You have little time and still want to trade and improve your finances? Moving averages could be the solution. Moving averages offer a simple way to trade, and with little time and clear, objective rules without any scope for interpretation. In this article, I would like to give you the advantages and disadvantages and various approaches to tackle the topic in a quite relaxed manner.
What is a moving average?
A moving average (MA) is the average value of a fixed number of periods. The basis for the calculation can be either the closing price, the opening price or another precisely defined value. In general, the closing rate is used.
What's the math here?
Let's take stock X as an example and calculate the current MA with a period number of 5. The closing prices of the last 5 days were: 40, 41, 41, 39 and 34. The average is then 39. This is the result when you add all 5 closing prices together and then divide them by 5 (195/5 = 39).
The mentioned example relates to the simple MA, the so-called SMA. However, there are also other variants, e.g. the Exponential Moving Average (EMA). This EMA weighs the latest rates higher to consider the recent developments more.
What are the classic rules?
If one proceeds from the classical approach, a buy signal (long position) is generated as soon as there is a closing price above the MA. A sell signal (short position) is generated when the closing price is below the MA. This also shows immediately that you are always invested because the closing rate always has to be on one side of the MA. However, if you consider a full-time employee who will primarily invest in equities, indices and ETFs, it is worth considering omitting all sell signals as these instruments tend to rise. In such cases, you would simply close a long position if the closing price is below the MA.
The effect of the selected period number
The exact choice of the number of periods has a strong influence on the signals for your own trading. The smaller the number of periods, the more sensitively the MA reacts. Conversely, of course, the following applies: The larger the number of periods selected, the lower the deflections and thus also less signals are generated. Here is the first problem: We have a trade-off. However, since we are aiming for a relaxed trade for employees on the big timeframes, the direction is clear. We want to have few, but clear signals.
Which number of periods?
As already mentioned, we would like to choose a high period number, but not too high to get any signals at all. Widely used is the 200s MA, but also the 90s and 50s are very popular. Let us look at the results for the DAX with the 200s MA of the last 3 years:
As you can see, the results are very sobering in 2014, and further moves sideways have not yielded any gains but slight losses. This shows that clear trends are of great advantage. The last opened trade would currently be a big winner. In general, it can be said that there were very few signals, and the time needed for trade management is very limited.
Let us look at the results for the MA 50 for the last year:
Here we have significantly more signals but the results are still very moderate because of a missing clear trend.
Let's look at the 90s MA:
Here the results look much better despite the sideways market. Obviously, this is not a usable backtest, but a clear tendency towards 90 is evident, since the advantages are obvious. On the one hand, more signals are generated than in the 200s MA, and on the other hand it is not as sensitive as the 50s MA.
If you add another MA, which has a distinctly different period length, you can see two different sensitive lines in the chart. The MA with the shorter period number reacts more sensitively (faster) and from time to time will cross the slower MA with the higher period number. This crossing can be interpreted as a trade signal. If the faster MA is crossing the slower MA from below, it is a buy signal. Conversely, a sell signal is generated when the faster MA crosses the slower one from above.
The following chart shows the DAX last year with the 90s MA (blue) and the 50s MA (red):
If there were only 9 signals on the 90s MA, then there are now only 4 signals. This already shows that a further reduction of the signals takes place. Whether this is synonymous with a better quality, you have to test a longer period. Furthermore, the addition of other MAs can lead to better results. Often the combo of 200s and 90s is seen.
Let us look at the results of the last 3 years:
There were 4 signals in 3 years. In other words, it does not require a lot of effort to trade this combo. But what do the results look like? In this concrete example, the results look disastrous. Red arrows are short positions and green arrows long positions:
The ideal case would be many green up-arrows and many red down-arrows. The reality is different. If we add as an additional filter that we do not want to enter any short positions, it looks a little better. However, it does not look particularly attractive. Please bear in mind, that the overall picture in e.g. the German DAX looks quite complicated for the last 3 years. There was no stable trend.
Nevertheless, a rule can be introduced here for the exit from a long position. You do not have to wait until the crossing of the MAs indicates the exit. If you get out of the trade as soon as the closing price is lower than the 200s MA the losses are much lower. At this point the results are definitely worth a backtest.
The following chart shows the comparison:
The exit with the improved exit technology (pink) results in a small profit.
Avoiding ranging markets
The biggest boost for a trend-following strategy is the avoidance of ranging markets. If you know when you do not enter a trade, you will avoid the potential losses. But how do you recognize ranging markets? There are a variety of objective decision making rules. E.g. detecting a trend due to the construction or use of an indicator such as the ADX.
Chart of the DAX over the past 3 years:
Green boxes show an uptrend, which means higher highs and higher lows. The red box shows a down trend, which is characterized by lower lows and lower highs. If trades are avoided, if there is no trend, unfavorable market conditions are filtered out.
DAX with the ADX as a trend filter:
If the ADX over 25 is a trend that can be considered strong enough. In such market phases, signals which generate the MAs can be used. Of course, this is just an idea of how to filter out bad signals and avoid ranging markets. At this point it is important to note that the number of periods of the ADX also has a significant influence on the performance.
Time spent is limited
Regardless of how you set up your own setup for MAs trading, it is important to note that the time constraints are very limited and thus also a good option for full-time workers. The only thing you have to do is to check once a day where the last closing price is which does not take more than one minute per market. With this methodology, it is relatively easy to monitor and trade several markets simultaneously. However, you should pay attention to the correlation to avoid high cluster risk. With cluster risk and correlation I mean that you should choose markets that are not too similar in their movements.
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In principle, trading MAs is a kind of breakout strategy, since the basic idea is to trade after something has been broken or crossed. The same is valid for the, some of you might already know.
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