Today’s tale marks the third and final piece of our moving averages series. You can find the first two messages here and here if you missed them.
You’ll recall one of the powerful attributes of the moving average (MA) is its ability to smooth out the often erratic price action. While this can provide more clarity in identifying the trend, it also allows us to create easy-to-spot trading signals. Here’s the gist of using MA crossovers.
First, pick a short-term MA and a long-term MA. The short-term one will move faster than the long-term one.
Second, when the short-term MA crosses above the long-term MA, it creates a buy signal.
Third, when the short-term MA crosses below the long-term MA, it creates a sell signal.
We’ve already explored a variation of this. Last week we showed how the price breaking above/below the moving average created buy/sell signals. This was the graphic shared:
The flaw of using price breaks of the MA is that it’s noisy. Sometimes we drop below the 50 MA for one or two candles, generating a sell signal, then the stock pops right back up, creating a buy signal.
Using MA crossovers is an attempt to smooth out these false signals. We replace the candlesticks with a short-term MA.
The 9/13 EMA Cross
One of the first combos I learned was the 9-13 EMA cross. The 9-day EMA is a proxy for the stock and provides signals when it crosses above/below the 13 EMA. It provides fewer and hopefully more significant signals than if you used the price breaking the 13 EMA as
It’s been a while since I’ve looked at this particular crossover, so I was impressed by how effective it’s been during the ongoing market correction.
It will never nail the exact top or bottom, because it takes a few down (up) candles before a sell (buy) signal is generated. But that’s okay! It still captures the meat of the trend as long as we see follow through. You’ll note the Friday-Monday rally, as strong as it was, still didn’t generate a buy signal. So, as far as this particular indicator goes, we’re still in bear mode.
Achilles Heel
The Achilles heel of this system is a trading range. Without follow-through after signals, you’ll end up getting chopped up, buying high and selling low over and over again. But, as long as a good trending environment eventually returns, profitable signals should as well.
Here’s an example of an environment from a few years ago that produced a fair bit of whipsaw.
Changing Frequency
The frequency of signals can be modified by using longer or shorter time frames. For example, the 9-13 EMA is probably most appropriate for a swing trader looking for multiple signals a month. If you’d rather see a few signals a quarter or year, you could simply use longer-time frames like a 20 and 50 SMA. Perhaps one of the most popular ones for long-term traders is the 50 SMA and 200 SMA. They’ve even come up with cool names for when this particular combo generates signals
50 Crosses Above 200 = Golden Cross
50 Crosses Below 200 = Death Cross
Anytime we get a death cross you’ll see a groundswell in articles on websites like CNBC that reference the ominous-sounding signal to drum-up foot traffic.
As shown below, we’ve only averaged about one to two signals a year with this time frame. So, it’s obviously most appropriate for long-term investors looking for a trend-following system that keeps them on the right side of the primary trend.
Summary
Let’s summarize the key points of our moving average investigation.
First, they are fantastic smoothing mechanisms that reflect the essence of the trend.
Second, they help identify the momentum of the trend.
Third, they are areas where support and resistance often form.
Fourth, they can be used to spot trend reversals
Fifth, moving average crossovers might be the simplest trend-following system ever created.
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