Two moving averages can be used together to generate crossover signals. Crossovers involve one relatively short moving average and one relatively long one.
As with all moving averages, the general length of the lookback period determines the indicator’s sensitivity. A system using a five-day EMA and a 20-day EMA would be deemed short-term. A system using a 50-day SMA and a 200-day SMA would be long-term.
A bullish crossover occurs when the shorter moving average crosses above the longer moving average. A bearish crossover occurs when the shorter moving average crosses below the longer moving average. As seen in “Look at me, MA,” when the five-period EMA (red) of Caterpillar (CAT) crossed below the 20-period EMA (blue), the stock began a downtrend correction from $95 to $83.
Moving average crossovers produce relatively late signals. After all, the strategy depends on two lagging indicators. The longer the moving average periods, the greater the lag in the signals. These signals work great when a good trend takes hold. However, a moving average crossover system will produce lots of false signals in the absence of a strong trend.
As lagging indicators, all moving-average-based strategies are not intended to get you in at the exact bottom nor out at the exact top. Rather, they keep you in line with the security’s price trend by being on the right side of the bulk of the move.
Bramesh Bhandari writes at www.brameshtechanalysis.com and provides online tutoring on technical analysis. He can be reached via email at firstname.lastname@example.org.