Moving averages are crucial in technical analysis, being the most widely used indicator by far. From newcomers in the trading business to the most experienced traders, moving averages are typically utilized in their charts. In the previous article, we discussed what an average and moving average are, and also took a look at different types of moving averages. In this article, we will explore various applications of moving averages.
Support and Resistance
Moving averages use multiple bar closes in their calculation, making them less affected by short-term noise. Consequently, it becomes easier to identify trends. Moving averages can serve as supports in uptrends and resistance in downtrends, as observed in the EURUSD chart below. During the 2022 downtrend, the 50-day moving average repeatedly captured the tops. When the chart flattened, the same average functioned as both support and resistance multiple times, albeit not as efficiently as during the trend.
Additionally, when the price crosses the moving average that had been functioning effectively as support and resistance, it could create buying or selling opportunities for traders. Therefore, either a reversal from the moving average or the crossing can present trading opportunities for patient traders.
The key point in using moving averages as support and resistance is choosing the right period and type of moving average. If the trend is sharp, as seen from November 2022 to February 2023, a short-term moving average may be best suited, possibly an exponential moving average. If the trend’s slope is smaller, either positive or negative, a longer period moving average can better identify the trend.
The most challenging time to use moving averages as support and resistance is when there is no clear trend in the chart. During such times, traders might opt not to enter a trade due to the lack of trade opportunities or may utilize a lower timeframe to identify shorter trends, which can create more trading opportunities but are generally less reliable overall.
Crossover Signals
Most systematic traders begin their journey with moving average crossover signals. Crossovers are one of the easiest ways to determine the trend’s direction and possibly even its strength. However, trends differ from one another. Some have a higher slope, some have more volatility. Because of this, it is often not efficient to use the same moving average crossover to make decent profits.
The basic principle of crossovers is that the shorter (fast MA) period moving average is more adaptable to price and changes direction faster, but it is more affected by noise, while the longer period (slow MA) blocks out more noise but is slower to adapt to direction changes. Using both of them, when the trend changes direction, the fast MA moves faster and crosses the slower one. If it crosses up, it signals a buy, but if it crosses down, it signals a sell.
In the example below, a 21-day exponential moving average is used as the fast MA, and a 34-day simple moving average is used as the slow MA. Using the exponential moving average for the fast MA increases the responsiveness of the crossover signals to sudden changes. However, because of this fast response, signals yield better results for sharp trend changes, but if the trend slope becomes lower and flatter, this method will create many false signals that could decrease overall profitability.
The obvious drawback of crossover signals is the consolidation periods. During these periods when there is no clear trend, fast and slow moving averages cross multiple times, creating too many false signals and causing significant losses. It is crucial to choose moving average periods and types according to the security’s trends and volatility and to backtest as much as possible to identify the strengths and weaknesses of this strategy before using it as a primary strategy.
Golden Cross – Death Cross
The 50-day and 200-day moving averages are the most widely used moving averages for medium to long term analysis. Their crossover is usually seen as a significant shift in the direction of the chart. When the 50-day moving average crosses the 200-day moving average to the upside, it is called a golden cross and is seen as a strong bullish sign. Conversely, when the 50-day moving average crosses the 200-day moving average to the downside, it is called a death cross and is seen as a strong bearish sign. Despite these perceptions, death and golden crosses often fail to generate profit in the Forex market because the signals come too late. Products that tend to create long-term trends are better suited for death and golden crosses.
