A moving average crossover is a popular strategy that scores of traders worldwide utilize. However, this is not a failsafe strategy, in fact, this strategy produces way too many false signals, especially in choppy market conditions, unless you use other indicators to validate these signals.
Today in this post you will learn a strategy that uses a combination of three moving averages with RSI that helps avoid false signals. Plus, I would also give a bonus tip that would further refine your entries and exits ,so you have stronger chances of getting into profitable trades.
I will start this article with the very basic topics to enable our beginner friends understand the concept effectively. However, if you feel you already know the basic ones, feel free to scroll down to the strategy part.
What are you going to learn in this article?
- What is Moving average?
- What is Moving Average crossover?
- What is RSI?
- How to use Moving average crossover strategy with RSI?
- Bonus tip
So, without wasting our time further let's get started.
What is a Moving Average?
A moving average is a technical tool that smoothes out the price movements, enabling us to observe the trend behind the price moves in an efficient and simple way. Fundamentally, a Moving Average (MA) is a trend indicator, that is it tells whether the price of a stock is going up or down or going sideways over a period.
I have written a detailed post on moving average and I would suggest that you read that post if you are not aware about the concept of moving averages.
What is Moving Average Crossover?
A moving average crossover occurs when two moving averages of different periods move above or below each other. Let's see this in a chart to understand this thoroughly.
Furthermore, a crossover can be bullish or bearish depending on whether the shorter period MA (in above chart 50MA is shorter period MA) is crossing above or below the larger period MA (In the chart above 200MA is larger period MA).
If the shorter period MA crosses above the larger period MA, it is a bullish MA crossover and when shorter MA crosses below the larger MA it is a bearish MA crossover. In the chart above, the shorter period MA, 50 MA crosses above larger period MA, 200MA at point B, so there is a bullish crossover at point B.
However, at point A, 50 MA crosses below the 200 MA, so there is a bearish MA crossover at point A.
A bullish crossover is a buy signal while a bearish crossover is a sell signal but it should not be used in isolation as it gives many false signals and needs other indicators, like RSI, to filter out the invalid signals. Let's understand the basics of RSI in the following paragraphs.
What is RSI?
A RSI is a momentum indicator, it tells how fast or slow the price of a stock is moving in a specified period. The default period for RSI is 14.
In a chart, RSI is plotted below the price chart and oscillates between 0 and 100 levels. RSI level above 50 suggests a bullish momentum, while RSI below 50 indicates a bearish momentum.
I have written a detailed post on RSI and would request you to peruse that post if you are a beginner.
Now that you have a basic idea of different indicators used in this strategy, let's move on to the most important part of the post, the strategy itself
How to use Moving average crossover strategy with RSI?
Before I discuss the details of the strategy, let me be clear here that every trader has his own way of using indicators, but the strategy I am discussing below is the one that I use regularly and profit from. You can use this strategy on any timeframe but I would suggest that you use this on a daily or a weekly timeframe. On lower timeframes I would advise you to do a backtesting before using it.
Also, I will only discuss the bullish crossover, that is, buy setup.
Let's get started.
I would divide this strategy into various actionable steps so it is easier to understand and apply.The strategy uses three moving averages- 200 MA, 50 MA and 21 MA with RSI.
Step 1- The Setup- Screening the right stocks-
First, we need to screen those stocks whose price is above 200 MA and 200 MA is slanted upwards. Price above 200MA suggests the stock is in long-term uptrend and a 200 MA line slanted upward means the stock is gaining momentum on a longer term basis.
In an uptrend, we would only take bullish moving average crossovers as buy signals and ignore the bearish crossovers which are sell signals. This enables us to take trades in the direction of trend.
Let's understand this setup with the help of a chart.
The chart above is a weekly chart of Bharti Airtel. The redline on the chart is 200 MA. Notice that price is above 200 MA, suggesting a long-term uptrend.Also, the 200 MA is slanted or inclined upward, suggesting a momentum gain on a longer term basis.
Now that you have an idea about the kind of stocks to screen for this strategy, let's move on to the next step.
Step 2- The Moving average Crossover-
Once you have found stocks meeting above criteria, now you have to look for a bullish moving average crossover between MA 21 and MA 50, that is 21 MA crossing above 50 MA. These are the potential entry points.
Let' see this in a chart.
This is the same chart that we have seen in the previous step. The red line is 200 MA and yellow and green lines are 50 MA and 21 MA, respectively. Notice that there is bullish MA crossover at two points as marked by arrows where 21 MA (green line) is crossing above 50 MA (yellow line). These can be potential entry points.
The Moving average crossovers shown in the above chart can be potential entry points (a buy signal) that need to be validated. RSI helps us in validating these signals, as discussed in the next step.
Step 3- Validation of Signal and Entry
To validate the potential buy signal we got in the previous step, you need to add RSI to the chart. A RSI level above 50 at the bullish MA crossover point suggests that there is enough momentum behind the move and the signal is valid. RSI below 50 at the bullish crossover point suggests there is little momentum behind the move and the signal is probably false.
Once the MA crossover is validated, you can enter the trade.
Let' see this in chart.
The chart above is the same chart that we used in the previous steps except that I have added RSI below the price chart. Observe that at the bullish crossover points, the RSI levels are 50.42 and 58.64, respectively. Since RSI is above 50 at both these points, the buy signals are valid and you can enter the trade.
Step 4- Stop loss and exit rules-
Once you have entered the trade, the next step is to set stop-loss in order to minimize the losses once the trade goes against us.
The stop-loss in this strategy is set just below the previous swing low.
See this in the chart below.
The bonus tip-
Sometimes, even after validating the moving average crossover signal with RSI, the trade goes against us. By adding another layer of validation, you can further filter out the false signals, increasing the chances of successful trades.
An indicator, Chaikin Money Flow (CMF) does this another layer of validation.
This indicator which incorporates volume in its calculation, measures the buying or selling pressure in a stock.
Chaikin money flow oscillates above and below 0 where a positive CMF (above 0) indicates buying pressure while a negative CMF indicates selling pressure.
A bullish moving average crossover validated with RSI above 50 and further validated by positive CMF increases the chances of a winning trade.
Let's see this in a chart.
Key Takeaways-
- A moving average crossover occurs when a shorter period MA crosses above or below a longer period MA.
- A crossing above the longer period MA is bullish while shorter MA crossing below the longer MA is bearish.
- Bullish MA crossover is a buy signal and vice versa.
- RSI validates these buy or sell signals.
- RSI above 50 validates a bullish MA crossover
- The signal can further be verified by Chaikin Money flow indicator, CMF.
Further reading-
Post a Comment