The plain vanilla moving average system is notorious for generating too many trading signals in a sideways market; however, a moving average crossover system provides an improvement. It assists traders in limiting the number of trades they take in this kind of market.
Instead of the common single MA in a crossover system, traders often employ two MAs, which is often referred to as ‘smoothing’.
An example of this is combining a 50-day EMA and 100 days EMA. The shorter one (50 days) is the faster-moving average, and the longer one (100 days) is the slower-moving average.
The shorter moving average takes fewer data points to calculate the average, leading to closer tracking of the current market price: thus, it responds more swiftly. On the other hand, the longer moving average requires more data points to calculate the average, so it tends to be further from the market price and reacts slower.
The following Bank of Baroda graph illustrates the way that the two moving averages can be plotted on a chart.
As is evident, the black 50-day EMA is closer to the current market price since it responds more quickly compared to the pink 100 days EMA, which reacts more slowly.
Traders have changed the standard MA system to a crossover system in an attempt to improve entry and exit points. This helps to limit the number of signals that are generated but increases the chances for successful trades.
The entry and exit rules for the crossover system are as follows:
Rule 1- When buying fresh long positions, make sure that the short-term moving average is higher than the long-term moving average. Remain in your position for as long as this requirement is met.
Rule 2- Once the short-term moving average becomes less than the longer version, it is time to close out the long position.
Let us use the MA crossover system to analyse BPCL, so that we can compare the results easily. The chart below shows the BPCL with a single 50-day MA.
MA showed 3 trading signals during the sideways market trend, but it was the 4th one that proved to be the most lucrative, as it yielded a 67% profit.
The chart presented illustrates the implementation of a moving average crossover system using 50- and 100-day exponential moving averages.
The black line plots the 50-day moving average, and the pink line tracks the 100-day one. As per the crossover rule, when the shorter-term MA crosses over its longer-term counterpart, it’s a signal to go long. An arrow marks how this point of crossover can help traders stay away from three unprofitable trades. This is definitely the biggest benefit of such a system.
A swing trader can use any combination to construct a MA crossover system. Popular pairings may include:
The more time that has passed, the fewer trading signals you will receive.
An example of a 25 x 50 exponential moving average crossover can be seen here, giving three trading signals that meet the criteria.
Of course, the MA crossover system has its uses in intraday trading as well. For example, one could use a 15 x 30-minute crossover to detect short-term possibilities. A more aggressive trader may opt for a 5 x 10-minute crossover instead.
This popular expression is often heard in trading circles – “The trend is your friend.” Moving averages are a useful tool for determining trends and identifying potential support and resistance levels.
MA is a trend-following system, and it is effective no matter the time frame or crossover combination.