By Ee Hsin Kok. Edited by Arjun Chandrasekar.
The moving average crossover is a powerful strategy that can be used to follow trends in the market. It usually consists of two moving averages, one on the shorter term and one on the longer term. In this article, we’ll discuss how to use it, and different variations to experiment with.
How to Use It
The moving average crossover is most commonly used to follow trends when they are defined. When the shorter-term moving average crosses over the longer-term moving average, it is a signal to go long. When it crosses below, it is a signal to go short.
In the examples below, we will use a 20MA (Red) for the shorter term and a 50MA(Blue) for the longer term. So whenever the red line crosses the blue line, we will buy or sell accordingly.
Signal to go Long (Buy):
Signal to go Short (Sell):
In the example above, we used a period of 20 for the shorter-term moving average and 50 for the longer-term moving average. However, we can combine almost any 2 periods like 50 and 150. What ultimately matters is that you find a combination that works for you.
If you’re more of an impulsive person or want to make more trades, you could have periods of 12 and 18 so that you get more trade signals. The downside to that would be paying higher commissions and a higher likelihood of suffering quick massive drawdowns during losing streaks. But the upside would be that if your strategy is profitable, you would make more trades and hence more money than if you were to use less responsive MA periods like 50 and 150.
On the other hand, longer MA periods allow for more reliable trade signals as trends are stronger when the signal is given, but the downside is that you have fewer trade signals and may miss out on profits when the market is making quick and sharp movements.
The idea of using moving average crossovers as a trade signal can also be used as the backbone to more advanced strategies. For example, you could test a strategy where you require a crossover and a pin bar to form before entering a trade or require momentum indicators like the MACD to crossover as well. Additionally, you need to define entry and exit rules for such a strategy. Are you going to have a profit target? A stop-loss? If you have a stop loss, is it going to be trailing a stop loss? On the surface, the moving average crossover is a simple strategy, but with so much to customize, you can adapt it to fit your needs and trading style.
In this article, we introduced the basic concept behind the moving average crossover. We also discussed how you can tweak the periods of the moving averages and customize the strategy by adding additional criteria behind trade signals. Ultimately, one of the most important factors behind the success of a trading strategy is its compatibility with you. Therefore, get out there and practice so you can figure out what kind of strategy fits you!