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By Jason Pearce


In a prior post on the subject of moving averages, we talked about what they are, the benefits of trading with them, and some of the common techniques that traders use.  They are a simple, yet effective, tool for traders that have stood the test of time.

However, this does not mean that moving averages are going to be the Holy Grail of trading.  While moving averages can be highly-effective, so much so that they may even start to take on a reputation of infallibility during those times when the markets are trending, they quickly lose their luster once the trend ends and the inevitable choppy period returns.  When that happens, the profits accumulated while riding the trend can be quickly burned up.

When the trend starts eroding and moving averages start spewing out false signals, a trader has to concentrate on playing really good defense.  That’s done by making sure you employ sound risk management, rely on diversification (both in terms of trading systems and the instruments being traded), and in some cases making adjustments in the trading parameters.

The first two points are non-negotiable.  You can’t be successful without them.  It’s the last point that is the gray area.  Adjusting parameters will work for some, but not for others.  That means you’ll have to test it for yourself and see if it makes sense to you.

In this post, I’m going to share with you a very simple solution for adjusting trade parameters.  This is an approach that has allowed me to move quickly and methodically to recalibrate after a false moving average trend reversal signal.  In other words, if I get knocked off the horse and it’s still running, I’ve got a way to get right back in the saddle.

Turn On the Radio

A useful analogy for this method is that the market is like a radio station and a moving average is your dial to tune it in.  The failed signals that occur when you’re using a moving average are like static; you sometimes need to adjust the dial when this starts to happen.

Suppose a market is trending higher and experiences the normal pullbacks along the way.  If the uptrend is still valid, the pullbacks should all be contained by a moving average that is trending higher with the market.  There’s no need to adjust the dial because Dr. Johnny Fever’s voice at WKRP in Cincinnati is still coming through loud and clear on your radio.

Eventually, though, the market will experience a pullback that corrects far enough to finally break the moving average.  Something has changed and this break is a sell signal.  The trader will now liquidate long positions and maybe even go short because it indicates that the trend has changed.

So what happens if the market recovers after the correction and goes on to score new highs for the move?  Well, one certainly can’t argue with the market and expect to win.  The only logical conclusion is that the recent break of the moving average was a false signal.

Something has still changed, though.  The failed moving average signal tells us that the countertrend volatility in the trend has changed, but the direction of the trend has not changed.  Therefore, you either need to be long again or at least flat.  There’s no justifiable reason for a trend follower to have any short positions on at this point.  Unlike a DJ on the radio, the market does not take requests.

When this sort of failed moving average signal happens and tells us that the countertrend volatility has changed, a trader has two choices: she can take the next signal on the very same moving average or else she can try a different moving average in order to adapt to the new volatility.

Your Options

Despite a failed signal, there’s certainly nothing wrong with using the exact same moving average for the next signal…and the one after that…and the one after that.  This is what a 100% systematic trader does.

Many professionals would advocate this systematic route as the market will eventually break the same moving average and not recover.  Then you’ll finally have the real trend change you were looking for.  It’s just a matter of how many failed signals you might get first before a successful signal finally materializes.

Nothing is certain in trading, except for this: you will have a string of failed signals from any and all trading systems, whether or not it’s based on moving averages.  Hence, the reason for proper money management and diversification.  Drawdowns are a fact of trading and you don’t want to risk depleting all of your capital during the whipsaw periods.

After a failed moving average signal, there is another option: you can use a different moving average to trigger the next trade signal.

Let me warn you right now that if you opt for the second choice, you could potentially be crossing a line over into discretionary trading territory and getting out of the purely systematic one.  However, just because you are acting like a discretionary trader doesn’t mean that you can just fly by the seat of your pants and that you don’t need any trading principles to guide you.  In my experience, the successful discretionary trader usually has just as many trading rules and principles to guide them as a systematic one does.

Moving the Dial

Whenever I take the second route and decide to use a different moving average after a signal failure, I immediately look for a slower moving average –meaning a longer moving average- that was not violated during the market break.  That might mean switching from a 20-day moving average to a 30-day moving average or from a 30-day moving average to a 50-day moving average.

The objective here is to get rid of the recent “radio static” by locating a smoother moving average that has not yet failed during the market’s trend.  This is done in order to accommodate the markets change in the countertrend volatility that occurred when larger corrective moves started to happen.

This begs the question: why not use this slower moving average to begin with?

The reason is because a slower moving average lags further behind the market.  This means that it will generate sell signals further away from the market tops and buy signals further away from the market bottoms.  And we all know that every trader endeavors to sell as close as possible to the top and buy as close as possible to the bottom.

