Moving average crossovers are an important tool in the arsenal of any trader. Moving Average Convergence Divergence (MACD) one of the most popular indicator depends on them. Crossovers mark important shifts in momentum and support/resistance regardless of holding period. Many traders can therefore just stick with the major averages and find out most of what they need to know. The most popular settings draw charts with a 20-day for the short-term trend, a 50-day for the intermediate trend and a 200-day for the big picture. Long-term crossovers carry more weight than short-term events.
However, when trading with these crossovers, you should know this that these averages are lagging indicators. What this means is that they are giving a signal about the past price action something that has already taken place. These averages work very well in a trending market but do not work well in non trending or choppy markets.
Major types of Crossovers are Price Crossover, Double Moving Average Crossover and Triple Moving Average Crossover.
Price Crossover
Moving Averages can be used to generate signals with simple price crossovers. A bullish signal is generated when prices move above the Moving Average. A bearish signal is generated when prices move below the Moving Average. Price crossovers can be combined to trade within the bigger trend. The longer Moving Average sets the tone for the bigger trend and the shorter Moving Average is used to generate the signals. One would look for bullish price crosses only when prices are already above the longer Moving Average. This would be trading in harmony with the bigger trend. For example, if price is above the 200-day Moving Average, chartists would only focus on signals when price moves above the 50-day Moving Average. Obviously, a move below the 50-day Moving Average would precede such a signal, but such bearish crosses would be ignored because the bigger trend is up. A bearish cross would simply suggest a pullback within a bigger uptrend. A cross back above the 50-day Moving Average would signal an upturn in prices and continuation of the bigger uptrend.
When using double moving average crossover as a technical indicator, you should be long when the short average is above the longer period average. And when it is below, you should be short. The crossovers of these short and longer averages provide the trading signal to act as they indicate that the momentum is shifting from one direction to another.
A bullish crossover occurs when the shorter Moving Average crosses above the longer Moving Average. This is also known as a golden cross. A bearish crossover occurs when the shorter Moving Average crosses below the longer Moving Average. This is known as a dead cross. The Golden Cross represents a major shift from the bears to the bulls. It triggers when the 50-day average breaks above the 200-day average. Conversely, the Death Cross restores bear power when the 50-day falls back beneath the 200-day. The 200-day average becomes major resistance after the 50-day average drops below it, and major support after breaking above it. When price gets trapped between the 50-day and 200-day averages, it can whipsaw repeatedly between their price extremes. This pinball action marks a zone of opportunity for swing trades.
The chart below of the S&P Depository Receipts Exchange Traded Fund (SPY) shows the 50-day Simple Moving Average and the 200-day Simple Moving Average; this Moving Average pair is often looked at by big financial institutions as a long range indicator of market direction.
Note how the long-term 200-day Simple Moving Average is in an uptrend; this is a signal that the market is quite strong. Generally, a buy signal is established when the shorter-term 50-day SMA crosses above the 200-day SMA and contrastly, a sell signal is indicated when the 50-day SMA crosses below the 200-day SMA.
In the chart above of the S&P 500, both buy signals would have been extremely profitable, but the one sell signal would have caused a small loss. Keep in mind, that the 50-day, 200-day Simple Moving Average crossover is a very long-term strategy.
Triple Moving Average Crossover
The triple moving average crossover system is also used to generate buy and sell signals. Its buy signals come early in the development of a trend, and its sell signals are generated early when a trend ends. The third moving average can be used in combination with the other two moving averages to confirm or deny the signals that they generate. It thereby reduces the chance that the investor will be acting on false signals.
The shorter the moving average, the more closely it will follow the price trend. When a stock begins an uptrend, short-term moving averages will begin rising far earlier than longer-term moving averages. For example, if a stock declines by equal amounts each day for 50 days, and then begins to rise by the same amount each day for 50 days, the 5-day moving average will start to rise on the third day after the change in direction, the 10-day average will begin to rise on the sixth day after the change, and the 20-day average will begin to rise on the eleventh day. The longer a trend has persisted, the more likely it is to continue persisting, up to a point. Waiting too long to enter a trend can result in missing most of the gain. Entering the trend too early can mean entering on a false start and having to sell at a loss. Traders have addressed this problem by waiting for three moving averages to verify a trend by aligning in a certain way.
