The 20 simple moving average (SMA) is a cornerstone of technical analysis, a versatile tool used by traders across various markets and timeframes.
What is a Simple Moving Average?
At its core, a simple moving average calculates the average price of an asset over a specified period.
Determining Trend
Moving averages are used to determine trend and as I mentioned before major institutions watch the 20 SMA. Markets can only trade three ways and that is up, down, and sideways. When using the the 20 SMA always trade directional and go with the trend. However be strategic and have a plan and what I mean by this is don't just enter anywhere. You will also want to manage risk as well knowing how much you will lose if you are wrong before getting into the trade. Risk management and knowing you risk/reward relationship and win rate needed is the most import thing you can measure before placing any trade. For now we will just be talking about buying shares at their normal price and setting an ideal stop in case you are wrong. Another note I want to point out before moving forward is that you want price to be above the 200 SMA as most institutions consider this also. My charts have a 20 SMA, 200 SMA and volume. For bullish trades I like the 20 SMA to be rising with price above the 200 SMA. While for Bearish trades I like for the 20 SMA to be below the 200 SMA and falling.
Rising 20 SMA
The easiest way to trade the 20 SMA is when it is rising and the stock is bullish. What you want to do is look to enter near the 20 when you see a green candle take out a red candle. Look to enter near the 20 SMA when the stock pulls back. Keep a close eye on the price action near the 20 SMA because in a strong uptrend price should bounce off of it. Look at the chart below of VRSN and notice where I placed the blue arrows. Look what happen when the last red candle is taken out by a green candle and notice how the 20 SMA kept rising with it with good volume below showing institutions are buying the stock.
Sideways 20 SMA
When the stock is moving sideways it is not of much use but you can keep an eye on it in case a transition from a sideways trend to uptrend is happening. What will happen is you will see the stock trading in a range creating support and resistance levels or creating a base. Keep in mind the stock has already risen in price and took a moment to stop and consolidate. While in consolidation you will see price get back above the 20 SMA and you will see price respect the 20. There are two ways to trade it and neither is a right or wrong way. The two ways are anticipation or confirmation and with anticipation you have to be correct in your timing. With confirmation you will have a break above the base that was built while the stock was consolidating. Also with confirmation you will see a uptick in volume. Look at the previous example with VRSN. Look where I place the first and you can see how the stock transition from a sideways trend to a uptrend. Now see how the price broke above the resistance level on strong volume and notice how it pulled back to the 20 SMA. You could have anticipated by entering on the candle before the breakout because price respected the 20 SMA. However it is best to wait for confirmation and catch it on a pullback where I placed the first blue arrow. Look at the chart below on QBTS after it started to consolidate. Notice the breakout on the low handle with a nice amount of volume. This is where I would enter because it happened near the 20 SMA.
Falling 20 SMA
A couple of things you can do with the falling 20 SMA is which is you can short near the moving average or you can short on a break down. When entering near the 20 SMA you are anticipating that the price will continue to fall. In the AMD chart below take a look at the blue arrows as you see the 20 SMA falling while price is below the 200 SMA. While I will not go into detail about shorting the stock I will mention this is where you can do it if you have the experience or you can buy a put option if you have the knowledge in trading options. In the picture below you can see a clear downtrend an notice where the blue arrow are placed you will see price break down and continue the downtrend after each attempt to rally. Lastly, notice how red candles took out green candles near the 20 SMA.
Breakouts and Pullbacks
For breakouts and pullbacks there are a couple of things I want to mention as regard to the 20 SMA. A breakout occurs when price breaks above a key resistance level just like I pointed out in the examples above. When it happens off the 20 SMA you are more than likely in the right trade at the right time if you take a position. However the 20 SMA will probably moving sideways and you will notice an increase in volume. A breakout can occur away from the 20 SMA also and it's no right or wrong answer if you should enter a position or not. If you see a break above a resistance level away from the 20 SMA with volume its more than likely safe to enter but if you want to wait until the 20 SMA catches up that is fine also.
