Swing traders use many indicators to help them assess potential trade opportunities. Moving averages – both Simple and Exponential – are among the most popular and effective when developing a trading strategy.
Today’s charting software makes it easy to display moving averages as lines on our charts, and they can help us to identify trends, likely areas of support and resistance, and even reversal points.
But to use them to maximum advantage, it’s essential to understand what they are and how they work.
What are Simple and Exponential Moving Averages?
In essence, a Simple Moving Average (SMA) is an expression of the average closing price of a financial instrument over a particular number of periods.
Any number of time periods can be used, but the 5, 10, 20, 50, 100, and 200, are among the most popular. Each ‘period’ represents a period of time, for example, 5 minutes, 10 minutes, 2 hours, etc. but for swing traders, each period will likely be 4 hours or one even one trading day.
Swing traders are focused on profiting from the main part of the trend. They’re not interested in trying to join a trend right at the start or leaving right at the end, the meat in the middle is where their profits come from.
In contrast, an Exponential Moving Average (EMA), gives greater importance to closing prices during the more recent periods.
While the calculation of the EMA can be a little complicated, fortunately, our software will perform them for us instantly and automatically.
The key takeaway is that EMAs are likely to give us a better indication of the current direction and strength of a trend than SMAs. And the fewer periods used, the more sensitive the picture will be to recent market sentiment.
The Theory of the EMA Crossover Strategy
Whether we are using SMAs or EMAs, the key idea underpinning the crossover strategy is the same.
When a shorter-term moving average line crosses a longer-term line, it may be an indication that an existing trend is accelerating or that it is losing momentum or about to reverse.
And we can tell which it is by looking at the direction of the cross and the existing trend.
An upward cross in a bull trend, for example, indicates a strengthening trend. But in a downtrend, it may signal a forthcoming consolidation or even a reversal.
The converse, of course, applies to downward crosses.
How to Trade the Moving Average Crossover
In the example below, taken from the EUR/USD weekly chart, we see the 20 EMA making an upward cross of the 50 EMA, indicating a strengthening uptrend after a bull pennant pattern had formed.
It’s also worth noting how the 20 EMA then remains above the 50 EMA – itself a bullish indicator – and goes on to act as resistance when price pulls back and begins to consolidate.
This is one of the beauties of EMA indicators – so many traders use them that they almost become self-fulfilling prophecies.
That said, it’s crucial to remember that they are lagging indicators only; and that the higher the number of time periods that are used, the greater the lag will be.
We should, therefore, never enter a trade based on a moving average crossover alone.
So, in our EUR/USD example, a strong bull candle formed on the day of the crossover and we could have looked to the four-hour chart to give us a precise entry.
This is a swing trade that would have given us a strong 6-day bull move before the price began to consolidate.
Even before the crossover, however, we might have noticed a Doji candle – indicating indecision – as the EA lines began to converge. And we might then have made a more aggressive entry as the price broke above the top of the previous upswing.
How to Use Candlesticks, Support and Resistance for Confirmation
Candlesticks such as hammers and inverted hammers are also good signal candles. But we should always wait for confirmation from the next candle before entering the trade.
Ideally, we should also look to trade only those crossovers that form at or near areas of horizontal support or resistance.
When the price is too far from EMA it is often a sign of being overbought or oversold and natural tendency to pull back towards the EMA, making this a high-risk entry.
Remember, huge numbers of traders are looking at these signals and if most of them act on the assumption that price is about to move in a certain direction, it very likely will.
So, in the example below, from the USD/JPY 4 hour chart, we see an upward cross on 8/9 that takes place in a support area, the blue 20 EMA, in fact, acting as support. There then follows a strong bull move during which the 20 EMA again acts as support on 8/10.
Weekly EURUSD Price Chart With 20 and 50 EMA – Potential long and short trades
By contrast, the upward cross on 8/24 takes place when the price has already pulled well away from the EMA lines and looks over-extended.
After a period of horizontal consolidation price then pulled back sharply, meaning that taking the crossover as an entry signal would in all probability have led to a losing trade.
In this way, the example is evidence of what we always need to bear in mind when trading the moving average crossover; and indeed when using moving averages at all – they are lagging indicators.
It’s therefore quite common for price to move significantly away from them before they catch up. And this time lag is accentuated when using longer time periods such as the 50, 100, or 200 averages.
For this reason, both SMA and EMA indicators – and the crossover strategy – are more effective in markets with a clear trend than those that are chopping sideways or ranging.
Risk Management and Stop-Losses
Finally, as with all swing trading strategies, sound risk management is crucial to long-term profitability.
This means using correct position sizing and appropriate stop-losses. And in the context of the moving average crossover, there are various possible approaches.
For example, since we are expecting the relevant moving average line to act as support or resistance, it makes sense to place our stop some distance to the other side of that line.
While we can use a standard number of pips for this purpose, the problem is that this method doesn’t allow for the differences in the volatility of different currency pairs.
A safer approach is to use a percentage of the Average True Range (ATR) of the instrument in question. Many traders use 50% as a rule of thumb, but this can be varied according to the attitude to risk and trading style of the individual.
We also need to be aware that if price pulls too far away from the EMA, this technique may leave us with a very wide stop and the risk of giving back a substantial proportion of our gains – particularly if we have got in early on a strong trend.
For example, look again at the strong bull move at 8/10 in the USD/JPY chart above.
In this situation, the smart option is to use a trailing stop, locking in profits by moving it in line with the close of each succeeding bar.
The moving average crossover is just one of many potentially profitable swing trading strategies, and it has the great virtue of simplicity.
Moving averages, though, are lagging indicators, and, like all trading strategies, it should only be used alongside a close study of the immediate price action and the candlestick patterns it is producing.
As an affiliate, I’ve partnered with TradingView to bring you their unique forex and stock screener that helps filter the best and most profitable trading opportunities. Get a free trial and access their charting platform with market-leading features.
Tim Thomas has no positions in the stocks, ETFs or commodities mentioned.
This post was produced and syndicated by Tim Thomas / Timothy Thomas Limited.
Featured image credit: Unsplash.