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Last Updated on 11 September, 2023 by Samuelsson
Moving averages are indicators that measure the n-period mean of a particular price point, mostly the close price. They are trend-following indicators and depending on the type of average that is calculated, they are classified into simple moving averages (SMA), exponential moving averages (EMA), linear-weighted moving averages (LWMA), and smoothed moving averages (SMMA).
Any of these moving average types can be used to create a crossover strategy, but traders often use the EMAs they focus more on the recent price data. In this post, we’ll discuss a 3 moving average crossover strategy, but first, let’s find out what a moving average crossover is.
What is a moving average crossover strategy?
A moving average crossover is a technical analysis method that uses two or more moving averages of different periods to analyze the trend and momentum of a market. Most times, EMAs of different periods are used for this. The longer-period EMAs indicate the trend, while the shorter-period EMAs are used to indicate the momentum of the price.
While one moving average can smooth out the overall price action and give us a good indication of the overall trend, using multiple moving averages helps to gauge the strength of the trends and also find trading opportunities. When only two moving averages are used, you can the golden cross and dead cross signals, which indicate the emergence of a bullish trend and a bearish trend respectively.
Why 3 moving averages for a strategy?
The idea of using 3 moving averages of different periods to create a strategy is to get an idea of the different trends in the market: long-term, medium-term, and short-term trends. The shortest period moving average in the system also indicates the price momentum and gives the trade signal when other conditions are right.
So, the main reason for using 3 moving averages is to know the situation of the various trends. They tell us when the long-term trend is in our favor and whether the short-term momentum is also on our side. If we choose to trade in both directions, the short-term moving average can tell us when to trade in the direction of the trend and when we may try the counter-trend move.
One thing you should note is that with the lagging nature of moving averages, even EMAs will not be able to pick tops and bottoms. But this is not necessarily a bad thing as it reduces false reversal signals, and sometimes, when the trend is changing, there are many such false signals due to sloppy trading conditions.
Our 3 moving average crossover strategy explained
As the name suggests, our 3 moving average crossover strategy makes use of 3 moving averages, and we are using EMAs of different periods. The 3 EMAs we use in the system are as follows:
- 5-day EMA
- 21-day EMA
- 63-day EMA
The 5-day EMA represents what happened in a trading week (there are 5 trading days in a week). It shows the short-term trend and momentum of the price action. The 21-day EMA shows what happened in the last trading month (there are about 21 trading days in a month). We use it to know the medium-term trend in the market. The 63-day EMA represents what happened in the market over the last 3 months (there are about 63 trading days in 3 months), and we use it to gauge the long-term price trend.
Here’s the general rule:
- The short-term, medium-term, and short-term trends are considered to be upward when the 63-day EMA is pointing up and lies below the 21-day EMA and 5-day EMA. The 21-day EMA is pointing up and lies below the 5-day EMA which is also pointing up.
- All the trends are considered to be in the downward direction if the 63-EMA lies above the other two and is sloping downward. The 21-day EMA is sloping downward and lies above the 5-day EMA, which is also sloping downward.
- When there’s an alteration of this arrangement — the 63-day EMA lying between the 21-day and 5-day EMAs — the trend may just be about to reverse from up to down or the other way round. It could also be that the market is in a range or that there is a deep pullback.
- A new uptrend is emerging if the 5-day EMA crosses above the other two from below them and the 21-day EMA cross above the 63-day EMA from below so that, from up to down, we have: the 5-EMA, 21-day EMA, and 63-day EMA.
- A new downtrend is about to emerge if the 5-day EMA crosses below the other two from above them, and the 21-day EMA cross below the 63-day EMA from above so that, from down to up, we have: the 5-EMA, 21-day EMA, and 63-day EMA.
How to trade with 3 moving average crossover
There are different ways to use the 3 moving average crossover strategy to find trading setups. Here, we will discuss three common ones, which are trading the emerging uptrend, trading the emerging downtrend, and trading trend continuation after a pullback.
Trading an emerging uptrend
Here, you are looking for a buy setup using the movement of the moving averages. You may also add other filters to reduce false signals.
The criteria for our buy setup are:
- The 5-day EMA crosses above the other two from below them
- The 21-day EMA cross above the 63-day EMA from below so that, from top to down, we have the 5-EMA, 21-day EMA, and 63-day EMA.
- The price breaks (closes) above the nearest swing high
We trail our profit.
Trading an emerging downtrend
Here, we intend to go short.
The criteria for our short setup are:
- The 5-day EMA crosses below the other two from above them
- The 21-day EMA cross below the 63-day EMA from above
- The price breaks (closes) below the nearest swing low
We trail our profit
Trading the trend continuation after a pullback
Here, we want to enter a trade in the direction of an uptrend after a pullback. Our criteria are as follows:
- The 5-day EMA crosses below the 21-day EMA, indicating a pullback
- The 5-day EMA then crosses above the 21-day EMA, indicating the continuation of the trend
We trail our profit.
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