Moving Averages are among the core set of classic indicators which have come to form the bedrock of technical analysis. Like all great indicators, Moving Averages are simple, effective and highly versatile meaning they can be sued effectively on their own or in conjunction with other technical indicators.
Moving Averages For Trend Direction
Perhaps one of the simplest ways to use moving averages is to use them as a guide for trend direction. Many technical traders use moving averages to help them quickly assess the direction of and strength of the trend in the market.
For example, if a trader is using the 21 Day moving average to assess trend then the trend will be classed as bullish when the price is above the moving average and classed as bearish when the price is below the moving average. The gradient of the moving average also suggests how strong the trend is. If the moving average is moving steeply higher, we have a strong bullish trend. If the moving average is moving steeply lower, we have a strong bearish trend. If the moving average is simply flat, then the market is typically in range bound conditions.
The image above shows a price chart overlayed with a 21-day moving average. You can see initially that price was moving higher supported by a steep upward gradient to the moving average which indicates a strong bullish trend. However, once price revered from highs you can see that we entered a choppy, rangebound period which was indicated by the flattened gradient of the moving average which oscillated between mildly bullish and mildly bearish. As you can see, the range then resolved into a strong bearish trend as indicated by the steep downward gradient of the moving average.
When traders are using a moving average in this manner, they will typically use the MA as a directional guide, looking to take trades in the direction of the MA using strategies such as breakout and momentum plays or looking to enter on retracements within the trend. Trading in the direction of the moving average can be a great way of capturing momentum in the market. However, traders need to be careful that they don’t get caught in range bound conditions looking to enter every time price moves above or below the moving average.
Moving Average Crossovers
Another way that traders can look to use moving averages is to trade moving average crossovers. This method employs the use of two MA’s; one shorter term and one longer term. Essentially, when the shorter-term moving average crossed up through, the longer term moving average this gives a bullish signal indicating that the market is at the beginning of a bullish trend. Conversely, when the shorter-term moving average crosses below, the longer term moving average, this indicates that the market is moving into a bearish trend.
There are many classic moving average crossovers used by technical analysts. Here are some of the key pairs:
- 9 & 21 day
- 50 & 100 day
- 50 & 200 day
The 50 & 200-day crossing is perhaps the most well-known moving average crossover. When the 50 crosses to the upside, it is known as the golden cross, and when it crossed to the downside it is known as the death cross.
In the image above you can see we have a price chart with the 50 and 200-day moving averages overlayed. There are two crossover instances on the chart; the first is the death cross where price sustains a heavy bearish trend after the 50 day MA crosses below the 200 day MA and the second is the golden cross where the price starts to trend higher after the 50 day MA crosses above the 200 day MA.
As you can see, these crossovers can be powerful technical signals preceding large trending phases. If traders can enter in the direction of the crossover, they have a good chance of capturing a period of momentum. Typically, traders will either look to enter as soon as the crossover occurs or again, will use the crossover as a directional bias to then look to take trades based on other technical setups in line with the directional bias given by the crossover.
As with all systems and strategies, the moving average crossover is not without flaws and there are occasions where we get a false crossover which produced no trend and sees price reverse shortly after the crossover occurs.
Traders need to also be careful with how they take profit on crossover trades as one of the key issues that many traders have when trading crossovers is that if they are looking to enter a trade on a crossover and then exit the trade on the next crossover, there can be many instances where price is has moved into significant profit but then reverses heavily before the next crossover, meaning that trader ends up giving back a lot of profit before exiting the trade.
In the image above you can see an example of where trading crossover to crossover can be frustrating. The market sells off heavily after a death cross, giving a really good level of profit. However, price reverses sharply higher before the next crossover meaning that at the point the trade exits the trade, they would have given back a large amount of their profit.