One of the simplest trend-following trading systems is a moving average (MA) crossover of two MAs superimposed on a price chart. An MA represents the trend of the period it covers. A shorter-term MA represents a more recent trend. The price itself is equivalent to a one-day MA. So, one can think of an MA system as a system that analyses three MAs.
In an MA crossover system, if the shorter MA is higher than the longer MA, the recent trend is bullish. That’s the basic buy signal. If the shorter trend is lower than the long-term trend, the recent trend is negative. That’s the basic sell signal. The price itself also represents the most recent trend and can be compared to the MAs with the same logic.
It’s up to the individual trader which signal the weights higher if there’s a conflict of signals. For example, the price may be above the short-term (buy signal) but the long-term is above the short-term (sell) and above the price as well (also sell). In these cases, the trader must take a call.
This sort of fractal system is scale-independent – the same logic applies, regardless of the time periods. So, the trader can set the time periods to suit his or her pocket and throw up signals in the desired time periods. A day-trader may use five minute and 15 minute systems, while a long-term investor examines the 100-Day MA and the 200-Day MA.
MA systems work very well when there is a trend. These give false signals when the trend is choppy or during a range-trading period. Diagnosing range-trading periods are critical to taking a valid trade. Some filter may be set up to avoid taking false signals.
Signals can be filtered further with either simple or crude means. For example, weights can be attached to events, such as new price highs or price lows, which might signify a breakout. Or a method of three successive sessions trending in the direction of the MA signals may be used. Volume action should also be taken into account before taking action on a signal. Ideally, once a trade is taken, it has to be held until the signal of a trend reversal is seen. In practice, it may be necessary to take a stop-loss.
There are two obvious signals at the moment. One is a long USDINR – the dollar has broken out to a new level along with MA buy signals. The other is a short Nifty. The downside breakout last week set up a short trade. Both signals remain valid in the short-term, intermediate-term and long-term crossover systems.
The author is a technical and equity analyst