Trading moving average crossovers is an effective trend-following technique used by many successful traders. To master this technique for your trading, however, there are a number of things you need to know. In this article, we will explain three ways in which you can use moving average crossovers for your trading.
In detail, we will answer these questions:
- What are moving average crossovers?
- How can I use the moving average crossovers to create trading signals?
- How to use the three moving average crossover technique to get the best trading signals
What are moving average crossovers?
Moving average crossovers are a simple-to-use technique that allows binary options traders to determine quickly whether the market is currently rising or falling. Based on the moving average crossover technique, you can find profitable trading opportunities with binary options that are both easy to find and create definite predictions. To understand how to use this technique, let’s take a look at how moving averages work first.
A moving average calculates the average price of the last periods. If you are using a moving average that takes ten periods into account and one period resembles one hour, your moving average calculates the average market price over the last ten hours. It then draws this price directly into your price chart.
The moving average repeats the process for each period in your chart, always using the last periods from the respective period’s position. For each period, the result is drawn into your chart, thereby creating a line.
When the market crosses the moving average upwards, it creates a buying signal. When the market crosses the moving average upwards, it creates a long signal. When the market crosses the moving average downwards, it creates a short signal.
When a trend changes direction, these signals create very good investment opportunities and generate a high percentage of winning trades if you trade the signals with high / low options. At first glance, this strategy seems easy and successful. There are, however, some problems.
In times of sideways market movements, the market can cross the line of the moving average a number of times and create invalid signals. Also, once the market has crossed the moving average, it does not necessarily remain on one side, even if the trend remains intact. Trading percentage retracements and market fluctuations can cause the market to cross the moving average again and create short-lived false signals.
How can I use moving average crossovers to create trading signals?
The position of this line in relation to the current market price can generate trading signals. Most of the time, the moving average and the market will move in the same direction. In times of changing market direction, however, the moving average will be slower to react. Depending on how many periods you use to calculate the moving average, the moving average’s delayed reaction will cause the market to cross the moving average sooner or later.
This is the first type of moving average that you can use for your trading,
- When the current market price is above the moving average, the market must have risen over the last periods. Consequently, you know that you should invest in rising prices to take advantage of this movement.
- When the current market price is below the moving average, the market must have fallen over the last periods. Consequently, you know that you should invest in falling prices over the last periods.
- Many traders create signals by trading the market’s crossing of the moving average.
- When the market is crossing the moving average upwards, traders conclude that the market has turned upwards recently and invest in rising prices.
- When the market is crossing the moving average downwards, traders conclude that the market has turned downwards recently and invest in falling prices.
These trading signals are simple to understand but also error prone. When the market is moving sideways, for example, the moving average will eventually move very close to the market. As the market swings upwards and downwards randomly, as it tends to do in a sideways movement, it will cross the moving average many times and create a lot of signals.
The overwhelming majority of these signals will fail to lead to long-lasting movements that are worth an investment with binary options. Instead, you will invest in random movements, and your odds of winning a trade will be roughly 50 percent – too little for binary options.
In trading situations like this, the moving average loses its power of finding profitable trading opportunities.
Using the crossover to generate signals
To fix the issue of false signals with moving averages, many traders started to combine two moving averages and trade the crossover of these two moving averages instead of the crossover of the market and a single moving average.
The logic behind this trading style is simple: by defining how many periods you use to calculate your moving average you can vary the nature of your moving average. A moving average based on only a few periods is agile and stays close to the current market price. The more periods you use to calculate the moving average, the slower the moving average will be to react to price movements, and the further the moving average will be from the current market price.
Consider this example:
- The market has moved upwards for a long time and has now started to turn downwards.
- You have two moving averages: one moving average based on 10 periods, and one moving average based on 25 periods.
What will happen?
- Of course, the moving average with 10 periods will react much quicker to the change in market direction.
- It will start falling and cross the moving average with 25 periods downwards.
- This downwards crossing indicates that the market has turned downwards recently and that traders should invest in falling prices to take advantage of this movement.
Conversely, when the faster moving average crosses the slower moving average upwards, you know that the market has started to move upwards recently and that you should invest in rising prices.
Compared to the strategy with only one moving average, this approach can eliminate many of the false signals that you would get during a sideways movement. Because both moving averages are based on multiple periods, they each move slower than the market itself. Consequently, you get less false signals during sideways movements.
This strategy is nonetheless unable to eliminate all false signals. During short sideways movements, the moving averages’ longer reaction time will save you from false signals, but longer sideways movements will cause both moving averages to get very close to each other and create the same kind of false signals that you would get with only one moving average.
To further avoid false signals, some traders to use moving averages that use many periods. A moving average that factors 30 periods into its calculation would require a sideways movement with a length of at least 30 periods to create false signals. By increasing the number of periods that you use for your moving average, you can increase the length of the sideways movement that you can survive without creating false signals.
This added security comes at a high price, though. A moving average based on many periods is slow to react to changing market environments, which is why your signals will be delayed significantly. When you get a signal, the signal might be so late that the market already has turned around again and you are investing in the wrong direction.
