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SIMPLE MOVING AVERAGES - TWO LINES
Doug Schaff
FX-Strategy
Moving Averages are commonly used as a tool for trend identification. They calculate and plot a simple arithmetic average of prices for a specified period.
Many users will consider the direction in which the average is moving and the relative position of prices compared to the moving average. Since one of the basic uses of moving averages is to define the underlying direction of prices and whether price rises or falls through the average, it is also possible to use two moving averages. The faster moving average (measured over the shorter period) may be used as a proxy for price and thereby eliminate the short-term fluctuations in price action. Many analysts will then consider the crossover of the fast average above the slow average (a Golden Cross) as bullish and the crossover of the fast average below the slow average (a Dead Cross) as bearish.
Some traders will use this as the basis for a system, but adding in controls over profit and loss.
When considering utilizing two moving averages to determine trading signals, it must be understood that since the averages are based on the close price, that the signals provided will imply entries on the close of the bar of crossover. On a simple visual look at the crossover points it can occasionally be misleading to look at the actual point where the averages cross. By the time this has occurred price has often moved quite some distance away from the averages. Consider the chart above which actually provides only two profitable trades with a probable third. The first is the initial sell order on the left although the profit is not that great and the second is the buy signal to the right center of the chart which occurred just as price was trending higher. The final sell signal looks as if it will produce a profit.
However, all other trades provide losses since the movement of price has outstripped the moving averages and by the time reversal is made, the market has exceeded the entry price.
This is quite normal with moving averages and it must be understood that the optimum lengths of the averages cannot be established ahead of the fact. In general a dual moving average system will make strong profits during a trending market, but the losses can be substantial during consolidation.
