The trading world is filled with indicators and strategies, but one of the most reliable and widely known tools is the Moving Average Crossover Strategy. This basic, yet extremely useful, technical analysis-ready-to-use tool is a cornerstone for both novice and professional traders, and provides a clear signal to ascertain when there is a potential reversal in the trend. If you want to take your decision-making to the next level and understand the trading environment of the stock market, you'll need to learn how to use this strategy.
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Understanding Moving Averages
To understand the Moving Average Crossover Strategy, you have to first understand (and accept) Moving Averages (MAs). Moving Averages are the foundation of the Moving Average Crossover Strategy. A Moving Average is a line plotted on a chart that averages price data over a defined period, smoothing out fluctuations and essentially filtering out short-term "noise" to show the trend direction.
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There are two general forms of Moving Averages that you will likely become familiar with.
Simple Moving Average (SMA): The average of a security's price over a certain number of time periods. For example, a 50-day SMA is the average closing price for the past 50 trading days.
Exponential Moving Average (EMA): This allows for greater weight to more recent price data. Therefore, it can respond in a faster manner to new information and quicker to price changes as compared to the SMA. (If you are interested in reading more about the difference, we have a blog on it: SMA Vs EMA - Simple Moving Average or Exponential Moving Average).
By examining the slope of an MA, you are able to identify the prevailing direction of the trend: an MA that slopes up is indicative of an uptrend (bullish), and an MA that slopes down indicates a downtrend (bearish).
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How the Moving Average Crossover Strategy Works?
The idea of the Moving Average Crossover Strategy is the result of two or more MAs, averaged over different time periods. A shorter-period or faster MA is a reaction to price action more recently than a longer-period or slower MA, which simply provides a wider view of the trend than the shorter-period MA.
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For our purposes, we are looking for crossover as a signal to trade, which happens when the faster MA crosses the slower MA.
Bullish Signal (Buy): The fast MA moves above the slow MA. This indicates that the more recent momentum is stronger than the momentum of the longer time frame. It signals the start of a new uptrend.
Bearish Signal (Sell): The fast MA moves below the slow MA. This indicates that the most recent selling pressure is greater than the long-term trend and signals the possible beginning of a downtrend.
The Golden Cross and the Death Cross
Two of the more well-known crossover patterns are:
The Golden Cross: This is a strong bullish signal, usually the 50-day MA crosses above the 200-day MA. This long-term signal indicates to traders that they are moving from a bearish to a bullish phase in the market.
The Death Cross: This is the opposite, a strong bearish signal, usually the 50-day MA crosses below the 200-day MA. This is an indication of the start of a bear market.
To effectively utilize in order to put these signals in practice, make sure you look at additional training like the Technical Analysis Crash Course.
Trading with the Moving Average Crossover
The idea is simple. However, successful trading with the Moving Average Crossover Strategy will take discipline and confirmation in addition to this concept.
Entry and Exit
Entry: One possible approach is to place a long position (buy) immediately after you notice a bullish crossover, and to place a short position (sell) immediately after seeing a bearish crossover.
Exit: Typically, a position is exited when the MAs crossover back in the other direction, suggesting that a trend reversal is likely.
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Confirmation is Key
The Moving Average Crossover Strategy is considered a lagging indicator, as it will only confirm a trend once the trend is already underway. This leads to potential false signals, or whipsaws, especially during choppy non-trending (sideways) markets. For this reason, some experienced traders like to use other technical analysis tools to confirm the MAs' signals, as listed below.
Volume: If you see an increase in the trading volume accompanying a crossover, the crossover signal is more likely to be valid.
Other Indicators: Consider using an indicator like the RSI or MACD (Moving Average Convergence Divergence) to help corroborate the trend (read here: How to Use MACD Indicator?)
Candlestick Patterns: Candlestick patterns, such as the Shooting Star Candlestick Pattern confirmation, can be helpful (read here; Shooting Star Candlestick Pattern.)
You may decide that you want to learn more about applying these styles and placing orders. If so, I suggest registering for a course like the Stock Market Beginners Course for Investors and Traders.
Pros and Cons: A Balanced View
As with any trading strategy, the Moving Average Crossover Strategy has advantages and disadvantages to consider.
The key to long-term success employing this strategy is to incorporate it into a well-defined risk management strategy.
Conclusion
The Moving Average Crossover Strategy is a fundamental concept in technical analysis that all traders should understand. It is an objective, powerful, visual method to confirm and trade trends in financial markets. It is important to understand that no trading strategy is perfect—especially since moving averages lag, and the indicator will only trade effectively in trending markets. If you combine moving averages with other technical indicators, you can develop a strong set of trading rules and strategies. Good traders build their trading approaches on basic concepts.
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