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By Casey Murphy, Senior Analyst ChartAdvisor.com
Different investors use moving averages for different reasons. Some use them as their primary analytical tool, while others simply use them as a confidence builder to back up their investment decisions. In this section, we'll present a few different types of strategies - incorporating them into your trading style is up to you!
A crossover is the most basic type of signal and is favored among many traders because it removes all emotion. The most basic type of crossover is when the price of an asset moves from one side of a moving average and closes on the other. Price crossovers are used by traders to identify shifts in momentum and can be used as a basic entry or exit strategy. As you can see in Figure 1, a cross below a moving average can signal the beginning of a downtrend and would likely be used by traders as a signal to close out any existing long positions. Conversely, a close above a moving average from below may suggest the beginning of a new uptrend.
The second type of crossover occurs when a short-term average crosses through a long-term average. This signal is used by traders to identify that momentum is shifting in one direction and that a strong move is likely approaching. A buy signal is generated when the short-term average crosses above the long-term average, while a sell signal is triggered by a short-term average crossing below a long-term average. As you can see from the chart below, this signal is very objective, which is why it's so popular.
Triple Crossover and the Moving Average Ribbon
Additional moving averages may be added to the chart to increase the validity of the signal. Many traders will place the five-, 10-, and 20-day moving averages onto a chart and wait until the five-day average crosses up through the others – this is generally the primary buy sign. Waiting for the10-day average to cross above the 20-day average is often used as confirmation, a tactic that often reduces the number of false signals. Increasing the number of moving averages, as seen in the triple crossover method, is one of the best ways to gauge the strength of a trend and the likelihood that the trend will continue.
This begs the question: What would happen if you kept adding moving averages? Some people argue that if one moving average is useful, then 10 or more must be even better. This leads us to a technique known as the moving average ribbon. As you can see from the chart below, many moving averages are placed onto the same chart and are used to judge the strength of the current trend. When all the moving averages are moving in the same direction, the trend is said to be strong. Reversals are confirmed when the averages cross over and head in the opposite direction.
Responsiveness to changing conditions is accounted for by the number of time periods used in the moving averages. The shorter the time periods used in the calculations, the more sensitive the average is to slight price changes. One of the most common ribbons starts with a 50-day moving average and adds averages in 10-day increments up to the final average of 200. This type of average is good at identifying long-term trends/reversals.
A filter is any technique used in technical analysis to increase one's confidence about a certain trade. For example, many investors may choose to wait until a security crosses above a moving average and is at least 10% above the average before placing an order. This is an attempt to make sure the crossover is valid and to reduce the number of false signals. The downside about relying on filters too much is that some of the gain is given up and it could lead to feeling like you've "missed the boat". These negative feelings will decrease over time as you constantly adjust the criteria used for your filter. There are no set rules or things to look out for when filtering; it's simply an additional tool that will allow you to invest with confidence.
Moving Average Envelope
Another strategy that incorporates the use of moving averages is known as an envelope. This strategy involves plotting two bands around a moving average, staggered by a specific percentage rate. For example, in the chart below, a 5% envelope is placed around a 25-day moving average. Traders will watch these bands to see if they act as strong areas of support or resistance. Notice how the move often reverses direction after approaching one of the levels. A price move beyond the band can signal a period of exhaustion, and traders will watch for a reversal toward the center average.
Next: Moving Averages: Different Flavors »
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