One of the most popular, important and “easy to use” #technical indicators is the Simple Moving Average (SMA). This simple indicator can be used to tell you several things about the #coffeemarket, however, it has one very important and primary purpose: a simple moving average allows traders to define and identify the trend.
In this article, we will first cover why it is so popular, then we will define what the moving average is, what the logic is and how one can use it when looking at prices across markets, with a special focus on the #coffee C market.
Why is it used?
This indicator is tremendously popular, even among traders who don’t “believe” in #technicalanalysis because it is both easy to understand and provides rapid insight about price direction, support/resistance levels and momentum.
We’ll discuss how this is constructed and used shortly, but for some background, at Coffee Trading Academy we are an organization that provides both coffee trading research and training. This indicator (along with various others) is taught in detail on Day 3 of our Coffee Trader's Course where we cover Technical Analysis.
What is a Simple Moving Average?
The crux of a Simple Moving Average is that it is an “average” or arithmetic mean of a given set of prices that “moves” or follows prices over a specific period. If we are looking at a daily chart, this could be (for example), the previous 20, 50, 100, or 200 days.
A 20-day SMA would sum the prices from the previous 20 days and divide it by 20. Similarly, to calculate the 200-day SMA, we would sum the closing days of the past 200 days and divide the final result by 200.
If you want to be fancy about it, the formula is:
(Where A to the sub "n" is the price of the asset at period n, and n is the total number of market periods.)
That covers the Moving Average portion of the name, the “simple” part distinguishes this moving average from an Exponential Moving Average (EMA) which provides added weight to more recent days. We won’t cover the EMA in this article, but it is “faster” and is more reactive to price.
Although the formula is mathematical, there is a fair amount of subjectivity in moving averages of any kind. This is because the number of periods to be averaged is determined by the user.
Practically any charting software worth its salt will provide moving averages and offer the user the option to choose the interval (days, hours, weeks, etc) to take into account. The software will then draw the curve into the chart.
How can I use the SMA?
The SMA can be used in several ways when looking at price, but here are 3 important ones: 1) #trend, 2) #support and #resistance 3) #momentum.
Trend
When we plot SMA on a chart beside prices it takes the form of a line that tends to follow below or above prices. The price’s relation to the SMA determines whether it is in an uptrend or a downtrend. A #market is considered in an uptrend when price settles above the moving average, and in a downtrend when it settles below its SMA.
The exact moment when price crosses the SMA can therefore be used as a buy/sell signal for momentum traders. #Traders receive a buy signal when prices cross above the SMA, and a sell signal when prices cross below this same indicator. At its core, this is similar to how some momentum hedge funds trade.
Support and Resistance
Another way that the SMA can be used is as support and resistance levels. This has a certain logic to it.
Looking at an uptrend for example, if we define the uptrend as being above the SMA then it stands to reason that when price is at or near the SMA (but hasn’t crossed), it is “cheap” and therefore a good buy. Therefore traders will buy or “support” the market when it trades near those levels.
The opposite is of course true in a bear trend.
Momentum
The final way that we can look at the SMA is as an indicator of momentum. Momentum is analogous to the rate of change of prices. The moving average serves toi smooth out price action over the given period. If the rate of change (or momentum) is very high there will be a very steeply angled moving average. If the rate of change is slow, then it will be a low angled moving average line.
All of these different methods beg the question of which moving average period to use.
This depends on our focus. Are we interested in monitoring a shorter or a longer term trend?
In general, there is an inverse relationship between how soon the moving average gives you a signal, and how reliable the signal. The longer time period will tend to reflect bigger, more lasting trends, but will only give signals rarely. A 200-day moving average will reflect long term trends, while a 20-day SMA will be more suited to rapid signals of short-term movements.
This is also why using multiple SMAs can be useful. In the example above, we are looking at a 6-month time range, and each candle represents a day.
The 20-day SMA is being used to monitor price trend in the short term. So the focus here is to have an overview of the horizon of days and weeks. Notice how the shorter periods track prices more closely.
On the longer term 200-day SMA, we get very few signals and prices are much further from the average.
This makes sense in a trending market. Since prices are in an uptrend, the average of many days will include much lower prices and will therefore be much below the market. In a sideways market all of the moving averages (short and long) tend to move sideways together as the averages include many prices that are similar.
In the example above, although the 20-day SMA oscillates between buy and sell mode in the short term, the long term remains bullish, suggesting that the market is volatile, but in a very strong uptrend.
Moving Average Cross
Using multiple moving averages together, can actually be used as a way to generate buy and sell signals. Instead of comparing when prices cross the moving average, we look at when the moving averages cross each other. In this case, we often refer to the shorter moving average as the “fast” line and the longer-term moving average as the “slow” line.
Combining the two moving averages to generate a signal provides us with more control as to when we generate signals.
In the example above, the uptrend is confirmed with a bullish crossover that occurs when the fast 20 day SMA crosses above the slow 200 day SMA.
Conversely, downward momentum would be confirmed by a bearish crossover, which be when the a fast SMA crosses below slow SMA.
Simple Moving Average’s Limitations
Keep in mind that there are a lot of limitations to using technical analysis, to include SMAs. If there was a “magic bullet” that always worked, we wouldn’t bother learning anything else about the market!
Two of the key disadvantages of using Moving Average are its simplicity and its subjective flexibility.
The simplicity of this tool means that anyone can have an opinion on the coffee market (or any market) with the click of a mouse button. This is great, but not all opinions are created equal. Having this simple tool at our disposal is a great way to have a first opinion on a market like coffee and to make some objective observations about short- and long-term trend.
However, keep in mind that trend-following is, by definition, a lagging indicator. It is based on information already widely known, and as we mentioned above, the faster the signal, the less reliable it is.
The second issue here is the subjectivity of selecting periods. It is tempting to cherry pick a moving average that confirms our already held assumptions about a market. We can also add so many moving averages to a chart that they start to become meaningless. Be thoughtful about which moving averages to includes and it is helpful to be consistent across markets.
Final thoughts on SMAs and the Coffee Market
Being able to identify trends and momentum is very valuable in the coffee market and having moving averages is a great tool to facilitate that. It provides rapid insight in a simple way.
When looking at this tool for coffee in particular, there are two things I would point out. #1 coffee is a trending market. Our little market can consolidate and move sideways if supply and demand is not very static, and people tend to be comfortable with knowledge about the future. However, this is the exception rather than the rule.
Coffee is a biannual crop that tends toward alternating surplus/deficit years. These are accentuated and punctuated by weather shocks that can require large repricing to attract the supply or demand necessary to bring prices back into equilibrium. Having SMAs will help us to observe and catch these trends.
#2 Keep in mind the timeframes of coffee. Coffee is an annual crop with two growing seasons (North and South of the equator).
Therefore, we want our moving averages to be long enough to filter out the day-to-day noise, but short enough to give us adequate warning. Personally, I like to look at the 20 day and 200 days, but feel free to play around with these periods to see what is most useful for you.
Thank for reading and let us know what technical indicators you find particularly useful for the coffee market!