Trend Trading: Using Moving Averages. Part 1.

Vladimir Daragan, Alex Ushveridze,  STTA Consulting Inc.

Trend is your friend. Is it correct? Without statistical analysis it is hard to answer this question. In our book Short-Term Trading Analysis we developed a profitable trading strategy which based on prediction of U-turn points. However, many traders prefer using trends for trading stocks. To help them we considered 101 year history of trading the Dow Jones Industrial Average using moving averages, i.e. the method based on using trends.

For the analysis we have used a simple moving averages

MA_n(i) = [P(i) + P(i-1) + ... + P(i-n+1) ] / n

where P(i) are closing prices, n is the moving average period. One can use more complicated definitions of moving averages (exponential, as an example) but the main results and conclusions are not changed much.

The simplest using of MA is shown on the figure. A trader must buy stock (index shares) if the closing price becomes larger them MA and close his position and start selling short is the closing price becomes less than MA.

Looks simple, doesn't it? Next figure shows the results of trading the Dow Jones index for the period from 1901 to 2001 for various periods (lengths)  of MA (from 20 to 200 days). We showed the relative capital growth: trading capital after 101 year trading using MA divided to the investing capital, i.e. after using buy and hold strategy. It was supposed that initial capital was equal to $10,000 and the brokerage commissions = $10.

One can see that for the MA period about 60 days one would obtain 15 times better results than the buy and hold strategy. However, there are some stones under water in using this method. We assumed that a trader was able to buy and sell exactly at closing prices. Generally, it is not correct because of bid-ask spread causing slippage. Even small slippage can significantly reduce a profit.

The next figure shows results of trading the Dow for two small slippages: 0.1 and 0.2 %. As you can see the slippage = 0.2% makes MA strategy worse than the buy and hold strategy!

More problems are arising if one considers trading the Dow during the last 25 years (1975 - 2001). Even for slippage = 0.1% the MA results are much worse than the buy and hold strategy as one can see from the next figure.

What is the reason? Probably during the last years the volatility of Dow became larger and using MA generates many false buy and sell signals that reduces a trading capital due to commissions and slippage. It is illustrated on the next figure.

One can see that price fluctuations eat out almost all profits which were obtained during long stable periods of growth or decline. What to do? One can try to use some smoothing methods to eliminate the false buy and sell signals. However, this problem is not simple. We will discuss it in the next publications.