In trading, a moving average is defined as a product of adding up the prices for a given interval and then dividing the sum by that interval.
Simple moving averages are effective for the analysis of trend and used extensively in algorithmic trading systems.
They are also appropriate for determining the support and resistance levels.
One can use a single moving average or combine a few different ones to plot on their charts.
By using faster, intermediate, and slower moving averages, one can observe the direction of the trend of from a different perspective.
Typical time periods for multiple moving averages vary and today’s charting packages allow to use any value for the interval.
Linearly weighted moving average is determined by using, for example, a seven-day interval and multiplying the close of the last bar by seven, multiplying the close of the previous bar by six, multiplying the close of the bar before that by five, and so on.
To calculate a weighted average that gives greater importance to the most recent data we need to add the sum of all seven bars and then divide by seven.
Exponential moving averages also are weighted to give more significance to the latest prices from current market context, with older prices becoming less important and eventually filtered out as time passes.
Numerous rules can be applied when using moving average in analysis.
Various intervals can be used, and, generally speaking, longer-term intervals will generate fewer trade signals than shorter-term ones.
We can use the high, low, or even the range of a given interval average in the moving average calculation, or, simply stick with the closing prices.
The most basic rules for moving averages?
Buy or sell signals can also occur when a fast moving average crosses over a slow.
This crossover tends to be much more meaningful if both moving averages have similar directional bias.
Known as a Golden Cross, a bullish or positive crossover occurs if both moving averages are moving up.
When both moving averages are moving down, bearish or negative crossover occurs, known as a Death Cross.
Those are two terms used to describe trend changes.
There are numerous moving average techniques, ranging from the simple to highly complicated trading systems based on crossovers or price breakouts.
But here’s very important facet about moving averages we need to keep in mind.
They do not perform satisfactory in choppy, volatile contexts or in markets that bound by a trading range.
In trading range conditions, long and short signals will be triggered every time the market fluctuates around the moving average lines.
Reacting to these signals would drain your account.
Before relying on moving averages, we have to keep in mind the fact that market spends most of its time moving from right to left and only a fraction of its time trending.
The bottom line is this.
We will require some filters to help us in figuring out which signals to take or fade.
The crossover of moving averages is one of such filters.
It involves the use of a faster moving average crossing a slower moving average to generate a signal.
When the faster average crosses the slower average from the bottom, a bullish signal is indicated.
When it falls through the slower average from the top, this would indicate further price weakness.
The idea behind this approach is that when the faster average price has dipped below the slower, the market participants are discounting the asset as bears mark down the price below long-term value.
The converse holds true if the slower moving average moves above the long-term average.
If the price action was nearing a prior extreme that represented a significant previous reversal point, this situation would require a watchful approach irrespective of the moving average picture.
After all, the moving average is a lagging indicator whereas a previous extreme presents a forewarning of probable heavy support or resistance.
When, due to declining market, a downside bearish crossover occurs and the faster average begins a period of being below the slower one, this calls for a closer look at all other aspects of the context and taking an appropriate action (e.g., exiting long positions, selling short, tightening stops, etc.).
There are numerous variations of this setup, and the traders test every possible combination of moving averages to increase their probability of success.
The real point where moving averages cross often occurs at the worst possible place to enter pricewise.
The dynamic of real time price action differs from the optical deception that shows up on the charts.
Those who are new to the trading will often observe a moving average crossover and conclude that the entry point is at the intersection of moving averages.
It is then assumed, based on how the market would often follow in the direction of the cross, that this approach performs extremely well.
Here’s the most important part.
In reality the two moving averages cross only after the price bar is completed.
If, for example, in the case of a bearish market the price bar is particularly steep, the actual point of entry is at the bottom of the bar, as opposed to at the point of the cross.
During the bullish trend the opposite dynamic occurs, forcing the trader buy the tops or to sell the bottoms.
This amounts to trend chasing as opposed to trend trading, a mistake that can frustrate inexperienced traders.
Following a strong breakout to the upside or a severe move to the downside, the market would pause and often retrace as scalpers cover their positions while others fish for tops or bottoms.
Applying the moving average crossover blindly would put one in a losing position right from the moment of entry, even though the trade ultimately may be correct.
The triple moving average crossover approach performs better by addressing the underlying weaknesses of the traditional methodology.
Different numbers can be used for short-term, intermediate and long-term moving averages, but the specific value inconsequential.
