The main problem is its a “reactive” rather than “predictive” way of trading. The method assumes that momentum will continue after a crossover with no thought to the current conditions of the market.
The 50/200 Crossover
Probably the most famous of the crossovers are the “death cross” and “golden cross”. Simply put, we are told to sell when the death cross occurs (which is the 50 day moving average crossing down below the 200 MA) and buy when the golden cross occurs (the 50 day moving average crossing up above the 200 MA).
The following chart shows the 50 and 200 moving averages crossing on a daily GBPUSD chart. The yellow dots indicate where the crossovers occurred. At first sight it looks like this might be a great strategy…
However the above chart is very deceiving. Let’s look at the same chart, but this time I have added vertical lines to project where the price actually was when the MAs crossed. The red circles indicate the earliest opportunity you could have entered each trade. On most occasions the entries were a long way from the crossover signals. In one case, the crossover would have caused you to enter at the worst possible time!
Moving average crossovers will work in strong trending markets, but the above ranging price action is more typical of the markets nowadays, where retail traders often get chopped up.
Let’s visit a zoomed in segment of that chart again, but this time I’ll add some supply and demand zones.
Suddenly the picture starts to get a lot clearer. We have a very good idea of where price may bounce – at a return to an area where there are institutional buyers or sellers. Compare that to the very late entries provided by the MA crossovers. The MA crossover is espoused by the same camp who believe “the trend is your friend” and you shouldn’t trade reversals because it’s equivalent to “catching a falling knife”. These blanket phrases are meaningless without applying them to the context of the current market action.
The MA crossover is espoused by the same camp who believe “the trend is your friend” and you shouldn’t trade reversals because it’s equivalent to “catching a falling knife”.
The problems that plague moving averages can be applied to indicators in general. However complex or craftily coded they may be, no indicator can predict the future of the market – they all follow price.
It must be remembered that markets (especially Forex) range a great deal of the time. It is during these periods that traders hand back the gains (and more) that they made during trending markets. The best we can hope to do is watch order flow and attempt to predict areas that will be of interest to the “smart money”.
Of course, not all supply and demand zones will work either. There are reasons why some fail and some work better than others. To really do well at supply and demand trading, there are filters and scenarios that need to be taken into account. It’s a skill to learn just like any other!
So what to do now with that pile of technical analysis books that are gathering dust on the shelf. Well… bonfire night is just around the corner!