How to Use Moving Averages Correctly – Can You Really Win with the Golden Cross?!
One of the first indicators you will run into when you start trading FX is the moving average (MA). Many beginner books and educational sites introduce it as the most basic of basics, and signals like the golden cross and death cross are especially popular because they are easy for beginners to understand. But can such a simple indicator really generate profits? In this article, we take a thorough look at moving averages, from the basics to practical use, and at the question of whether you can actually win with the golden cross.
What Is a Moving Average? The Basics and Types
A moving average is a line connecting the average price over a set period. By smoothing out price fluctuations on the chart, it makes the market trend easier to see. The main types are as follows.
1. Simple Moving Average (SMA)
The most basic moving average: it simply adds up the prices over the specified period and takes the average. For example, a 20-day SMA calculates the average of the closing prices over the last 20 days.
2. Exponential Moving Average (EMA)
A moving average that gives more weight to recent data. Because it reacts more sensitively to price changes than the SMA, it is said to help spot trend reversals early.
Common Moving Average Signals Traders Believe In
The moving average signals introduced in many trading books include the following:
1. Golden Cross and Death Cross
A golden cross, where a short-term moving average crosses above a long-term moving average, is considered a buy signal, while a death cross, where it crosses below, is considered a sell signal. For example, a golden cross in which the 5-day MA breaks above the 20-day MA is said to suggest the start of an uptrend.
2. Granville’s Rules
A method of reading the market from the position of price relative to the moving average. For example, there are rules such as “if price breaks above the moving average, pulls back, and then bounces off the moving average, buy.”
3. Trend Identification
If price is above the moving average, the market is judged to be in an uptrend; if it is below, a downtrend. The direction of the moving average itself is also considered important.
Can You Really Win with the Golden Cross?
The simple strategy of “buy on the golden cross, sell on the death cross” has been known for a long time, but when used as a standalone indicator in real trading, it usually produces disappointing results. Let’s examine why.
1. It Is a Lagging Indicator
A moving average is essentially a lagging indicator. Because it is calculated from past prices, by the time a cross occurs, the trend has often already formed. In ranging markets in particular, price frequently reverses right after a cross.
2. The Ranging Market Trap
It is said that the market spends about 70% of its time ranging. In a ranging market, golden crosses and death crosses occur frequently, and many of them turn out to be false signals. Losses often come when a cross forms at the top or bottom of the range and price then reverses.
3. Experimental Testing
If you backtest a simple system that enters only on crosses of the 20-day and 50-day moving averages, you generally get results like these.
- Win rate: about 40-45%
- Profitability: net losses in ranging markets, positive only in strong trending markets
In other words, the reality is that trading on golden crosses alone makes it hard to stay profitable over the long run.
The Role of Moving Averages in Trading
In the technical trading method recommended on this site, moving averages are positioned strictly as a supporting indicator. What matters are the following three elements of analysis.
- Dow Theory: the fundamental framework for understanding market trends
- Horizontal levels: support and resistance lines that mark important past price zones
- Multi-timeframe analysis: a method of grasping the market context across multiple timeframes
With these combined, moving averages are used in a supporting role as follows.
Dow Theory and horizontal levels are covered in detail in the articles below, so please refer to them.
How to Use the 20 MA
In the chart setup recommended on this site, the only moving average we really focus on is the 20-period SMA, the “20 MA” that this site is named after. Rather than cluttering the chart with multiple moving averages, we use the 20 MA from different timeframes.
For example, on a 1-hour chart (H1), display:
- The 20 MA of the 1-hour chart (H1)
- The 20 MA of the 4-hour chart (H4) (= the 80 MA on H1)
- The 20 MA of the daily chart (= the 480 MA on H1)
With this simple setup, you can check the trends of different timeframes on a single chart.
Practical Examples
Moving averages are mainly used in the following ways.
- Confirming trend direction: check the direction of the recent trend from the slope of the short-term MA
- Fine-tuning entry decisions: for example, if you are considering a short entry while the 20 MA is rising, follow Granville’s rules and wait for a retracement after price breaks below the 20 MA
- Acting as support and resistance: especially during strong trends, the 20 MA can act as support or resistance
Why Use It Only as a “Supporting” Tool?
As you know, a moving average has a period setting. So what will you set it to? Some people use the 25 MA, others the 75 MA, and others the 5 MA. If the period changes, the shape of the MA naturally changes too, and so does the timing at which it turns from rising to falling. In other words, an indicator with parameters that people can input may vary in how reproducible it is. That is why we don’t use the MA as the main basis for trade decisions.
Reasons for choosing 20 periods include the fact that four weeks (≈ one month) contain 20 trading days, and that 20 is commonly used in popular indicators such as Bollinger Bands. However, what matters is fixing your own way of using it and your own style. Whether the number is 20 or 21 doesn’t make that much difference.
Key Points for Using Moving Averages Effectively
To use moving averages more effectively, keep the following points in mind.
1. Combine Them with the Market Context
Use moving averages to reinforce the market context you have identified with Dow Theory and horizontal levels. For example:
- If you judge the market to be in an uptrend: use a bounce off the 20 MA as one reason for a buy entry
- If you judge it to be a ranging market: don’t use the MA, and prioritize range trading off horizontal levels
2. Consistency Across Timeframes
In the multi-timeframe analysis recommended on this site, the relationship between moving averages on multiple timeframes is also important. Here are some examples.
- If the daily 20 MA is pointing up, the H4 20 MA is pointing up, and price on H1 has broken above the 20 MA, an uptrend is highly likely
- When the MAs on each timeframe point in the same direction, the trend may be strong
3. Don’t Use Them as a Standalone Indicator
Most importantly, don’t use moving averages as a standalone buy/sell signal. Use them strictly as a supporting indicator combined with other analysis.
Summary: Moving Averages Are Not a Cure-All
Moving averages, especially golden crosses and death crosses, are popular with beginners, but the chances of winning with them alone are low. You need to be especially careful in ranging markets, where they produce many false signals.
On this site, moving averages are positioned strictly as an indicator that supports Dow Theory, horizontal levels, and multi-timeframe analysis. Making effective use of the 20 MA while checking that it is consistent with the other elements of your analysis leads to more accurate trades.
Next time, we’ll cover “The Right Timing for Stop Loss and Take Profit – Avoiding Beginners’ Fatal Mistakes.” We’ll take a detailed look at how to make the most of entry points found through technical analysis, including moving averages, and how to manage risk. Stay tuned!
