When day trading in the various financial markets, there are many different indicators one can use to create a trading signal. A trading signal will become the basis of a statistically valid trading system for a trader to use on a day-to-day basis. A trading signal can be simple or as complicated as a trader desires, but often traders prefer to use simpler signals on which to base their trades. One of the simplest trading signals one can use in creating a trading system is a moving average cross.
A moving average is the average price of an asset calculated over a certain time period. Using moving averages can give a trader a visual representation of the direction of the market that can be simple to under. There are several different types of moving averages that traders use to create trading signals. The most common type of moving average used is the simple moving average, which as its name implies is calculated simply by taking the average price over a period of time. There are also exponential moving averages and weighted moving averages. These two types of moving averages give extra weight to more recent data when calculating the average price, but they are calculated differently.
The basic idea of a moving average cross signal is that the trader observes two moving averages, one calculated on a shorter time period than the other. When the shorter moving average crosses the longer moving average, this is interpreted as a signal indicating that a new trend has begun in the direction of the cross. If the cross is upwards, this is interpreted as a long signal. If the cross is downwards, it is interpreted as a short signal. Many trading systems using a moving average cross use it only as an entrance signal. A trailing stop loss is usually used to exit trades in these systems.
Moving average cross systems are essentially a type of trend following system. Trend following systems can be very profitable during periods when markets are trending. For example, at the time this article was written (August 2007) a simple trend following system would have yielded large profits on almost all of the major currency pairs in the foreign exchange market. However, trend following systems experience drawdowns when markets are ranging, as they will often give signals that are immediately reversed, causing the trader to incur small losses with each failed signal. With proper risk management these drawdowns can be managed and trend following systems can be used to beat the market indexes.
