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Binary Options Trading Strategy: Simple Moving Average
If you have been wondering what a Simple Moving Average is, then you came to the right web page. Today we are going to explain to you the fundamentals behind the Moving Average and how it can be applied in trading. Then we are going to discuss an essential binary options trading strategy which involves the use of the Simple Moving Average.
What is a Simple Moving Average (SMA)?
The Simple Moving Average (SMA) is an on-chart curved line, which averages a certain amount of chart periods. In this manner, the Simple Moving Average is a relatively lagging indicator. This means that it needs more time in order to react to price moves.
This is how a 5-period Simple Moving Average looks on a chart:
This is the hourly chart of the EUR/USD. The blue curved line is a 5-period SMA. This means that the Simple Moving Average on the chart averages 5 periods in order to point a value in a certain moment. Each place on the SMA responds to a price level according to the Y Axis on the chart (the price scale on the right). This level is an average of the 5 previous candle levels.
The Simple Moving Average could be adjusted to average a certain amount of periods according to your will. Remember: The more periods you include in your SMA, the more distanced and smoother the line will be. Also, the lag will be bigger too.
Since you have a raw SMA picture in your mind, let’s now switch to a more detailed explanation.
Calculating the Simple Moving Average
Let’s take again a 5-period Simple Moving Average. Say that on the hourly chart for the last 5 periods, the EUR/USD price has been at 1.1100, 1.1110, 1.1120, 1.1130 and 1.1140. Let’s now average these with a simple mathematical calculation:
This is how the 5-period moving average formula looks like:
SMA5 = (n1 + n2 + n3 + n4 + n5) / #n
“n” refers to the respective period and “#n” is the number of periods involved. In this manner:
n1 = 1.1100
n2 = 1.1110
n3 = 1.1120
n4 = 1.1130
n5 = 1.1140
#n = 5, because we use a 5-period SMA and we average 5 periods.
Let’s now apply these values into the formula:
SMA5 = (1.1100 + 1.1110 + 1.1120 + 1.1130 + 1.1140) / 5
SMA5 = 5.5600 / 5
SMA5 = 1.1120
So, if the last five candlesticks on the EUR/USD chart are showing 1.1100, 1.1110, 1.1120, 1.1130 and 1.1140, our 5-period SMA will show a value of 1.1120. Not that hard, right?
The same applies for bigger period SMAs. If you use a 20-period SMA, the last 20 periods on the chart will be averaged the same way as with the 5-period SMA. In that case, the formula will look like this:
SMA20 = (n1 + n2 + n3 + n4 … + n18 + n19 + n20) / 20
For 50-period SMA, the formula will be:
SMA50 = (n1 + n2 + n3 + n4 … + n48 + n49 + n50) / 50
…and so on for as many periods you want!
Applying Simple Moving Average in Trading
You can apply a Simple Moving Average to every chart, which has a “time” axis measured by periods. This includes:
1) Forex Charts
2) Stock Charts
3) Commodity Charts
4) Index Charts
5) Bond Charts
Since the SMA is a lagging indicator which acts as a support or resistance, it is a very useful tool to confirm trends and reversals. If the price switches above your SMA, then you get a signal for an eventual bullish trend. If the price goes below your SMA, then a bearish trend might be on its way. The higher period your SMA is, the more accurate your signal will be. However, higher period SMAs put you in the market later, because the lag is bigger. Have a look at the image below:
This is the 30-minute chart of the Apple Inc. stock for Feb 10 – 25, 2016. We have included a 20-period SMA (blue) and we have marked all the signals it provides. Notice that in most of the times when the price switches through the SMA, we see a new trend coming. However, there are two false signals which can lure us into bad trades.
Simple Moving Average: A Trading Strategy That Works
The SMAs can be combined on the chart. Different period SMAs act with different “speed” on the chart. Higher period SMAs react slower to price action, while lower period SMAs react faster. This way, two Moving Averages on the chart would often cross and interact with each other. This is how traders generate signals. If our two SMAs cross upwards, we get a signal for a bullish trend. If the two SMAs cross downwards, we get a bearish signal. In this manner, we will buy when the two SMAs cross in bullish direction and we will sell when the two SMAs cross in bearish direction.
If you are getting confused, this image will make it all clear for you:
This is the H4 chart of the Gold for Sep 3 – Nov 3, 2015. The blue curved line is a 20-period SMA and the red curved line is a 50-period SMA. Notice that the blue 20-period SMA moves faster than the red 50-period SMA. This is so because it is a smaller period SMA and has less lag. Thus, this is the faster SMA on the chart.
The green circles show the moments where we open a new trade with closing the previous one. The black arrows show when the SMAs are tested as support or resistance.
The image shows 5 trades based on crossovers of our SMAs:
Trade 1: We sell when the two SMAs cross downwards. We hold until they cross in the opposite direction. We generate a profit equal to 1.12%.
Trade 2: With the closing of the first trade, we open a new trade, which is long (we buy). We exit the trade when the two SMAs cross downwards. We generate a profit of 0.96%.
Trade 3: With the closing of trade 2, we enter trade 3, which is short (we sell). We hold until the SMAs cross upwards. Unfortunately the signal is bad and we accumulate a loss of 1.66%.
Trade 4: Closing the losing trade, we enter a new long trade. We hold until a downward SMA crossover. We generate a profit of 1.37%.
So, if we have a bankroll of $1,000 leveraged by 1:100, we would have a buying power of $100,000. Let’s see what happens if we invest 5% of our buying power in each of these trades:
Bankroll: $1,000 / Buying Power: $100,000
Trade 1: Investing $5,000 (5%) and making a profit of 1.12% = $60
Bankroll: $1,060 / Buying Power: $106,000
Trade 2: Investing $5,300 (5%) and making a profit of 0.96% = $50.88
Bankroll: $1,110.80 / Buying Power: $111,080
Trade 3: Investing $5,554 (5%) and getting a loss of 1.66% = -$92.20
Bankroll: $1,018.60 / Buying Power: $101,860
Trade 4: Investing $5,093 (5%) and making a profit of 1.37% = $69.77
Total Profit: $88.37