Moving averages are one of the most common indicators traders use to analyze the market.
There are different trading strategies you can create with the moving average indicator, but in this post, we will discuss the moving average crossover trading strategy.
First, let's understand the indicator.
What is the moving average?
The moving average is a technical indicator that continuously calculates the n-period average price of a security and plots it as a line on the price chart.
For example, a 10-period moving average will calculate the average close price over the last 10 candles and plot the line as the price moves.
The moving average indicator is usually built into all trading platforms.
There are different types:
-Simple moving average (SMA)
- Exponential moving average (EMA)
- Linear-weighted moving average (LWMA)
- Smoothed moving average (SMMA).
But the common ones are the SMA and EMA.
What are moving averages used for?
To identify a trend
Moving averages are mainly used to identify the trend of the market:
If the price is trading above the moving average and the moving average is sloped upwards, we can say that the price is in an uptrend.
Let me give you an example with the chart below :
As you can see, the moving average line slopes upward, and the price is above the moving average.
Clearly, the trend is bullish. So, we look for only buying opportunities because buyers are in control of the market.
On the other hand, if the price is below the moving average and the moving average is sloped downwards, the market is said to be in a downtrend.
See the chart below:
As you can see in the above chart, the moving average line slopes downward, and the price is below it.
Obviously, the trend is bearish, so we look for selling opportunities since sellers are in control of the market.
Finally, if the price is moving around the moving average and the moving average is flat, we can conclude that the market is in a range (moving sideways).
See the chart below :
As you can see in the chart above, the moving average is flat, and the price is moving around it.
So, it’s pretty clear that the market is ranging.
A ranging market means that buyers and sellers are in a sort of equilibrium, so no group is in control of the market.
In this market condition, you can either trade using ranging market strategies or avoid trading if you are a trend follower.
To identify potential support and resistance levels
A moving average often acts as a dynamic area of support and resistance.
For instance : in an uptrend, when the price makes pullbacks, it often finds support at the moving average and bounces upwards.
Look at the example below:
As you can see in the above chart, whenever the price reached the 20-period moving average, it bounced off, showing that the moving average was acting as a dynamic support level.
Similarly, in a downtrend, we can often see that the price encounters resistance when it pulls back to the moving average.
See an example in the chart below:
As you can see, the 20-period moving average was acting as a dynamic resistance level:
whenever the price rallies to the moving average, it reverses to continue the downtrend.
Therefore, the moving average indicator can help us in catching pullbacks in a trending market.
Using multiple moving averages
When using more than one moving average on a chart, each one will indicate a different trend in the market.
A long-period moving average will indicate a long-term trend, while a short-period moving average will indicate a short-term trend.
See an example below:
As you can see in the chart above, the 200-period moving average shows the long-term trend of the market ; the 50-period moving average shows the medium-term trend of the market; and lastly, the 20-period moving average shows the short-term trend of the market.
Generally, using two or more moving averages helps you to get a broader idea of the market structure and market trend.
Moving Average Trading Strategy
There are different ways you can use moving average indicators to create a trading strategy.
You can use it in combination with other indicators and tools to confirm your entries or use it alone to create a strategy that can find high probability entry and exit points in the market.
In this post, I will share with you a simple and profitable moving average trading strategy called, “The moving average crossover trading strategy.”
So, what is the strategy all about?
The Moving Average Crossover Strategy
The moving average crossover strategy makes use of two moving averages and gives a signal when the faster (smaller-period) moving average crosses the slower (longer-period) moving average.
For this trading strategy, we will use these two moving averages :
-The 20-period simple moving average
-The 50-period simple moving average
When the 20-period simple moving average crosses above the 50 simple moving average, we have a buy signal as it means that the market is about to start a new uptrend.
So, it would be appropriate for us to take a buy position.
Look at the chart example below:
As you can see in the chart, when the 20 simple moving average crossed above the 50 simple moving average (golden cross), we had a good buying opportunity.
