Moving averages crossover strategy
The moving average crossover strategy is geared toward finding the middle of a trend. A trend defines price action in which prices move in a specific direction over a period of time. Generally, trends are either upward or downward, as sideways movements are considered consolidation and not trends. Most of the time—approximately 70%—capital markets trade in tight consolidative patterns and only trend 30% of the time. With this in mind, it is important to be able to define a trend and jump on as soon as it is recognizable.
This is another strategy that is based on moving averages which is easy to follow. Please also, do not follow any strategy that says it is holy grail because there is no such thing and also do not buy anything that says will make you rich over night. Let us rather take a look at this beautiful simple system. It uses EMA (Exponential Moving Averages) with certain periods: 10, 25 and 50. Signal to when you can start thr trade is when the 10 period of EMA crosses or goes through the period of 25 EMA and 50 EMA, it has to go through both of them. Based on that, if it goes through them on the uptrend we trade a call and if it goes through it on downtrend we trade a put.
How Moving averages crossover strategy works
You have now a basic outline how this strategy might work but let us take a look at details so you will not get confused, here are the exact settings needed in order to execute the trade based on this strategy. First thing you need to do is to open metatrader 4 and give in the indicators written below. You can use it for any currency pair.
Time grame: 15 minute or 1 hour chart
Indicator: 10 EMA, 25 EMA and 50 EMA
- When 10 EMA goes through and crosses 25 EMA and also 50 EMA in uptrending.
- Wait for a candle bar to close over 50 EMA for a clear signal.
- When 10 EMA goes through and crosses 25 EMA and 50 EMA in downtrend.
- Wait for the candle bar to close over 50 EMA to avoid false signal.
How trading works here:
The 3 Simple Moving Average method could be interpreted as follows:
- The first crossover of the quickest SMA (in the example above, the 10-day SMA) across the next quickest SMA (20-day SMA) acts as a warning that prices might be reversing trend; however, usually a trader would not place an actual buy or sell order then.
- Thereafter, the second crossover of the quickest SMA (10-day) and the slowest SMA (50-day), might trigger a trader to buy or sell.
There are numerous variants and methodologies for using the 3 Simple Moving Average crossover method, some are provided below:
- A more conservative approach might be to wait until the middle SMA (20-day) crosses over the slower SMA (50-day); but this is basically a two SMA crossover technique, not a three SMA technique.
- A trader might consider a money management technique of buying a half size when the quick SMA crosses over the next quickest SMA and then enter the other half when the quick SMA crosses over the slower SMA.
- Instead of halves, buy or sell one-third of a position when the quick SMA crosses over the next quickest SMA, another third when the quick SMA crosses over the slow SMA, and the last third when the second quickest SMA crosses over the slow SMA.
How to Capture a Trend
Short-term trends can be captured using short-term moving averages. A moving average is the average of a specific period, and when a new data point is added, the first period of the average is dropped. A moving average crossover strategy looks for periods when a short-term moving average crosses either above or below a longer-term moving average to define a short-term trend.
For example, when the 5-day moving average of the USD/JPY prices crosses above the 20-day moving average of USD/JPYprices, a short-term trend could be considered in place. One trading technique could be to purchase the USD/JPY prices when the moving averages cross over looking to ride an uptrend in the currency pair. By combining a short-, medium-term, and long-term moving average, an investor can attempt capture up, down, and sideways movements.
Longer moving averages are gauged to capture longer-term trends within a financial market. When the 20-day moving average of gold prices crosses below the 50-day moving average, as seen in the chart of gold, a medium-term trend is considered in place.
Issues with a Standard Moving Average Crossover
The concept of a moving average crossover seems great, but a fundamental problem is that when the market is consolidating, a moving average crossover will give a number of false signals. During the period between April 2014 and April 2015, the 5/20 moving average crossover produced 5-signals that did not foreshadow a trend. This does not mean you would not have made money trading this strategy, but you would not have experienced an upward (or downward) bias in the currency pair that would be consider significant.
One way to enhance a moving average crossover strategy is to add an additional study that will weed out some of the false signals. For example, by adding a Bollinger band (created by John Bollinger, this study helps define a histogram of prices above and below a mean level) to the 5/20 crossover strategy, you can also help define a range.
In the case of the USD/JPY you could only purchase the USD/JPY currency pair when the 5-day moving average crosses the 20-day moving average and the exchange rate crosses above the Bollinger band high (2-standard deviations above the 20-day moving average) with an x days period. The number of days (x) is subjective, but using a period of less than 3-days is preferable. By adding an additional layer, the strategy becomes more robust, but also less frequent.
Now we have everything in order. Patience is the key here to wait for the right moment, for the signal to show. You have to meet with the criteria we have outlined and act accordingely. This is how they look.
Advantages and Disadvantages
You have to know this is not trend following strategy but is basicly the opposite since you make the entry when there is change of the direction if you check correctly. But if all is executed as it should be, from teh point of entry in the trade, you are in the trend following direction. Problem is that it can happen to fake the signal that is why it is important to follow the rules and make sure you execute it only when the tiem is right and not before. And do not use the system with low volatility since it will be to no use. It is good since it is simple to follow since it only uses three moving averages and it is not really some sort of rocket science when it comes to it. It can return you with big profits if you know how to be dsciplined. If you see that the trade will go against you, you can use the feature that is supported by binary options brokers which is called close early and you get some money back, so you do not get maximum loss.
The bottom line
Moving Average crossovers are often viewed tools by traders. In fact crossovers are often included in the most popular technical indicators including the Moving Average Convergence Divergence (MACD) indicator (see: MACD). Other moving averages deserve careful consideration in a trading plan:
- Adaptive Moving Average
- Exponential Moving Average
- Triangular Moving Average
- Typical Price (Pivot Point) Moving Average
- Weighted Moving Average