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Using Moving Average Crossovers for Decision Making

Views 10KMar 22, 2024

As a trader, you need insight into price action. The best way to get an informed look at possible price trends is though technical analysis. However, there are a variety of indicators that you can use to time your investments and predict potential outcomes in the market. One of the most commonly used indicators - both by new traders and experienced pros alike - is the moving average, which calculates the average price of a stock each day over a specific period.

When analyzing the price of a stock, a moving average can help you look at past trends and how they might reverse, or if current trends may continue for a long period of time. However, the moving average itself only provides part of the information you need. Instead of relying on it solely, it is essential to consider the moving average as part of the signal and look for stronger markers, like crossovers.

To effectively understand moving average crossover rules and how to apply them to your trading decision-making, it’s important to understand:

• What moving average crossovers are

• What types of crossovers you can use

• Trading signals from crossovers

• Examples of moving average crossover strategies

• Disadvantages of moving average crossover strategies

A moving average crossover system helps to answer which direction the price may be trending (if at all); where the potential entry point may be for a trend trade; and when a trend may be ending or reversing.

There is a lot of information to learn, so let’s get started. 

What moving average crossovers are

There are multiple types of moving averages that can help you build your trading strategy, but two of the most common are:

Simple or smoothed moving average (SMA) —  shows the smooth progression of the calculated price average over a period of time. This moving average can be slow and lag behind fast moving trends, making it more appealing to longer-term traders. 

Exponential moving average (EMA) — requires more complex calculations that apply more weight on recent trends. This weighting can give faster signals and react more quickly to current trends, but can also give a higher number of false signals.

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Both of these moving averages can be set with any time period you wish to analyze. Overall, a shorter-term period will be more beneficial for short-term traders like day traders, while a longer-term moving average can help swing traders and others who don’t need to react as quickly to the most recent trends.  

Because different moving averages can give false signals on their own, many traders will look for crossover patterns. These occur when you plot multiple moving averages on a chart and the short-term moving average crosses above or below the long-term moving average. These crossovers can indicate that a large shift is coming, so it is important to be aware of the different types and what they mean.

Types of moving average crossovers

There are two types of crossovers to be particularly aware of — a golden cross and a death cross. A golden cross occurs when a short-term or medium-term moving average goes above the long-term average, often after an initial downturn. On the other hand, a death cross is when the short- or medium-term moving average crosses beneath the long-term average. 

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During a golden cross, the short-term average indicates that the trend is moving towards a more rapid price increase and the bulls are leading the market. In contrast, a death cross will often indicate that bears are taking over the market and there is a downturn developing. While neither a golden cross nor a death cross can give a definitive prediction, they may signal different actions traders may wish to take.

Trading signals from crossovers

When the death cross occurs and a short-term moving average drops below the long-term average, it may signal an upcoming downtrend, causing many traders to sell in hopes of avoiding further losses. The opposite is true, as well, with traders buying after a golden cross in hopes of capitalizing on a lasting upwards trend. 

Once a crossover has occurred, the long-term moving average can continue to impact the price action, acting as a resistance level for a death cross, when the price will hit the long-term average level like a ceiling and drop again; or a support for a gold cross, making the price bounce up off of it. The resulting gap between the two moving averages can cause the price to bounce back and forth repeatedly, leading to more opportunities for swing traders to strike. On the other hand, when there are periods of trend-less markets, high volatility, large-scale whipsaws, and frequent crossovers, day traders may decide to hold or even wait to enter the market until the noise has died down. 

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To gain more insight into price action and help identify extremely overbought or oversold trends and trading ranges, you can analyze moving average crossovers in relation to a price envelope. There are no rules on how large to create the envelope or where to place the boundaries. However, a smaller envelope will often be used for a short-term moving average and a long-term will have a larger envelope. Short-term traders often use a 3% or even smaller envelope, while a mid- or long-term approach may use a 5% or larger envelope. The price can whipsaw between the two boundaries and either bounce, leading to a price correction, or break out with a crossover. 

Examples of moving average crossover strategies

When using a moving average as an indicator, there are a number of varieties to choose from. Different strategies will be more helpful to you based on your trading style — for instance, day trading vs. swing trading. Overall, day traders use more short-term charts and swing traders use more mid-term over long-term outlooks. To better understand some of the patterns you will want to look for, here are a couple of examples. 

Long-term moving average crossover strategy

While moving averages can be created for all lengths of time, traders will often chart a crossover strategy using 50-day, 100-day, or 200-day moving averages — especially when using the SMA. These longer periods can help show significant long-term historical trends and potential times to move for swing traders. With this chart, traders can easily see when the current 10-week trend is increasing in movement as it crosses over the longer-term 100- and 200-day averages that span 20 and 40 weeks, respectively.

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Typically, when the 50-day moving average crosses upwards through the 200-day average, traders will treat it as a signal to enter the market as the uptrend continues. The opposite is also a strategy, with traders exiting to avoid further price drops if the 50-day average crosses in a downwards trend.

Short-term crossover strategy

A popular trading strategy with a shorter-term moving average uses a 4-day, 9-day, and 18-day moving average together to help determine in which direction the market is trending. 

When the 4-day moving average crosses over the 9-period and then they both cross over the 18-day moving average, it may be seen as a buy signal. The stronger the angle of the crossover, the stronger the signal. If the market is moving sideways and the 4- and 9-day moving averages merely drift over or under the 18-day crossover, then the signal is weaker and traders may want to keep an eye on the price to ensure it remains above or below the longer trend depending on your desired outcome. 

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Some aggressive traders will even enter or exit a position if the 4-day and 9-day moving averages show significant momentum, even before they cross over the 18-day moving average. However, it may be safer to wait for them both to cross over the 18-day moving average and ensure that the trend truly is moving in the direction of the break and momentum won’t dwindle.

Disadvantages of moving average crossover strategies

While moving average crossovers can be a strong tool in your technical analysis toolbox, it is best to use them in conjunction with other indicators because of certain disadvantages. Continuous ranging markets cause all moving averages to eventually converge toward a single price level. Because of this, the price action does not always have enough movement to make a moving average a strong enough indicator on its own. 

Moving averages are also based entirely on historical data — sometimes leading to significant lag. By the time the moving average may show a noticeable trend, it may be too late to enter or exit the market effectively for your strategy. 

In addition, the calculation for moving averages is not predictive in any way, which can make the results can appear random or ineffective in a choppy market. While altering the time frame can help with rapidly evolving market conditions, there can still be numerous false signals when the different moving averages get tangled up, leading to significant losses. To avoid these issues, it’s best to use a moving average crossover strategy as a confirmation of other technical analyses. 

Final Thoughts

While they have drawbacks, moving average crossovers are still a helpful tool to employ in your trading strategy. Beginners and professionals both recognize that the confirmation provided by moving average crossovers are a helpful indicator. Using them in combination with other technical anlaysis can help you develop a robust and effective trading strategy and make smarter decisions with your trades.

Build your moving average crossover strategy 

Start building a strong trading strategy today on the moomoo app. With 68 technical indicators and 38 drawing tools, you can gain an increased understanding of the best options for your trading style and find the different analyses that work best with moving average crossovers. 

Explore moomoo today to see how this information-packed trading platform can help you build a strategy to grow your portfolio and trade like a pro.

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