We would hold on to this buy trade until the 20 simple moving average crosses back below the 50 simple moving average, and when this happens, we would close our buy trade on the corresponding candle.
Let me give you an example with the chart below :
As you can see, when the 20 simple moving average crossed back below the 50 simple moving average, the trend changed direction. So, it was a perfect time to close our trade.
In fact, in the right market situation, when the 20 SMA crosses below the 50 SMA, it is a good signal to take a sell position. See an example in the chart below:
Obviously, the dead cross (faster moving average crossing below the slower moving average), was a good signal to sell.
If we had placed a sell trade, we would hold it until the 20 SMA crosses back above the 50 SMA.
Then, we would close our sell position on the corresponding candle.
See that same chart again below:
Of course, this kind of strategy seems almost too good to be true.
In my opinion, trading the moving average crossover in this way may not be always an effective strategy because blindly taking every crossover signal the strategy provides will likely result in more losses than wins.
But luckily, there are a few changes we can make to greatly improve the strategy and reduce the number of losses.
As you would expect, the first major problem with this strategy is that it tends to perform well only in a trending market.
When we have a non-trending market (a market that is moving mostly sideways), the moving averages will tend to generate many false signals, as you can see in the chart below :
Notice that we have four crossovers’ signals on that chart.
If you take every moving average crossover during this kind of market condition, you will certainly have multiple losses in a row before finding a winning trade.
As you can see, if not traded during the right market condition, this strategy can blow up your entire trading account, which is why I recommend you to wait for suitable market conditions before using this strategy.
So, how do you identify the market condition to avoid the strategy and one to trade the strategy ? Here’s what to do :
Once you've identified that the market is not trending and is stuck in a range, draw the support and resistance levels at the boundaries of the range.
Look at the example below :
We have a level of support at the lower boundary of the range and a level of resistance at the upper boundary.
Once these levels are drawn, ignore all crossover signals that form inside of these boundaries because they are more likely to be false signals.
That's not to say you can't trade a ranging market using a different strategy, but you should ignore the moving average crossovers until the price can break above resistance or below support.
See an example in the chart below:
As you can see in the chart example above, we had three false signals that we ignored because they happened inside the range, but the last signal was a valid one because it happened after the breakout of the support level.
The breakout of the support level indicated that the market was no longer in a range and was headed downward.
Now comes the question : how do you enter this trade?
Well, you can enter your trade at the close of the candle that made the breakout and place a stop loss a little bit far away from the support level.
The profit target should be at least a 2:1 reward to risk ratio.
See the chart again below:
As you can see in the chart above, the breakout of the support level confirmed the crossover signal that happened inside the range.
To enter the trade, you just need to identify the candle that made the breakout and enter at the close of it.
The profit target should be placed at the next support level, but if there is no support level, you can calculate a 2: 1 reward/risk ratio and take your profits at that point.
The stop loss should be placed above the support level or a little far away from it.
Let’s look at another example below:
In this NZD/USD H1 chart above, the market was ranging, so the right thing was to ignore all moving average crossovers that occurred inside the range.
But as you can see, there was a moving average crossover inside the range.
This was a clear sell signal.
What should you do in this case?
You should simply wait for the breakout of the support level, as that will confirm the sell signal provided by the moving average crossover.
Now, take a look at the chart again below:
You can see that the breakout of the support level confirmed that the moving average crossover signal is valid.
So, we can take our trade by placing an entry order at the close of the candle that made the breakout.
Two important things you must always keep in mind about this strategy :
1-Don’t trade moving average crossovers that occur inside the range; always wait for the breakout of the range.
2-Don’t trade moving average crossovers on lower timeframes, because the strategy fails when it is used on the 5 or 15 minutes timeframe.
In this post, I have shown you the moving average crossover strategy and how you can filter the signal so that you take only trades with a high probability of success.
You can learn more profitable trading strategies from our free Telegram channel where we interact and share more knowledge. I also give out 2 to 3 live Forex signals per week for free in that channel.