How to Make Money With Moving Averages
11/04/2009 12:01 am EST
Moving averages may be rearview indicators, but they're useful for confirming trends and spotting buying and selling points. Key ingredients in many trading strategies, moving averages are very popular tools. Moving averages are typically trend-following tools that help traders determine what kind of trend, if any, a given market has developed.
One problem with moving averages is that many of the uses of moving averages have not been quantified, especially in the live ammo world of actual short-term trades. As a result, a number of short-term trading strategies for stock and ETFs that rely on moving averages or even multiple moving averages have often underperformed the market, and many more when you add in trading costs.
Trading Markets' research into short-term price behavior in both stocks and ETFs finds two key roles for moving averages in our trading strategies. These roles enable us to use moving averages for what they are best equipped to do, at least from the perspective of a short-term, high-probability trade designed to last five to seven days.
Here, we will take a look at those two roles and which two moving averages have been quantified to fit the bill.
Only Buy Above the 200-Day
The most important moving average in our research, the one that is most important to our high-probability ETF trading strategies, is the 200-day moving average. While we have developed a few trading strategies that are moving average agnostic, the vast majority of our high-probability trading strategies call for buying above the 200-day moving average.
The green highlighted sections show when the SDPR S&P 500 (AMEX: SPY) was trading above its 200-day moving average. The pink highlighted section shows when the SPY was trading below its 200-day moving average.
If you examine a large set of data, you will notice that markets that are above the 200-day moving average tend to recover after short-term pullbacks. At the same time, you will also notice that markets that are trading below the 200-day moving average tend to resume their downtrends after temporary bounces.
This tendency has been uncovered time and time again in our testing of both stocks and exchange traded funds. And while there have been a few, specific exceptions, our backtesting confirms that for the vast majority of the time, and for the vast majority of traders, the 200-day moving average is a critical technical indicator to help traders do the right thing on the right side of the market.
The Five-Day Moving Average Exit
The other moving average that has withstood our testing (testing which has included thousands of stocks since the early 1990s and hundreds of exchange traded funds since inception) is the five-day moving average.
What do we use the five-day moving average for? Our testing has shown that for short-term trading strategies that are based on buying after pullbacks (buying the selling), exiting the trade after the market closes above its five-day moving average is a simple and effective trading strategy for exiting high-probability trades (selling the buying).
Exiting trades after they close above their five-day moving average is one excellent and quantified strategy to "sell the buying" and take profits from high-probability trades.
A close above the five-day moving average is a sign that the market is gaining strength. Remember that the five-day moving average takes the average of the five most recent closing prices of the market. When a market closes above the average of its recent closes, it is a quantified show of strength that high-probability traders can rely on when looking for the requisite "strength" into which to exit high-probability trades.
One last note: When we use moving averages in our testing and our trading strategies, we use the simple moving average rather than any of the more exotic varieties. We have found that we gain no significant edge in our testing by substituting more complex moving averages when basic, easy-to-calculate moving averages like the simple moving average, is available.
By David Penn, editor-in-chief, TradingMarkets.com