There is not much difference between a 15-period and a 16-period or even 20-period moving average, and focusing on periodicity is counterproductive.
The bottom line is this.
Their variability is insignificant, and trying to fine-tune the periodicity is nothing more than retrofitting of data.
The actual utility of the three-SMA filter is in the fact that it is measuring the short-term, the intermediate-term, and the long-term trend.
The underlying idea is that when the fast average is above the medium average and the medium average is above the slow average, the market is in an uptrend.
The reverse, with the medium below the slow average and the fast below the medium average, indicates that the market is in a downtrend.
For the most part the utility of this approach is as an analysis tool.
It can instantly and effectively tell us if market is in a trend, but it cannot ascertain whether that trend will continue.
The crossover method can also serve as a negative filter.
For example, we may choose to stay flat (not having any open positions) if there is any disagreement between the three moving averages.
If the medium average is above the slow but the fast average has dipped below the medium, the direction is ambiguous and we should look for additional data.
While simply waiting in these contexts, we can save ourselves from numerous bad entries acting only on the most consistent price patterns.
Put it another way.
For trend followers, this three-SMA approach provides a useful analytic tool to test their assumptions.
Moving averages are completely unbiased as an indicator as opposed to, say, channels, which can be plotted differently based on the individual choice of price points.
Although the three-SMA filter can be used as a trend detection tool only, there is one situation where it becomes fairly accurate trade trigger.
Trends tend to go through alternating stretches of low and high volatility.
Low volatility is usually characterized by consolidation, or simply sideways price movement.
High volatility, in comparison, is generally heavily directional, even though this is not always the case.
The transition from low volatility to high is often represented by a range expansion that precedes the beginning or continuation of a trend.
Therefore, for trend followers this type of progression is vitally important.
During its life cycle, each trend will exhibit alternating periods of rest and resumption.
The low volatility (‘‘rest’’ portion) could take the shape of a retracement or a sideways consolidation.
The shift to high volatility (‘‘resumption’’ portion) is often represented by a strong directional move.
Here’s the most important part.
The location where the “rest“ phase of the market abruptly becomes a period of resumption, is one of the most advantageous points at which to enter a trend.
When volatility begins to slow down, as reflected in price action compressing, the three moving averages will start to converge, making the fast, medium, and slow price averages nearly identical.
If at this point all three moving averages begin to diverge in sequential alignment in either direction, then a trend follower need to consider taking an action.
This particular variation of the averages crossover approach offers reduced risk, which makes it rather attractive.
The key reason this trade would carry little risk is because all three moving averages are exceedingly close to each other, and consequently, it would not take a significant adverse market move to trigger a crossover indicating that the setup was unsuccessful.
All of the above describes a classic volatility breakout, where low volatility transitions into high volatility, in the direction of the dominant trend.
When bulls and bears agree on price and the market is calm, there is a visible contraction of volatility.
However, as one group becomes dominant the market will start advancing in that direction.
The point is this.
The triple moving average provides a clear visual image of this dynamic, which when it happens may generate handsome profits if the market move sustains itself for a longer term.
One of the values moving averages offer is being a foundation for more advanced indicators, in which, for example, two moving averages are used in comparison.
This is accomplished by subtracting or by dividing the value of one moving average and the other.
To determine the market direction trend followers rely extensively upon traditional moving average “crossover” techniques.
A standard approach, for example, involves two simple moving averages of various periodicities, such as a 4-day and a 8-day moving average.
When the fast moving average value is greater than the slow, the trend is considered to be up.
When the fast moving average value is less than the slow, the trend is considered to be down.
Traditional strategies involving moving average crossover are very useful at identifying the market direction during sustained trends and filtering out market noise.
But here’s the problem.
In sideways markets these techniques tend to trigger false trading signals.
The outcome is repeated “whipsaws” which can accumulate trading losses as alternating long and short entries are signaled every time the moving averages cross each another.
Some approaches try to minimize the effects of choppy market by using bands enclosing the moving averages, other strategies incorporate additional moving averages to filter out false triggers.
As you can see, backtesting is quite simple activity in case if you have the right backtesting tools.
The testing of this strategy was arranged in Forex Tester 3 with the historical data that comes along with the program.
To check this (or any other) strategy’s performance you can download Forex Tester 3 for free. In addition, you will receive 16 years of free historical data (easily downloadable straight from the software).
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