Jacqueline Pretty – IG Markets – CFD Trading
One strategy for predicting price movements is the golden cross, which occurs when a short-term moving average crosses a longer-term moving average.
Moving averages are indicators that measure the average price movement of a stock, index, commodity or currency pair over time. When a short-term moving average crosses above a long-term moving average, this confirms upward momentum. If the short-term moving average crosses below, it confirms downward momentum.
If we look at a chart of the AUD/USD forex pair from October 20 to October 22, 2011, we can see the pair ranging between 1.02 and 1.028. Then, late on October 21, the pair nearly rose to 1.032.
So how do traders know whether the pair is really breaking out of the range, or whether it will fall again?
This is where the golden cross comes in. The AUD/USD price is charted alongside the 20-day and 50-day moving averages (in green and grey respectively). At 9:30pm on October 21 we can see the two meet, and by 10:15pm the 20-day moving average had crossed above the 50-day moving average, a confirmation of upward momentum.
This would be the signal to enter a long trade, so you open a long position on one contract of the AUD/USD at 1.02600.
A good way to exit this trade would be to set a trailing stop – as the golden cross confirms existing trends, the signal that the AUD/USD has started trending down would not occur until after it had already turned. For this example, let’s say you set a trailing stop at 65 pips from your entry price.
This means that whenever the AUD/USD rises, your stop will rise. If the AUD/USD falls, your trailing stop will remain at the most favourable price, thus locking in your profits should the forex pair continue falling.
The AUD/USD hit a high of 1.05008 at 4am on October 25, and your stop was triggered at 1.04358 at 5pm. The four-day trade made a profit of USD1,758 (1.04358 – 1.026000 = 0.01758), excluding the dealing spread, overnight financing, and other charges.
Golden crosses can be a good addition to any trading strategy – as they confirm existing trends, and therefore may increase the chance of making a profit.
However, because the method signal established trends rather than warning of impending trends, it can result in traders entering trends late. In the longer-term chart, we can see the AUD/USD falling from 1.03538 on October 19 to 1.01474 in less than 24 hours, but the 20-day moving average didn’t cross over the 50-day average until this trend had ended. Making the moving averages shorter-term (such as 7-days and 14-days) will result in earlier signals, but it will also result in more false signals.
This strategy becomes much more effective when used with other technical indicators, such as support and resistance. In the previous example, a number of golden crosses occurred within the support and resistance range, and none of these led to a strong trend. In contrast, the golden cross occurred that at the same time as a breakout of resistance resulted in a 240 pip movement.
*As CFDs are a geared product, CFD providers offer a range of risk management tools such as trailing stops, guaranteed stop losses and limit orders. Risk management tools can vary from provider to provider.
This article was written by Jacqueline Pretty – IG Markets – CFD Trading
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