In a previous article “Using Moving Average to Determine Trend & Entries“, I introduced readers to the most commonly used components of technical analysis, the simple moving average. A moving average is a running mean of the closing price of a stock over x number of time periods. The two most widely used averages, even by those who rarely look at price charts, are the 50day and 200day simple moving averages.

In that article I talked about two key strategies that harness the power of the moving average to help investors determine their entries and exits for stocks they are interested in. We looked at how the slope of the average itself can helps us stay in a stock even when price displays rather choppy trading action. It can also help us exit a stock by telling us when the dominant trend has come to an end.

We also discussed a price crossover strategy, where one uses the price-to-moving-average relationship to determine ideal entry and exit points for the stocks in one’s portfolio. I mentioned that one should buy a stock once it crosses the moving average from below, and sell the stock once it crosses the moving average from above. One can use short-term (10-day), medium-term (50-day) and longer-term (100-day) moving averages, depending on one’s determined holding period.

In this article I want to introduce what is perhaps the most common strategy involving the use of moving averages: the moving average crossover. In this strategy, one would use two different moving averages – a longer-term average and a shorter-term average – and apply them to a price chart. Strategic information is determined, as the name implies, whenever the two averages cross over each other and form our moving average crossover.

The way this system works is very simple: a buy signal is generated whenever the short-term average crosses the longer-term average from below and a sell signal is generated whenever the short-term average crosses the longer-term average from above. Some of the most commonly used moving average combinations in the moving average crossover strategy are:

• 5day and 20day moving averages for short-term trades
• 20day and 50day moving averages for medium-term trades
• 50day and 200day moving averages for long-term trades

In the chart below you will see the S&P 500 with the short-term set of moving averages overlaid. You can see that this set of averages over a period of 6 months captures a number of prominent trends. It keeps the investor out of the drawdowns and gets the investor back into the market at a better entry point (below the previous exit). However, you can also see that the action during September (within the black box) was pretty choppy. This generated two signals that were premature before a profitable sell signal was generated. Choppy, sideways price action, often called “whipsaw” price action, is the Achilles heel of any moving average crossover trading system.

The S&P 500: 5day/20day Moving Average Crossover Buy and Sell Signals

Of course, the moving average crossover system can be applied not only to Exchange Traded Funds like SPY. It is also a great system to use on individual companies. In the chart of Apple, Inc. (Nasdaq: AAPL) below, you will see the longer-term averages (50day/200day) applied to three years of price data. Even over this stretch of time only 2 signals were generated, and both profitable. The bearish crossover in late 2012 would have saved investors in AAPL shares a drawdown of about -14%, not to mention about 10 month’s worth of opportunity costs on the investment capital waiting for shares to rebound. So commonly used are these two moving averages on stocks and indexes that analysts have given pet names to the crossovers. The bearish crossover of the 50day and 200day moving averages is called a “death cross,” while the bullish crossover of the same is called a “golden cross.” On the AAPL chart below, you will see one of each:

AAPL: 50day/200day Moving Average Crossover Buy and Sell Signals

In a final article in this 3-part series, I’ll introduce you to what is arguably the most powerful way to use moving averages: the mean-reversion strategy. It requires adding an additional technical indicator to the chart, but once overlaid it provides picture perfect and very precise entry and exit points for your trades.

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