Moving average crossover strategies
Moving averages are typically one of the most popular indicators for technical analysts. How can crossovers provide traders with opportunities in the market?
Moving averages are often the first technical indicator traders will utilise when they set out attempting to understand how to trade. However, it is notable that those averages often remain relevant to highly competent traders, who have experience and knowledge of many additional tools. That highlights the importance these averages can play in the realm of technical analysis, with traders across the spectrum utilising them on a regular basis.
Types of moving average crossovers
Moving averages can be utilised in a number of manners, from providing support and resistance, to indicating potential turning points around crossovers. Each trader will have their own favourite averages, yet it is worthwhile noting two groups of averages: long-term and short-term.
Long-term moving averages
Long-term averages (eg 50, 100 and 200) are slow moving, providing less sensitivity to short-term price action than their short-term counterparts. Those long-term averages will typically provide fewer signals in any method of use, yet that relative rarity can also raise the perceived importance of those signals. Owing to the slow nature of these moving averages, there is a risk that signals can be relatively lagging in comparison to the short-term averages.
Short-term moving averages
Conversely, the shorter-term moving averages (eg 5, 10, 20, and 50) can provide a trader with a more active indicator, with recent price action providing a significantly greater. Signals are much more frequent, with the reactive nature of these averages meaning that signals can be timelier than the long-term moving averages. However, with more signals and reactive movement there can be a greater number of false signals.
When utilising a moving average crossover strategy, the key is to look at the shorter, more reactive average as a guide of what direction the market could be turning. It is worth noting that crossover strategies are typically more useful within a trending market, with sideways trade expected to bring buy and sell signals with little end product.
When it comes to choosing which moving averages to utilise, traders will undoubtably want to find the magic numbers that will somehow provide the consistent trade strategy that the others do not have. However, it is not the case that the more obscure combination is the best method, for this reduces the self-fulfilling element of this trading strategy.
Golden cross and death cross
Long-term moving average crossovers can often be labelled ‘golden’ and ‘death’ crosses, depending on whether they have bullish or bearish connotations. Let’s take a look at the death cross, with a 100 and 200 simple moving average (SMA) strategy.
This 100/200 combination highlights the strengths and weaknesses of a longer-term SMA crossover strategy. The USD/CNH chart below highlights this strategy perfectly, with the long-term nature of these moving averages ensuring that signals are few and far between. There are just two on this daily chart, which covers almost two years. Nonetheless, the lack of frequency ensures that there are less false signals.
The left crossover has seen the shorter 100 SMA break below the longer 200 SMA line, providing us with a sell signal. On this occasion we have seen it provide a great reversal signal, with the pair deteriorating heavily for the ten months that followed. However, the second crossover proves less successful, with the price having already moved sharply higher before the buy signal was produced.
This highlights the somewhat lagging nature evident with this type of strategy. If a trader was to await the opposite crossover to exit their first position, they would have given up most of their initial winnings.
Trading is often about learning from losers rather than only focusing on your winners. Thus, this example is useful as it can show you different strategies that can be used to mitigate such type of events. Firstly, when we are looking at the exit from position one, a trade could have utilised either the 100- or 200-day SMA as a dynamic stop-loss. A break through either of these major moving averages holds significant value aside from the crossover, and thus such a strategy could lock in profits earlier.
Secondly, looking at the two trade entry points, it is useful to see what makes one more successful than the other. The issue with the second entry is that the price had already moved significantly higher by the point of the breakout, raising the risk that the entry is too late. Thus there has to be some form of element which considers what stage of the market reversal we are within.
Generally, the further away from the 100-day SMA the current price is, the more the price is travelling at a faster-than-average pace. As such, entries where price is a substantial distance from either of these long-term moving averages could raise the risk of a late entry.
Short timeframe crossover signals
Next, let’s look at the strengths and weaknesses of a strategy based on short-term moving averages. The example we use below is the 10- and 20-day SMA on the same USD/CNH chart. This provides us with a very different type of trade signal, with the two moving averages tracking the price action much more closely. This provides us with a substantially higher number of trades, yet that also brings a higher number of false signals.
The sensitive nature of this form of crossover means that they typically do not operate well in a sideways environment, which generally provides a raft of unprofitable buy and sell signals. However, with that weakness comes the benefit of a significantly timelier signal when things do work out. Thus, it is easy to break down this chart into different phases, with the trending phase providing particularly profitable, while the consolidation phases prove particularly unprofitable.
Unlike the longer-term SMA crosses, the sensitive nature of this form of crossover allows for a timelier exit signal. Thus, profitable trades can be exited in a manner than can lock in profits to a greater extent than the long-term strategies.
Looking at how we could make this type of strategy profitable, the key here is being able to differentiate between the trending and consolidation phases. The main method we can utilise in this example is looking at the price action as the key gauge of whether we are within or breaking from a consolidation phase. The consolidation phase tends to provide us with peaks and troughs that differ from the typical lower highs and lower lows seen within a downtrend.
Thus, when we see the consolidation phase in the middle, none of the bullish crossovers are joined by higher highs in price. Nor are the bearish crossovers accompanied by a lower low in price. With that in mind, the bearish signal only finally comes once the price breaks through support at ¥6.5683. This ability to marry up the price action with the signals of a shorter-term moving average crossover strategy provides a trader with greater accuracy and less false trading signals.
Alternate forms of moving averages
When looking at other potential crossover strategies, it is important to note that not all moving averages are made equal. While we have been looking at the simple moving average, the use of alternate averages can provide another approach to this technique. One such average is the exponential moving average (EMA), which gives a stronger weighting to more recent candles in comparison to those further back. As such, this will provide a more sensitive and dynamic signal compared with the SMA.
Three moving average strategy
Sticking with the EMA, the utilisation of multiple averages can provide us with a good mix of the long- and short-term moving average strategies. For a trending market, we should see these averages line up where the shorter moving average is closest to the price, and longer average is furthest away.
Taking any other combination as a signal that we are in consolidation phase, it means that we could utilise an EMA (more dynamic and relevant) in a manner which also allows for both short- and long-term elements to the trading strategy. Once again, it also makes sense to incorporate an element of price action into this triple EMA crossover strategy.
This information has been prepared by IG, a trading name of IG Markets Limited. In addition to the disclaimer below, the material on this page does not contain a record of our trading prices, or an offer of, or solicitation for, a transaction in any financial instrument. IG accepts no responsibility for any use that may be made of these comments and for any consequences that result. No representation or warranty is given as to the accuracy or completeness of this information. Consequently any person acting on it does so entirely at their own risk. Any research provided does not have regard to the specific investment objectives, financial situation and needs of any specific person who may receive it. It has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such is considered to be a marketing communication. Although we are not specifically constrained from dealing ahead of our recommendations we do not seek to take advantage of them before they are provided to our clients.