Dealing with Trouble

If a trending market is making very shallow pullbacks, the trend is being contained by a faster moving average.  No problems here.  It makes perfect sense to use this faster moving average that is running close to the market’s current price.

It’s when those pullbacks start to become sizable that the trouble begins.

The faster moving average will start getting picked off left and right with one false break after another, causing a string of losses, only to see the market turn right back around and continue the trend.

In an attempt to avoid racking up even more false signals and a continued losing streak, a slower moving average can be used.  But the slower moving average is further away from the market’s current price, so you will most likely be selling at a lower price and buying at a higher price than you would with the faster moving average.

The trade-off here is one of speed vs. accuracy.

The faster moving average gets you in and out quicker, but generates more false signals.  The slower moving average generates less false signals, but it gets you in and out of the market much later in the game.

What we are attempting to accomplish here with the use of parameter adjustments is to have the best of both worlds by using a faster moving average when it works and then switching over to a slower moving average when the fast one start to experience turbulence.

This certainly does not mean that the slower moving average won’t eventually fail at some point own the road.  It will.  It just means that, thus far, its track record for the recent trend has not yet been blemished.  So the trader who switches to a slower moving average for the next trade signal will be risking capital on a parameter that has not yet experienced a loss during the current run.

Who Wants Pizza?

Let’s take a look at an example of how a trader might have used this method of “tuning in the radio” to trade Domino’s Pizza (DPZ) stock since last spring.

To keep things simple, the trades will be on the long side only.  No shorting!  Also, we won’t worry about the impact of commissions, slippage, position-sizing, etc.  End-of-day prices will be used to determine the hypothetical profits and losses for each trade.

Initially, the 20-day moving average will be our weapon of choice.  A two-day close above the 20-day MA is a buy signal and a two-day close below the 20-day MA is a liquidation (sell) signal.  For this example, trading will commence on May 1, 2016.

After gapping down to multi-month lows in late April of last year, DPZ finally bottomed out at $116.91 on May 4, 2016.  Three weeks later, the stock made a two-day close above the 20-day MA for the first time in over a month and triggered a buy signal at $121.29 on May 25th.  Time to place our online order and buy some pizza stock.  You want that with pepperoni and sausage?

On May 31st, Domino’s closed back under the 20-day MA.  The next day it manages to hang on by the skin of its teeth and close back above the 20-day MA by a mere two cents.  The long position stays intact.  Boy, was that a close call.

On June 27th, Domino’s completes a two-day close below the 20-day MA and triggers a sell signal at $122.08.  The result of this first trade is a profit of 79 cents-per-share.  Not much, but it beats a loss or a poke in the eye with a sharp stick.

Just three days later, DPZ triggers a new buy signal when it gaps up to a two-month high and makes a two-day close above the 20-day MA.  The entry price is $131.38.

The next sell signal finally comes on August 16th when Domino’s closes below the 20-day MA for two days in a row.  The exit price of $143.97 results in a profit of $12.59-per-share.  Now we’re cooking with gas!

However, a new buy signal is triggered just three days later at $147.28 and new highs for the move are reached one day after that.  It’s a good thing we got back in.

But wait just a minute.  Since the last two sell signals were quickly followed by new highs for the run, it appears that the 20-day MA is not doing all that great of a great job, after all.  Although it’s getting us in the trade, it has bumped us out too early.  We have to keep getting right back in the trade.  That doesn’t even take into account the “near miss” we had on June 1st.

To move the dial and slow things down a little bit, let’s increase the moving average parameters by 50% and see how the 30-day moving average has been performing on this run.

As it turns out, a buy signal via the 30-day MA was triggered at $124.82 on June 7th.  Although DPZ closed back under the 30-day MA on June 27th, it was a one-day event and not a two-day event like the 20-day MA experienced.  Therefore, the trade would have stayed intact.

Furthermore, the stock stayed above the 30-day MA during the mid-August dip as well.  So it would have been a winning trade for over two months now.  Based on this, it makes sense to go ahead and make the adjustment and now use the 30-day MA for our new trade parameters after getting long again at $147.28.

On September 9th, DPZ dropped to a three-week low and close below the 30-day MA.  Fortunately, it recovered the next day and a sell signal was avoided.

On October 5th, Domino’s had a three-day streak of dipping below the 30-day MA and then closing just pennies above it.  Our luck finally ran out and a sell signal was triggered on October 14th when a two-day close below the 30-day MA prompted an exit at $151.12.  This trade made a profit of $3.84-per-share.

