When you draw technical indicators on a chart it can have the effect of making you feel secure in the fact that the added structure puts perceived boundaries on the price action, and with this in mind, moving averages have to be right up there in terms of their comfort blanketing ability (like mollycoddling a trader in swathes of fresh linen sheets). Moving averages on a stock chart can make you feel safe, and go further still, by instilling confidence that can make you believe that a position will be a dead-cert. The most common moving averages which people use are the 10-day, 20-day, 50-day, 100-day and 200-day respectively.
It’s important to note which are the most common variants, because humans have a natural tendency to want to be mavericks in the markets, and this is more often than not, to their detriment. When you hear statements which refer to the market reflecting herd mentality, your natural reaction (if it’s anything like mine) is to not want to be part of the herd, because after all, if the frequently claimed 98% of cattle in the market are losing money, why would you want to be following what they are doing? Moooo!
You don’t want to follow the losing herd per se, but you do want to follow the order flow in the market which is creating the current price action. In the case of using moving averages to signal trade entry points, it’s essential you use the most common periods, those which the majority of traders using them will have drawn on their charts. Getting in-sync with the market means exactly that, and in order to do this then it is beneficial to see the same chart everyone else is seeing; you’ll seldom find a better example than when a market is in a strong down trend and there is a sharp and sudden spike upwards back to a moving average, which usually creates a huge form of pin bar, only for the price to head back down and continue on its original path.
When you see moves in the market which don’t quite makes sense to you, then it is worth analyzing through the chart time frames in this fashion to see if you can identify what just happened. Including a 50-day, 100-day and 200-day moving averages on your stock charts is a relatively sensible place to start. If you are using moving averages on your charts, and work through the different time frames then it’s highly likely that what just happened, is that price pulled back to the 100-day moving average on the 4 hour chart - or something to this effect, and then resumed the strong downwardly trend.
Whilst moving average crossovers provide zero substance, understanding how the market pulls back to individual moving averages, even when the price is trending away from the indicator can offer up some fantastic trading opportunities with large profit making potential. Again, this another market nuance that is really best viewed in your live trading account to be appreciated and better understood. The great thing about using this technique as an entry signal is that the price often pulls back to the moving average with pin-point accuracy meaning that you can trade these set-ups with an extremely tight stop loss.
"If price breaks through, or even more convincingly, closes through a moving average after one of these strong pull-back spikes, then exiting your current position is highly recommended."
Some individuals prefer to use moving average crossovers as a confirmation to take up a position in the market, usually something along the lines of, if a 10-day moving average crosses through the 50-day moving average then enter the market on that basis. The issue with using these indicators in this way is that because they are a lagging indicator, meaning they reflect past data sets, a trend could already be well underway and about to reverse by the time the entry signal is confirmed. You are trading in the past.
Furthermore, using a moving average crossover technique in ranging markets will provide a huge amount of false signals that will almost always negate any profits made on successful trades. If you have a method that both identifies and confirms ranging market conditions to eliminate this issue, then trading crossovers could possibly work with some degree of success, otherwise they are likely far more useful for supplementary purposes to your main entry technique. I use pullbacks to moving averages as an entry point occasionally, but only when there is huge room to travel between current price action and the average. As they are difficult to catch I will use a pending order which is somewhere in the range I am looking to hit (as the averages are constantly moving). If you want a more detailed, visual explanation then it is on my personal HedgeFX trading charts which are available on the site.
Some of the most successful trading techniques contain if statements along the lines of the current price level must be above or below a specific moving average period in order to meet the criteria for a trade entry, and this is possibly the most useful way of implementing this particular indicator into your trading strategy. Bear in mind also, that these indicators are not fixed; that is to say that if you are trading in June and you look back and mark where the moving average was in January, it may not be in the same position when you go and check back in December.
Price can move up to a level that falls short of the moving average line by quite some distance, which at the time appears random; it is only when a strong ensuing downtrend occurs that the moving average line is dragged down and then comes rest perfectly on top of the seemingly random high witnessed previously. The market can take on very strange, and sometimes future-predicting behavior at times, which can serve as a huge distraction to your overall trading objectives. It is advised to not waste energy attempting to find explanations for the market's behavior, and rather, spend all of your time focused on building a profitable trading system that delivers consistent returns.
Moving averages alone (not crossovers) most certainly have a part to play in the markets, and they are certainly one of the most widely used technical indicators. Taking the time to understand how price action moves and reacts in relation to moving averages will most certainly serve you with valuable knowledge which can be used to increase your overall trading abilities. Technical indicators can be massively effective when used in conjunction with the right system, and it is true that some of the most profitable traders both in the past, and present rely on technical analysis as the sole basis for their entry and exit points in the markets.