One of the most fundamental technical analysis tools that traders start off with is the moving average indicator. A few weeks ago I presented a short tutorial on utilizing the moving average indicator for short term trading. I demonstrated the best settings and presented a few demonstrations so that traders could get a good feel for using this basic analysis tool.
Today I want to expand a bit more and present a tutorial on using two moving averages instead of just one. The method is called the moving average crossover and it's probably one of the first if not the first indicator that was used to create a trading system decades earlier. If you look at publications going back 50 years, especially those that focused on commodities you will see the dual moving average crossover in action.
These Indicators Were Originally Created For Futures Traders
Many indicators that you commonly see used for stocks today were originally invented for commodities and futures. Before the 80's the stock market was relatively quiet and did not exhibit too much volatility, there were no short term traders to create the volatility we see in today's market. Commodity markets were always substantially more volatile in the past then stocks. Therefore, indicators were needed to help trade volatile financial markets. In this day and age stocks have become as volatile, if not more volatile, than commodity and futures contracts, so these indicators were adopted for the stock market. As a matter of fact all indicators that were once used for commodities and futures are now used for stock market analysis.
How To Use The Dual Moving Average Crossover
The Moving Average Crossover uses two simple moving average time frames. The first time frame is 90 days and the second time frame is 14 days. I find that using a combination of these two time frames produces a good mix between the short term time frame and the long term time frame. The other reason why I use the 90 day period is because it consistently produces the best results out of all moving average time frames tested.
The 90 Day Is the Slow Line And The 14 Day Is The Fast Line
The Biggest Mistake Traders Make
The dual moving average crossover has to be used under the right conditions to work properly. This is where the biggest problem arises; most traders do not use the dual moving average crossover in the correct market environment. I have seen numerous times when traders use moving average indicators when markets are flat and trend less and I have seen many traders use these indicators when markets are retracing. This is not what these indicators were designed for and if you use them under the wrong market conditions you will never realize the true benefit of these wonderful trading tools.
Apply The Crossover After A Reversal Occurred
The best time and the only time I use the moving average crossover is after a particular stock or other market has bottomed out and reversed direction or has topped out and is already beginning to come back down. Let me show you some basic examples so you can get an idea of what type of market environment I'm talking about.
Apple Ended Strong Uptrend and Began A Down Trend
Here is another example of a stock that is clearly reversing direction. Most reversals can take anywhere from 1 to 4 months. The longer the consolidation period before the reversal of trend the better the odds the trend will go your way.
The Longer the Stock Consolidates The Better The Trend Afterwards
Often you will see a similar pattern develop in a sector. In this particular case, several gold stocks and the actual commodity are going through a similar pattern as we speak. Take a look at a few different gold stocks or the actual commodity and you will see the same type of trading pattern across the board.
Long Term View of Trend Reversal
Utilizing The Moving Average Crossover Correctly
After you find a stock or market that has reversed direction you must wait for a confirmation signal prior to market entry. You have to wait for the market to trade completely outside of the 14 day simple moving average. If you are going to take long trades, the market must trade completely above the 14 day simple moving average. You would enter a MOC (market on close) order a few minutes before the closing bell assuming no part of the stock or other market has touched the 14 day simple moving average that day. If the market comes back down and trades within the average, the trade is nullified and you must wait for another day that the market trades completely above the 14 day simple moving average.
Trade Is Initiated After the Crossover And Market Trading Above Both Averages
Here is an example to the short side. You have to be very patient and disciplined when trading crossovers. Notice that we could have entered earlier, but we wait till the 14 day moving average is below the 90 day moving average and the stock trades completely below the 14 day moving average as well.
The Entry Is At The Close Of the First Bar To Trade Completely Below Both Moving Averages
Things To Keep In Mind
The Moving Average Crossover is one of the best technical analysis tools when used correctly. Always remember to wait for market reversals before applying this indicator. Also remember to change the setting on the slow moving average to 90 bars and on the fast moving average to 14 bars.