Luckily, there is a way to create trustworthy signals that are quick to react to changing market environments. This way is the three moving averages crossover technique.
How to use the three moving average crossover technique to get the best trading signals
The three moving average crossover technique does exactly what its name indicates: it adds a third moving average to its signal creation process. With the combined power of three moving averages, you can create reliable signals that still react just as quickly to changing market environments as a two-moving-average system with two short moving average.
The logic behind the three moving average crossover technique is simple. When you use three moving averages with a different number of periods, you can not only determine whether the market is moving up or down but also whether the market is in a trend or in a sideways movement or not.
During a trend the fastest moving average is the closest moving average to the current market price, the middle moving average is in the middle, and the slowest moving average is the further away from the current market price. This knowledge allows you to identify precisely what is happening in the market.
- When the fastest moving average is above the middle moving average and the middle moving average above the slowest moving average, the market must be in an uptrend.
- When the fastest moving average is below the middle moving average and the middle moving average below the slowest moving average, the market must be in a downtrend.
- When the order of the moving averages is mixed, the market is not trending. It is in a sideways movement, and you should not invest.
Based on these indications, there are two ways in which you can generate trading signals:
- When all three moving averages indicate a clear trend, you can invest in this trend until one moving average destroys the picture of a perfect trend.
- You can invest every time the moving averages position themselves to create the picture of a clear trend. This happens every time the middle moving average crosses the slowest moving average to the side of the fastest moving average.
- When the fastest moving average is above the slowest moving average and the middle moving average crosses the slowest moving average upwards, it confirms that the market is in an uptrend.
- When the fastest moving average is below the slowest moving average and the middle moving average crosses the slowest moving average downwards, it confirms that the market is in a downtrend.
With the first method, you will create more trading signals, but the second method will help you to invest in movements right when they begin, which increase your odds of winning the trade. Both methods can work just fine, and which method you should choose depends on your personality.
The biggest advantage of the three moving average crossover technique is that you can adapt a two moving average crossover strategy without losing the quickness in which it generates signals but gaining a lot of security. All you have to do is choose the third moving average shorter than the two moving averages that you already have.
Now, you create signals in exactly the same way as before: when the middle moving average crosses the slowest moving average. You do, however, have the shortest moving average to confirm the signal. You only invest when the fastest moving average already is on the side of the slowest moving average that the middle moving average is crossing to. If it is not, you ignore the signal.
With this type of trading strategy, you can avoid sideways movements but still successfully find trading opportunities during trending periods. It is the perfect strategy of trading moving average crossovers.
Theoretically, there is no limit to how many shorter moving averages you can add to secure your strategy. You can also trade a five moving average crossover technique or a ten moving average crossover technique. As long as you use the two slowest moving averages to create the signals and all other moving averages to confirm the signal, you should be fine.
There is, however, a limit to how much moving averages it makes sense to use. We recommend the three moving average crossover technique. Adding more moving averages is overkill that increases complexity without improving accuracy significantly, which is always a bad tradeoff.
How can I eliminate false signals?
If you feel that combining three moving averages is too complicated for your taste, there are other ways in which you can eliminate false signals from a strategy that uses only one or two moving averages.
These ways are:
- Wait for a number of periods to confirm the crossover: When the market crosses the moving average, you can wait for a number of periods to see if the market swings back quickly. If it does not but does continue to move away from the moving average you can invest in a binary option more safely.
- Wait for the crossover to extend: To eliminate false signals you can make it a rule that the market has to cross the moving average for a minimum extension before you invest. You can calculate this minimum extension by using a percentage of the asset’s price, an average of the last periods trading ranges, or another relevant value generated by a technical indicator.
- Search for increased volume: You can only invest in crossovers that are accompanied by an increase in volume. Generally, market movements with high volume are more significant than market movements with low volume because more traders support the movement. During a crossover, you can use this knowledge to evaluate whether the crossover is a true signal. For a strong signal, the volume should be at least as high as the average volume of the preceding periods. Since a higher volume indicates a stronger signal, you can improve your signals by requiring a higher volume, maybe twice as much as the average.
- Use highs and lows instead of closing prices: In an uptrend, you can make it a rule that the low of a period has to cross the moving average, not just the closing price. Conversely, in a downtrend, the high has to close the moving average before you invest in a change in trend direction.
Each of these ways can help you to improve your winning percentage and to secure your trading strategy.
Moving average crossovers are a simple technique to create trading signals. Despite their simplicity, crossovers can help you to find highly profitable trading opportunities. This combination of easy-to-use signals and high quality makes moving average crossovers attractive for all traders and especially newcomers.
To improve the quality of your signals, you can combine multiple moving averages or use on of the other techniques that we recommended.
In any case, moving averages are a great basis for your trading strategy. We wish you a lot of fun and success!
More about Moving Averages
If you want to learn more about the use of moving averages in binary options, we recommend you to read the following: