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As a trader, you need to master the two technical indicators that are very simple to use but most effective. These are the trendlines and the moving averages. These two technical indicators can be used with a naked eye by just eyeballing the chart. They work for all markets. While calculating the moving averages, the time period used to calculate the average is very important. The shorter the time period, more fluctuations and whipsaw. What this means is the chances of getting wrong trading signals increase with shorted time periods.
There are three types of moving averages. Simple averages are calculated by dividing all the prices with the number of time periods used to calculate the average. In case of weighted and exponential moving averages, more weight is given to the recent prices as compared to the old ones making them more responsive to recent price action as compared to the simple moving averages.
Now, longer time period averages tend to move slowly and have a long curve that makes them slow in giving trading signals. Traders use a combination of slow and fast averages in trading. A trading signal is generated when the two cross each other and hence the name crossovers.
Most traders use the combination of three averages. When the short period average crosses the medium one, this gives a trading signal but this need to be confirmed. Confirmation is obtained when the short and the medium move above the longer period average. Futures traders use the combination like 4,9 and 18 period averages. Stock traders use longer periods like the 40 day, 100 day and 200 day to generate trading signals.
Now next to trendlines, moving averages are the most widely used technical indicators. So when using moving average crossovers, when the short period average is above the long period average, you should be long. Similarly when the short period average is below the long period average, you should be short.
The crossovers of these short and longer averages provide the trading signal to act as they indicate that the momentum is shifting from one direction to another. Moving average crossovers are an important tool in the arsenal of any trader. Moving Average Convergence Divergence (MACD) one of the most popular indicator depends on them.
However, when trading with these crossovers, you should know this that these averages are lagging indicators. What this means is that they are giving a signal about the past price action something that has already taken place. These averages work very well in a trending market but do not work well in non trending or choppy markets.
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