Support and Resistance
The 20 SMA can be used to determine support and resistance in a strong uptrend. However you can use horizontal support and resistance by just looking at price on the chart. If the price of the stock found support at a certain price level you can enter but that is not how I use the 20 SMA. As I mentioned earlier, moving averages are used to determine trend and they can act as support in an uptrend and resistance in a downtrend.
Entries and Exits
We have all heard to old market axiom that time in the market beats timing the market. While this is true for investors that hold positions for the long term it is also true you can time the market to make profits. It is not easy doing this because it takes a level of study and practicing to get good at it. While using the 20 SMA you have two types of ways to enter a trade. You find a trade that is breaking out above a resistance level or you can enter on a pullback to the 20 SMA. Look for a pullback and maybe some basing. When you see a green candle take out a red candle with volume that your buy signal.
Breakout Entries
Not all breakout entries are the same and you will see some that happen right off of the 20 SMA and some that happen a nice way away from it. While you can enter both I'd prefer the 20 SMA be close to the price. Breakouts usually happen after a consolidation or basing period and breaks out above a resistance level. In the illustration below, forgive my bad drawing but notice the break above the blue line on high volume. This is where I would enter due to the confirmation it has given. While this is just a illustration the basing period can be longer and it can base below its previous high which I call a low handle. Look back at the QBTS chart for reference to a low handle.
Pullback Entries
When looking for a pullback entry you want to see price blast above the 20 SMA with a nice amount of volume and start to pullback on lower volume. Your entry is on a green candle that takes out a red candle on good volume near the 20 SMA. As seen in the illustration below, forgive my bad drawing once again but this what I look for on a pullback. I like to see price above and the 20 SMA above the 200 SMA also which puts the probabilities in my favor.
Risk Management
The most important section in this article which should have been mention first. If you are stating with a small account of you have a larger account. Your rules for risk is what keeps you trading and not losing all your capital. The rules I'm going to layout are pretty simple. Never risk more that 1-2% of your account of any given trade and apply the 8% rule when setting your stop. That meaning if the stock corrects 8% from where you entered it you are out with no questions asked. To get you capital allocation for your trade take you max loss per trade which should be 1-2% of your account and divide the dollar amount by 0.08 which is 8%. For example let's say you have a $10k account and you want to risk 1% on any given trade. 1% of 10k is $100. Take that $100 and divide by 0.08 and that will give you a capital allocation of $1,250.00. For your position size take your capital allocation and divide it by the price of the shares you are buying. Lets say the price is $10, that would mean you can only buy 125 shares. You then set your stop loss 8% below the $10 price which is $9.20. Summary below:
Risk: $100
Capital allocation: $100 ➗ 0.08 = $1,250
Share price $10
Position size: 125 shares
Stop loss : $10 ✖ 0.92 = 9.20
Now let's briefly speak on risk/reward and how you should exit. Using the 8% rule for your stop notice if you go up 8% you are up 1 times your risk and if you go up 16% you are up 2 times your risk. The general rule is to aim for 2:1 or 3:1 risk reward ratio. So in our trade example If you go up 3:1 you would earn $300 on this trade if you closed it at a 24% gain. To calculate your exit on on 3:1 take the price you entered and multiply it by 1.24 and you should get a price of $12.40 as shown in the example below:
Exit = $10 ✖ 1.24 = $12.40
If you are able to do this over and over again in you can grow a small account in a short period of time. Finding trades with the 20 SMA gives you high probability setups and puts you in the right trades at the right time.
Conclusion:
The 20 simple moving average is a valuable tool for traders of all experience levels. Its simplicity and effectiveness make it a reliable tool for identifying trends, spotting potential support and resistance levels, and generating trading signals. However, it's crucial to remember its limitations and use it in conjunction with price action, volume and a sound risk management strategy. By mastering the 20 SMA, traders can gain a deeper understanding of market dynamics and improve their trading performance. In my ebook I will go more in depth on using it with a proper risk management strategy which will be released soon and will be free. Thank you reading.
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