- January 6, 2019
- Posted by: CoachShane
- Categories: Trading Article, Trading Indicators
The three moving average crossover strategy is an approach to trading that uses 3 exponential moving averages of various lengths.
All moving averages are lagging indicators however when used correctly, can help frame the market for a trader. You can see how MA’s can give you information about market states by looking at the Alligator trading strategy that I posted a while ago.
Using moving averages, instead of buying and selling at any location on the chart, can have traders zoning in on a particular chart location.
From there, traders can use various simple price action patterns to decide on a trading opportunity.
Why 3 Moving Averages For A Strategy?
There is no magic in moving averages but they can be used to form the basis of a simple trading strategy that works.
For some reason, Forex traders especially enjoy these types of strategies. You can develop many trading systems using averages but remember that complex trading strategies are not always best.
When in doubt, do less.
The benefits of using a triple moving average strategy?
- Shows us the longer term trend direction and if the shorter term trend is in our favor
- We can see a shorter term trend to determine if we will be taking a with trend or counter trend trade
You must keep in mind that the lagging nature of moving averages, even EMA’s, will not enable picking tops and bottoms. That is not a bad thing as times when the trend is changing can make for some sloppy trading conditions.
The main difference between using 2 moving averages, such as the Golden Cross strategy, and 3 averages is having a longer term trend direction.
The Triple Moving Averages – What Do They Represent?
As I mentioned, the 3 EMA’s will have different lengths and they will be:
- 9 period EMA
- 21 period EMA
- 55 period EMA (some will use the 50 EMA moving average but it doesn’t really matter)
The 55 EMA will be considered the longer term trend direction indicator:
- When the 55 EMA is below both the 9 and 21, we will consider the trend to be up
- When the indicator is above both of the shorter term moving averages, we will consider the longer term trend to be down
The 21 EMA is considered a medium term trend indicator:
- We want to see the 21 below the 9 and above the 55 for an uptrend
- The 21 should be above the 9 and below the 55 for a down trend
The 9 period will be seen crossing over and under the 21 period more times than crossing the 55:
- The 9 EMA crossing over the 21 while already above the 55, is an uptrend and looking for a buy trade
- If it crosses below the 21 while already below the 55, that is a down trend and looking for a sell trade
There will be many times where the 9 EMA will crossover the 21 period which will turn the short term trend against the longer term trend. There can be trading opportunities in line with the shorter term trend and against the longer term trend direction.
When we get an mix of trend directions, we are conservative with profit targets and must exit when facing adverse price action.
Trading With Three Moving Averages – The Strategy
While we could simply trade the crossovers, that is not the best way of using the 3 EMA’s. Expect a lot of whipsaw if you decide to take a trade based on only a crossover.
You can tell a lot about the market from the state of the moving averages:
- When the indicators are jumbled together, consider the market to be in a trading range
- When the faster moving average starts to pull away from the others, consider momentum entering the market
- Seeing the 9 and 21 EMA crossing and separating, we are looking at a trending market
- When all the averages line up, strong trend is in play
From those four items, we can determine what type of trading setups we need to enter the market.
This one hour price chart is a Forex currency pair although you can use this on any instrument.
- We look for the moving averages to line up in the same direction in order – 9, 21, 55
- Once the final cross takes place, in this case the 21 crossed the 55, we look left for a swing high
- If that swing high has been taken out, we on the close of the candlestick – note the green arrow
- If the swing high has not been taken out, buy on the close of the candlestick that does so
You can see on the left side of this price chart that the swing high was taken out prior to the cross. You buy the close.
Continuation Trade – One Example
Once we are in a confirmed trend, we can look for the 9 EMA to crossover the 21 EMA which reverses the short term trend direction.
Using the same rules, we look for a swing high to be taken out once the 9/21 cross back in an uptrend direction.
Note on this chart with the red X, while the averages crossed, the swing high was intact saving us from a losing trade.
If we do have a crossover in the short term trend, we don’t know if we are looking at a potential longer term change. The key is to read the price action!
If the crossovers happen, price is essentially performing a pullback. In pullback trading, we do not want to see strong momentum against the trend.
If momentum occurs when the averages cross, I would suggest standing aside until price normalizes.
- We use the lowest swing low of the range as the area that needs to break to consider shorts
- The 21 EMA has crossed the 9 and crossed the 55 EMA setting up a short
- Sell the close of the candlestick that forced the moving average crossover
The short setup is the mirror opposite of the buy setup and they share the same vital variable: we need to see a pivot low or high broken before taking the trade.
Stop Loss + Profit Taking + Trailing Stops
There are many ways to place your stop loss on these types of trades and there are a few things to keep in mind:
- Allow room for price to move so avoid a tight stop loss
- Be consistent
Using the 2 X ATR allows your stop to remain outside the normal volatility and allows price to fluctuate.
Using previous swing highs or lows are a simple visual area but due to the lagging nature of moving averages, the pivots may be far from price
We have the cross to the downside on this crude oil futures chart and the candlestick we’d short is marked.
Set the stop to 2 X ATR or choose the swing high. In this case we get stopped out but if we didn’t, we could trail the 55 EMA, the 21 EMA or set profit targets at risk multiples. Aiming for previous swing low zones is also a good plan.
Continuation Trade – Second Example
As discussed earlier, we could use the shorter moving average crossovers for continuation trade but remember what a crossover represents:
A change in the direction of the trend – short or longer term.
This means that you could be looking at a market that is getting weak. Using our rule of needing a swing high or low to be taken out before taking the trade can save us some losing trades.
But what about a strong trending market?
Heading back to the crude oil chart…..
I have circled a gap in the averages and how far price has moved from the averages. Price has dropped with momentum and although the cross of the averages is a trade, you may have trading plan rules in place forcing you to stand aside.
Why? You expect a snap back in price due to the previous momentum.
This is where continuation trade will come into play.
- Price pulls back into the 9/21 EMA
- A reversal pattern, reversal candlestick, or simple trend line break is a trade trigger
- Stops can go above the last high candlestick
- Rules regarding profit taking are the same as the other strategies
What about Bitcoin?
- Price pulled back and a large momentum candle takes out the previous 4 hours to the upside
- Pullback and momentum steps into the market
- Pullback into the EMA’s and inside candle (lower time frame range) or
- Trend line break and entry
The key points are:
- Market is trending
- Market has upside (downside) momentum
- Price pulls back in between the 9/21 moving averages
As with all trading strategies, back test your rules and design a trading plan that includes everything from markets to risk tolerance.
Triple EMA Trading Strategy – Thoughts
The lagging issue with moving averages can cause problems such as price moving too far too fast. This can have us getting into a trade just when price snaps back to an average price.
The good thing is we can judge momentum based on the separation of the averages as well as the distance price is from the averages.
Adding in the needed breaks of swing levels in all trades except the continuation two method, ensures that price action is showing us a trending price pattern.
Having three moving averages helps us have no doubt if a market is trending or is ranging.
- If we see separation in the averages, we have a trend
- If price is whipping back and forth around the averages, we have a range
If you don’t blindly trade the 3 EMA crosses, you could find an edge in this type of strategy where you take advantage of trend, momentum, and a simple trade management and profit taking routine.