One of the most basic signals that you learn to help in your CFD trading is the crossover signal. Actually, there are several variations of the crossover rule, which we’ll cover here.
The most simple crossover rule is when the price crosses over a certain level. This might be an area of historic resistance, and for the price to pass this indicates a breakout, and possible continued rising values. This is not the usual meaning of a crossover, but it is the simplest.
The next type of crossover is when you have a moving average on your price chart, and the price crosses over the moving average. The moving average in this case is relatively short term, say a ten day moving average (SMA10), and thus tends to follow the price fairly closely. When the price changes direction, from a downtrend to an uptrend or vice-versa, the price passes over the average line. The crossover rule in this case states that you should buy when the price crosses above the average line, and sell (or go short) when the price drops below.
It’s easy to see that this will generally make you buy in an uptrend and sell when it turns to a downtrend, so it is an obvious way to make sure you trade in the correct direction, provided you have a trending market that is not too volatile. But this method can result in too many signals, as in practice the price will not move smoothly and you will get ‘false’ signals that prove to be wrong quickly. You can deal with this by putting in a time delay, so the price must stay above or below for a few days after crossing, but as this delays your trading, you will lose some of each move.
The reason that you get false signals with this crossover method is that the price can spike sometimes away from the general price movement. Now if you are trading contracts for difference, you will be particularly concerned at this, because your losses are leveraged. You want the best chance of only taking successful trades. The answer is to use not the price, but another line that follows the price without generating spikes. Such a line is a short term moving average.
This leads to the two moving average crossover method. In this case, you have two moving averages, with different numbers of days, and you trade when these lines cross each other. Typically you might use five days and twenty days for the moving averages (SMA5 & SMA20). When the shorter period moving average rises above the longer, that is a signal to enter a long trade. When it drops back below, you sell your position, and go short too, if that is your trading style.
The two moving average crossover method will help reduce the number of false trades taken. The price for this reliability is that it is less sensitive, and will lag more than the single moving average crossover, but that is a worthwhile price to pay to avoid the drawdowns.