Question:
What is the significance of the crossing of the long, medium and short moving averages? How can a trader utilize this as a trading strategy? I have found your answers to be very informative.
Elmer from Hill Country
Answer:
Elmer, your question is deceptively simple, much like peanut butter and jelly. On the surface, P&J is a simple food for children, but underneath, it is packed with nutrition and flavor.
Using moving averages to find trades is one the simplest and most well-known trading strategies. In its most basic form, a buy signal generates when a shorter moving average crosses a longer moving average in an upward direction. A sell signal generates when a shorter moving average crosses a longer moving average in a downward direction. Like P&J, though, there is so much more to the story …
For example, MACD, Golden Cross, 5-day, 50-day, 200-day, Multiple Moving Averages Crossover Indicator, Exponential, and smoothing out are terms (along with many more) that add complexity to the simplicity of trading on moving averages. The story becomes more complicated when one adds technical indicators and mathematical formulas to find that winning trade. Many software-trading packages rely on moving averages underneath all of the technical jargon to find trades. The reason is simple. Moving averages are about trends, which are akin to the earth’s core—every movement on the surface starts at the core. The trend is the core of trading. It is all about movement, up or down.
And like most things in life, we tend to simplify that which is complex, and often that get us in trouble. For example, a simple maxim about moving averages says, Buy when crossing the X-day moving average. Sell short when it crosses below. The problem with this is that it is a low-probability trade. A.I. Stock Market Forum performed a back test with the S&P over the last thirty years to test this maxim, and here are the results. If you bought the market when it crossed above its 50-day moving average, and you sold it short when it crossed below, you were correct 22% of the time. If you bought the market when it crossed 100-day moving average you were right 19% of the time. If you bought the market when it crossed 200-day moving average you were right 17% of the time.This doesn’t mean you couldn’t make money, it just means it is a low probability trade.
The bottom line here is that moving averages are lagging indicators. Once the line is crossed, the action has passed. Current events can change a moving average line like that (snapped fingers). Having said that, I will say they are a fine tool for confirming a trend, assessing the strength of a trend, and forecasting a possible trend. Keep in mind, the more complex the moving average strategy becomes (mixing with technical indicators and mathematical formulas), the more reliable it is, unless of course a seismic event of some magnitude occurs.
Trade in the day; invest in your life …
