What is Moving Average Crossover Candlestick Pattern?

Trading the financial markets can often be complicated. However, traders and investors can use various tools in their technical analysis to gain more insights and better understand trends. Using the various tools and indicators, traders can deploy strategies. One such strategy is the moving average crossover. In this blog, we will look at what this strategy is and how one can use it.

What is a Moving Average?

Before understanding the moving average crossover strategy, it is vital to understand the moving average.

When you look at the price of an asset, you might notice short-term fluctuations in prices. Usually, the prices do not constantly move in one direction, which might make it difficult to understand the ongoing trend. However, a moving average smoothens out these short-term fluctuations in prices allowing traders to get a clear picture of the underlying trend. The moving average is a viable tool for several asset classes, such as stocks, commodities, and indices.

Some of the common moving averages in use are:

• Simple Moving Average (SMA): As the name suggests, the SMA is a simple moving average, which is calculated by taking the total prices over a period and dividing it by the duration. The SMA is easy to calculate and use.
• Exponential Moving Average (EMA): The EMA is a more agile and responsive moving average as it places more weight on recent prices.
• Weighted Moving Average (WMA): Similar to an EMA, the WMA also attaches higher weights to recent prices. However, each price point is assigned a different weight.

Moving Average Crossover Strategy

Now that we have explored what is a moving average and the different types of moving averages, let’s take a look at the moving average crossover strategy.

The moving average crossover is a strategy that makes use of two or more moving averages to identify trading opportunities, trends, and trend reversals. The strategy involves taking two moving averages of different periods and identifying buy or sell signals when one moving average crosses over another. The moving averages can be of the same type or different types.  

With the help of moving averages, traders can deploy trading strategies suitable for different market scenarios. Here are some of the common moving average crossover strategies:

Price Moving Average Crossover Strategy

Although this strategy makes use of one moving average, the crossover of the price helps in generating buy or sell signals.

In this strategy, a moving average such as a 20-day or 50-day moving average is plotted on a chart. If the price of an asset crosses over the moving average, it indicates a buying opportunity. But if the price falls below the moving average, traders can take it as a signal to exit existing positions or enter into a short trade.

Double Moving Average Crossover Strategy

The double-moving average crossover strategy makes use of two moving averages of different lengths. A crossover of the moving average can help traders identify trend changes or any buying or selling opportunities.

Let’s take a closer look at the strategy with the help of an example.

For example, a 7-day simple moving average and a 21-day simple moving average are plotted on a chart. When the 7-day SMA crosses above the 21-day SMA, it is a bullish signal. Whereas, if the 7-day SMA crosses below the 21-day SMA, it is a bearish signal.

The double-moving average crossover strategy can help identify changes in the underlying trend. When the shorter moving average crosses over the longer moving average, it is known as a Golden Cross. If the shorter moving average crosses below the longer moving average, it is known as a Death Cross.

Benefits of Moving Average Crossover Strategy

The moving average crossover strategy has several benefits. These include:

1. Ease

One of the key benefits of the strategy is that it is easy to use and understand. The calculation of moving averages is easy and the tools to plot these averages are easily available on trading platforms. The concept is easy to grasp making it an accessible indicator for many traders.

2. Trend-Following

Moving averages provide a broader view of an asset’s trend. Traders can use the moving average crossover strategy to follow the underlying trend or identify any trend reversals that take place.

3. Multiple Timeframes

Moving averages are applicable on multiple timeframes. Traders can make use of moving averages or moving averages crossover strategy for either intraday trades, swing trades, or even positional trades. Different types of moving averages also enable easy adaptability to different timeframes.

4. Reduces Market Noise

An asset's price is often subject to short-term market fluctuations. Additional external factors may also impact the price of an asset in the short term. However, a moving average smoothens the price data which reduces the market noise and provides a clear picture of the underlying trend.

Limitations of Moving Average Crossover

Although the moving average crossover has several benefits, there are certain limitations as well.

1. Lagging Indicator

Moving averages are a lagging indicator as it takes past data into account. Further, it does not respond quickly to any sudden changes in the market which may result in inaccurate signals or missed trading opportunities.

2. False Signals

Moving average crossovers can also generate false signals when the price action is volatile and choppy. The lack of a clear trend can lead to the generation of false signals.

3. Limited to Trending Markets

A moving average crossover strategy is especially useful in trending markets as it allows traders to capitalise on ongoing trends or trend reversals. However, in a range-bound or sideways market, the moving averages may generate false signals, leading to losses.

Conclusion

Moving averages are easy to understand and a helpful tool for traders. The moving average crossover is a great strategy for new traders as they can benefit from trend reversals and apply them on various timeframes. However, it is also important to know that the strategy has its limitations. Depending on the market conditions, traders should adapt their trading strategies accordingly. Making use of other technical indicators and a better understanding of market conditions can help increase the effectiveness of moving averages.