Let the Moving Averages Guide Your Trading
Being one of the most widely used technical tools in the market; the Moving Average (MA) needs little introduction to seasoned FX traders. For those new to the FX world a Moving Average is a trend following tool used by chartists which helps determine the underlying trend by smoothing past price data.
An understanding of the application of Moving Averages is an excellent addition to any traders knowledge base, although they are often under employed by many traders, perhaps due to their simplicity. This can be a costly mistake as they are an excellent timing tool during trending markets, and adherence to their rules gives traders a convenient method for exercising discipline.
Today I am going to discuss the triple crossover method to highlight the potency of using multiple moving averages to engage in strongly organised trends. Multiple moving average systems have the advantage of combining the strengths of shorter term and longer term moving averages, and attempt to address the reasons for the mixed returns found in empirical studies of single moving averages when compared with buy and hold strategies evidenced in equity market research.
A system combining short and long term moving averages targets a reduction in the false trade signals typical when using short term moving averages only, along with targeting a reduction of the lag in signals that occur when a system employs only longer term moving averages.
One of the most widely used triple crossover systems is the 4-9-18 day moving average combination popular amongst futures traders and introduced by R.C. Allen in his 1972 book, How to Build a Fortune in Commodities. Today I am going to demonstrate that the system can also be effective when applied to the foreign exchange area.
How to Use the 4-9-18 Day Moving Average System
Since shorter-term moving averages follow price more closely (due to them averaging more recent prices) the 4-day average will follow the trend most closely, followed to a lesser extent by the 9-day and then the 18-day average.
During an uptrend the proper alignment will therefore be the 4 day average above the 9 day average, which will be above the 18 day average, with the reverse alignment applying during downtrends (4 day will be the lowest, followed by the 9 day and then the 18 day average).
A buy alert takes place in a downtrend when the 4-day average crosses above both the 9 and 18-day averages. Confirmation of the buy signal is received when the 9-day average then crosses above the 18-day average giving us our desired moving average alignment. During a strong uptrend the averages will stay in the correct alignment although some inter-mingling may occur during consolidations and corrective movements, during which some traders may choose to take profit or alternatively add to positions, depending on how aggressive they wish to trade. For simplicity today I’m just going to focus on strict application of the rules.
Sell alerts take place when the uptrend reverses to the downside, at this point the shortest (and most sensitive) 4 day average will dip under the 9-day and then the 18 –day average. Confirmation of the sell signal occurs when the next longer average (9- day) drops below the 18-day average, although some traders may wish to liquidate their longs when the 4-day first crosses the 9-day average. Strict adherence to the rule will be to wait till the confirmation is received and the correct moving average alignment is in place to avoid premature exits.
Let’s now take a look at a daily chart to see how well our system has worked recently, in this example with the AUD/USD, we will examine the system using Simple Moving Averages (SMAs).
Looking at the chart for the period studied we can see that the triple crossover system called for 9 trades with the last trade currently being open. Marking the final trade at market of 1.0472 (at time of writing, although I acknowledge it is unlikely to be the rate the last trade is cut) and utilizing a long only strategy would have yielded a profit of ~831 pips currently, a long/short strategy would have improved the return to a profit of ~1328 pips.
The weakness of the strategy is naturally the potential for wide stop losses (maximum ~113 pips on one trade in this period examined) before the averages realign correctly and trigger the opposing trade signal.
In subsequent technical commentaries I will look at ways traders can mitigate this risk, in the meantime I encourage traders to test the effectiveness of using multiple moving average strategies like this one on their favourite currencies across differing time periods.