In the previous article, we learned how to use the moving average for determining the direction trend. The Moving Average lines not only helps us in identifying the direction of the market but also tells us when a trend is about to end and potentially reverse. In today’s lesson, we will see how the moving averages can be used to enter trades at the reversal of a trend.
The principle of the strategy is to discover the crossover of the two moving averages on the chart. When the moving averages crossover, it is a sign of market reversal halting the existing trend. So at this point, we need to find a suitable ‘entry.’
Moving Average Crossover Strategy
Let us consider an example to explain the above-discussed strategy. Below, we have a daily chart of USD/CHF on which we have plotted the two moving averages (10-Period & 20-period). We can see the market being in a strong downtrend, and it is also confirmed by the two moving averages, where the ‘faster’ MA is below the ‘slower’ MA.
The next step is to find the overlap of ‘faster’ MA with the ‘slower’ MA from above, which is also known as the crossover of MAs. Once the crossover happens, there is a higher chance of the trend reversing. The below chart shows precisely how the crossover takes place, which means the trend can potentially reverse anytime now.
But, we shouldn’t be directly going long soon after the crossover. We need to confirm the trend reversal. A ‘higher low’ after the crossover validates the trend reversal, and this could be the perfect setup for going ‘long’ in this currency pair.
The below chart shows the ‘higher low,’ which is formed exactly after the crossover. Therefore, we now have confirmation from the market, so we can take some risk-free positions.
As we can see, in the below chart, the trade goes in our favor and hits our initial target. However, aggressive traders can aim for a higher ‘take-profit’ as the new uptrend can reverse the entire downtrend, which is seen on the left-hand side. The reversal is also confirmed by moving averages where the ‘faster’ MA is above the ‘slower’ MA. The stop-loss for this trade is placed below the identified ‘higher low’ with a take-profit at a new high or significant S&R area.
The crossover strategy works beautifully in both volatile and trending markets, but they do not work that well in ranging markets. This is because the crossover takes place multiple times in the ranging market, and this leads to confusion about the market direction. To find high probability trades, one can also combine the strategy with other technical indicators to get additional confirmation of the trend reversal. In the next article, we shall see how moving averages can act as key support and resistance levels.