Using Two Moving Averages
As an alternative, to try and overcome the disadvantages of a single moving average, you might look at a system using two moving averages to generate trading signals. This is another commonly used system, and is called the double crossover method. Again, it’s best when the financial security is trending rather than moving sideways.
First you plot two moving averages on the charts, with one of them a shorter time frame than the other. The signal to buy or sell is given whenever the averages cross. There are many different average pairs used – five day and 20 day, 12 day and 24 day, 10 day and 30 day, 10 day and 50 day, and so on. Since we already have a chart with a 10 day and 50 day moving average, we’ll look at that one.
The way it is usually stated, there is a buy signal when the shorter term moving average crosses above the longer-term average, and a sell signal when the short-term average falls below the long-term average. Sometimes there is also a requirement for the long-term average to be moving in the direction of the trade, i.e. upwards if you are buying. I’ll just look at the chart for crossings, and see how we would have done trading long. Here are the crossings –
We would have bought at 200, selling at 240, where the stock was trading when we got the signal. We would buy again at just over 280, selling quickly for a loss at about 260. Our final trade on this chart would be buying at 290 and selling at 325. Our net gain would be 55, going long only. In this time the stock went from 160 to about 360, with in addition some tradable retracements, so this method obviously left some of the possible profits on the table. But it did finish up with more gains than losses.
Again you can play with the time periods used and back test to try and optimize the signals. It’s generally recognized that the double crossover method lags the market a little bit more than using a single average, but usually produces fewer whipsaws.
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