have confirmed that the 200 SMA will hold as a resistance you are ready to step in on the market and open a trade. The safest approach would be to place your Stop Loss above the 200 SMA.
Example: EUR/USD — H4 Time frame
As you can see on the graph below after making a long downtrend the price retraced in a correction back to the 200 SMA and it actually tested it 3 times all of which resulted in a drop-down. From the beginning of the downtrend until the end of the last dropdown after a touch, 1 month of time has passed in which you could have bagged in the astonishing 524 pips in profit.
- 200 SMA — Support:
The 200 SMA can also be used as a support level. First of all, you will need a previous uptrend, after that a correction reaching down to the 200 SMA and touching it and third and I will repeat that again — The second source of confirmation! The rest is pretty much straightforward trading. Lets’ see an example:
Example: EUR/USD — H4 Time frame
In this case, we saw a huge move up followed by a few small corrections the last of which reached and touched the 200 SMA. After the touch, we witnessed a huge move up which took about 9 days to develop but brought a little bit over 300 pips in our pockets. Actually, the price continued going up and in the course of a little bit over 2 months it accumulated around 950 pips — now this is a good profit.
You can always use the 200 SMA as a confirmation of a breakout and continuation of the trend as you have probably already guessed, but I will leave this topic for the future. As you can see using the 200 SMA as a support or resistance level can be quite profitable, but you have to test your strategy first, before jumping in with any investments. The road to success in Forex is connected with a lot of back-testing and demo-testing! I am finishing this article with a reminder:
Never use the 200 SMA as a sole signal for entry!
ALWAYS USE A SECONDARY CONFIRMATION SIGNAL!
Disclaimer: This is not a proposition to trade or to invest. This is just an educational article. Any investments made based on this article and any losses are at your own risk.
Written by Ilian Iliev
08.03.2018