To illustrate, we’ll use the 5-day, 10-day, and 20-day moving averages. When an uptrend begins, the 5-day moving average will start rising first. Traders view this as interesting but of no major significance. As the upside momentum increases, longer moving averages gradually begin to follow suit.
A buying alert takes place when the 5-day crosses above both the 10 and the 20. That is, the average price of the stock over the last five days is greater than its average over both the last ten days and the last twenty days. This shows a short-term shift in trend. A buy signal is confirmed when the 10-day then crosses above the 20-day. The 10-day average price of a stock is more meaningful than the 5-day average price. If the average price over the last ten days is greater than the average price over the last twenty days, the shift in momentum is considered to be much more significant.
Conversely, when an uptrend changes to a downtrend, the first thing that happens is that the 5-day declines below the 10-day and 20-day averages. This constitutes an alert that a sell signal may be forthcoming. The confirmed sell signal occurs when the 10-day crosses below the 20-day resulting in an alignment in which the 5-day average is below the 10-day average and the 10-day average is below the 20-day average.
Investors and traders might be wise to incorporate another indicator into their decision-making. To increase the reliability of the signals given by the system outlined above, it might be wise to use the 50-day moving average as a context and reference. The best and most profitable time to buy a stock is early in a new trend. Later buy signals carry greater risk that the stock will soon decline (because stocks don’t go up forever). Therefore, if the 50-day average has been in a significant decline and is now leveling off or just beginning to rise, a buy signal using the triple crossover method outlined above has a greater chance of success than if the 50-day average has been rising for a long time, or is beginning to level off or decline after a prolonged advance. In other words, the intermediate-term 50-day average can be used to confirm and "support" the signals given by the shorter-term moving averages. Generally, it's better to avoid buying a stock if its 50-day moving average is in decline. A short-term trader might make an exception to this general policy in order to profit from a snap-back toward the declining 50-day average from an extreme oversold condition.
An example of triple moving average crossover is shown in the chart below of Wal-Mart (WMT) stock. 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 are reversing trend; however, usually a buy or sell order is not placed yet. The second crossover of the quickest SMA (10-day) and the slowest SMA (50-day) finally triggers the buy or sell signal. A more conservative approach is to wait until the middle SMA (20-day) crosses over the slower SMA (50-day).
Limitations of Crossovers
Moving Averages Crossovers add horsepower to many types of trading strategies. But try to limit their use to trending markets. They work best in trending markets, where an uptrend or downtrend is firmly in place, but they generate many false signals in choppy, sideways markets. Moving averages emit false signals during the "negative feedback" of sideways markets. Keep in mind these common indicators measure directional momentum. They lose power in markets with little or no price change.
Moving Averages crossovers produce relatively late signals. After all, the system employs two lagging indicators. Moving Averages are lagging indicators because they use historical information. Using them as indicators will not get you in at the bottom and out at the top but will get you in and out somewhere in between. The longer the Moving Average periods, the greater the lag in the signals. These signals work great when a good trend takes hold. However, a Moving Average crossover system will produce lots of whipsaws in the absence of a strong trend.
For years, technicians have tried to filter crossover systems through trend-recognition formulas in order to reduce whipsaws. You can try this for yourself, or just look for price patterns that tell you the crossovers are worthless. Take a look at a chart of any market with a strong trend. You will see that the moving averages are not crossing back and forth repeatedly. They will be moving in the same general direction in a more or less parallel fashion. Now look at a chart of a non-trending market. As this market moves sideways the moving averages will be crossing back and forth very frequently. Look at the implications of this simple examination of the charts. If we are trading the crossovers we will be trading most frequently in non-trending markets and trading most infrequently in strongly trending markets.
With a little thought and effort I’m sure we can design some reliable entry signals that are based on moving averages but avoid the typical crossover signals. For example we could measure the slope of several moving averages and when all the averages slope upward we would have a buy signal.We could also measure the distance between several moving averages and implement our trades when the averages are all headed in the same direction but start getting farther apart. This procedure would give us a series of entry signals within the same original trend. This should provide an excellent entry and re-entry strategy.
Persistent rangebound markets limit the usefulness of all types of average information. All moving averages eventually converge toward a single price level in dead markets. This flatline behavior yields few clues about market direction. So stop using averages completely when this happens, and move to oscillators (such as Stochastics) to predict the next move.
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