The Moving Average Crossover

The Moving Average is probably one of the most common technical indicators used by Forex Traders.
Plotting the moving average on a chart helps to smooth out the day to day noise of the market and gives us the ‘average price’ of the market over a specified time period. Principally it is used by traders to help identify market trends over time.
The Moving Average Crossover makes use of two moving averages from different time periods to generate trade entry signals.
A Long (buy) trade entry is signaled when a short term moving average crosses a longer term moving average. A Short (sell) trade entry is signaled when the fast moving average crosses below the longer term moving average.

The Moving Average

The basic premise of the Moving Average is that it displays the average price of the market calculated over a specified time period. For example, to calculate a 20 Day moving average, you would simply add the last 20 market closing prices and divide the figure by 20. This would then give you the ‘average’ price of the market over 20 days. This figure is known as the 20 Day Simple Moving Average (SMA).
Common time frames are 10, 20, 50, 100 and 200 days. The actual number of days you use for your moving average will depend on the timeframe of your trades. High timeframe moving averages tend to suit longer term trading time frames such as daily and weekly charts. The significance of long term moving averages as points of support and resistance in shorter time frames should however still be noted.
If the moving average value is rising over time, then the market is considered to be trending up. Similarly if the moving average value is falling, then the average price of the market is falling and therefore the market is considered to be trending down. For this reason the moving average is a good indicator for identifying trends in markets. The longer the timeframe for which the moving average is set, then the stronger the trend is over the given time.
There are other more complex calculations that provide variations on the Simple moving average. Of note is the Exponential Moving Average where the calculation gives a greater weight to more recent market prices.
Whichever moving average you use the principals behind the Moving Average Crossover remain the same.

Using the Moving Average Crossover to Trade

Moving average crossovers are used as a signal that the momentum in the market is changing and a new trend may be developing. This is because the basic principle here is that the near term price is rising or falling in relation to the historic average. While moving averages do not predict where the market is going, they can provide an indication of where it is most likely to go.
Trading the moving average crossover is straightforward. The strategy uses two moving averages of different periods. The shorter time period moving average is referred to as the fast moving average. The longer term moving average is referred to as the slow moving average. A crossover occurs when a faster moving average rise above or falls below a slower one indicating a likely change from the longer term trend.

Golden Cross - Trade Entry For a Long Trade

The entry point for a long trade is when the fast MA crosses the slow MA. This is seen as a bullish signal and a potential buying opportunity. This is occurrence is sometimes referred to as a ‘Golden Cross.’

The example above shows a GBPUSD entry into a long trade generated on the daily chart. Here the 20 Day fast MA has risen above the slow 50 Day SMA. Note the firm continuation of the trend over the following weeks.

Also of note is that pullbacks in the market are first contained by the 50 Day SMA and then as the trend gets stronger, by the 20 Day SMA. Placing a rising stop loss beyond the 50 Day SMA would have been a good approach for this trade.

Death Cross – Trade Entry for a Short Trade

The entry Point for a short (sell) trade is when the fast MA crosses the Slow MA. This is seen as a bearish signal and a potential selling opportunity. This is sometimes referred to as a 'Death Cross.'
Here we have used an example on the 4 hour USDJPY chart using a 10 Day SMA and 20 Day SMA. Note how the 10 Day SMA contains the limits of the price action for a number of hours..
Again with this trade using the SMA levels as a location for a stop loss would have managed risk while providing a good run on the trade until the eventual stop out on the 2nd March.

Considerations

The number of trade entries generated by this strategy will depend upon the number of days used in the calculation of the moving average. Implementing a strategy using say 20 and 50 day moving averages, you will generate more entry signals than by using a 50 and 200 day moving average. However you are also likely to generate more false signals and lower returns per trade.
On lower timeframe charts particularly, moving average crossovers are quite common and therefore using them as the only indicator for trade entry may prove of limited success.
Moving average crossovers can be used in both ranging and trending markets. While they will occur less in trending markets, the quality of the signal generated is likely to be be better.
In ranging or volatile markets, more signals will be generated. However more crossovers does not necessarily translate into more trading opportunities as there will be a tendency for many of these crossovers to provide 'false' signals.
While Moving average crossovers will tend to provide more profitable entry points in trending markets they can still be used in ranging or volatile markets. The key to the success of using them though will rely on using the crossover as a starting point for your analysis. Try using the signals generated as the basis for your analysis. Validating the signals by means of another indicator, such as an Oscillator (RSI, MACD, Stochastic) can help to add greater validity to a trade entry and help to filter out any false signals.