Now that you know how to plot the moving averages on your chart and determine price trends, it’s time we showed you how to actually execute your trades. And, to be honest, getting in and out of the market astutely is nothing short of fine art.
But, before we dig more into that, it’s important to note that moving averages can also determine when a trend is about to end and reverse.
Read that again.
In the live market, moving averages can also signal reversals. This is a vital piece of information and one that shapes the direction of the rest of this lesson. Read on to learn more about moving averages, the moving average crossover, and related trading strategies.
As you already know, there is no secret formula to calculate how long a specific trend will last. Some are short-lived, while others last for days, weeks, or even months. However, moving averages can help shed some light on trends and trend strength.
Below are a few moving average observations that can help quantify trending markets:
In reality, reading an exponential, smoothed, or simple moving average is pretty simple stuff. Basically, they reflect a periodic average price and the prevailing trend defines price action. However, when we incorporate multiple moving average values, things get a bit more complex.
A reversal occurs when a market changes course from bullish to bearish or vice-versa. Reversals are local to the price action of any capital markets trade, including forex, shares, futures, or CFDs. Accordingly, many reversal trading strategies exist and are favored by active traders around the globe.
So how can one predict a trend reversal? Is it even possible at all?
Although accurately projecting a market reversal is a challenge, it is possible with these three words –Moving Average Crossover.
A moving average crossover is a technical tool in forex that occurs when two different moving average lines cross over one another. Therefore, a moving average crossover strategy is a comprehensive plan designed to help forex traders enter and exit trades. Simple as that!
By definition, moving averages are lagging indicators. Subsequently, the crossover technique may not capture the exact top or bottom of a prevailing trend. However, the moving average crossover strategy can definitely help traders identify the bulk of a trend.
A robust moving average crossover strategy can help forex traders answer the following questions:
Perhaps the best thing about this type of strategy is that it is self-contained. All you have to do is drop a couple of moving averages on your chart, grab a beer, and wait for them to crossover. Additionally, they can be any type, from the simple moving average to the exponential moving average. The choice is yours!
If you’re lucky enough and the moving averages cross over one another, it could signal that the trend is about to change soon, giving you the chance to get a better entry. And, by having a better entry, you have the chance to bag more pips!
Essentially, there are two main types of crossovers: the golden and dead cross. In addition, the moving average convergence divergence (MACD) indicator involves the moving average crossovers. However, the MACD is a conversation for another time!
For the golden cross, we need two averages with different periods: one that is a shorter period moving average and one that is a longer period moving average. When the shorter period MA crosses the longer period MA bottom-up, it’s a buy signal.
Inversely, if the MA with a shorter period breaks below the longer or slower moving average, then it’s a sell signal. Remember, it doesn’t matter if you are using smooth, simple, or exponential moving averages – it’s all good!
To make things super-duper clear, let’s take a look at one more example when a crossover occurs. This time we will use a 6-month chart and two simple moving average values for the USD/GBP.
As you can see, we plotted two moving averages, a 50-day moving average, and a 200-day, much slower moving average. Notice, the MA with a smaller period crossed the MA with a longer period; we now know this as a buy signal. So, if you were to go long at the crossover of the moving averages you could make yourself some mad pips!
Of course, not every trade will be a thousand-pip winner, a hundred-pip winner, or even a 10-pip winner. Any given trade could be a loser, which means you have to consider things like where to place your stop loss or when to take profits.
Always remember, don’t go jumping in without a plan!
The moving average is a great way to stay on top of trends and reversals. No matter if you are using a smooth, exponential, or simple moving average, each can be a powerful trading tool. Further, by incorporating crossovers and more involved tools such as the MACD, you can quickly level up your forex trading game.
In the next lesson, we will look more into how Moving Averages work with Support and Resistance levels. When you’re ready, check out how these concepts can help improve your overall trading strategy.