Two days later, DPZ exploded higher and posted a new all-time high.  I guess this proves that Domino’s really does have fast delivery!

This fast turnaround indicates that using an exit signal by way of the 30-day MA break was premature.  Plus, it had some close calls back in early September and early October where some sell signals were narrowly missed.

To remedy this situation, we will slow things down even more with the moving average.  To do so, we will increase the moving average parameters by about two-thirds and examine the performance of the 50-day moving average during this multi-month run higher.

Initially, DPZ made a two-day close above the 50-day MA on June 17th and triggered a buy at $127.79.  It then made a two-day close below the 50-day MA and triggered an exit at $122.08 on June 27th.  The trade resulted in a loss of $5.71-per-share.

The stock made a second two-day close above the 50-day MA on June 30th and triggered a buy at $131.38.  Since then, DPZ has not once closed below the 50-day MA.  The pullbacks in September and October -which both established the lows for the month- ended just above the 50-day MA.

This indicated that, after initially stumbling out of the gate, the 50-day MA has found it’s footing on the second trade attempt and is currently tuned in to the market.  Therefore, after getting the new buy signal via the 30-day MA at $159.45 on October 18th, we will use the 50-day MA for any new trade signals going forward.

In mid-November, DPZ experienced a sizable three-day selloff that pushed it below the 50-day MA.  However, the stock never went below the 50-day MA on a closing-basis.  It recovered and went on to make new highs.  Looks like we’ve made the right decision so far.

Domino’s sold off again in December.  This time it did make a two-day close below the 50-day MA and triggered a sell signal.  The trade was liquidated on December 13th at $161.86, resulting in a profit of $2.41-per-share.

Nearly a month later, DPZ finally makes a two-day close back above the 50-day MA and triggers a buy signal on January 11th at $168.96.

The question now is “Do we use a two-day close below the 50-day MA as our exit signal again or do we adjust the parameters again and see what an even slower moving average would do?

If you look at the performance of the 75-day moving average (a 50% parameter increase from the 50-day MA) you will note that the two-day close below it on January 3rd was the first sell signal since the original buy signal was triggered at $132.59 back on July 1st.  Also, the steep correction in mid-November ended after the stock tagged the 75-day MA and started to recover.

In addition, the 50-day MA and the 75-day MA aren’t all that far apart at the moment.  Given the similar locations and the better recent accuracy of the 75-day MA, I would lean towards using the 75-day MA for new trade parameters.

Regardless of whether you pick the 50-day MA or the 75-day MA for your parameters on the new trade, the liquidation signal was triggered on April 10th at $173.75 when Domino’s made a two-day close below both the 50-day MA and the 75-day MA.  This last trade booked a profit of $4.79-per-share.

The Results Are In

Recall that the trade campaign on Domino’s stock was initially started ten and a half months ago with the 20-day moving average.  The objective of this strategy was to adapt to changes in the trend by finding and using the moving average that was not breached during the most recent countertrend moves.  This means that it contained the corrections in the overall trend and didn’t get suckered by a “Larry Bird head fake” that shook out the faster moving averages.

Had a trader “remained static” and just stuck with using the 20-day MA parameters for entries and exits the entire time, he would have been in and out of the market eight different times.  The results were four winning trades and four losing trades.  Not taking into account the commissions and position-sizing scheme, the net result from trading DPZ would have been a profit of $17.02-per-share.  That’s not too shabby.

However, the strategy of “tuning in the radio” would have only produced five trades.  Yet they were all winners and the net result was a profit of $24.42-per-share (not including commissions, slippage, etc.)

As you can see, the parameter adjustment strategy had one-third less trades than using the 20-day MA alone.  This would obviously have cut down on commissions and potential slippage.  But even without taking that into account, the net profit of the parameter adjustment strategy was still a significant 43% greater than that of trading with the static parameters of the 20-day MA.

This one trade example does not mean that a parameter adjustment strategy will always make money or even that it will beat the results of a static parameter strategy every time.  The point of the exercise was to get you thinking about the potential of having dynamic parameters that adjust to market conditions.

Even though it was mentioned earlier in the post that this sort of active management of the parameters was in the realm of discretionary trading, there’s no reason that it can’t fit neatly into the category of systematic trading.  A trader would simply need to determine the rules for when to adjust the moving average parameters and what parameters to shift to.  Once that’s programmed in, voilà, you have yourself a mechanical system!

Keep Fine-Tuning

Although the parameters for the trade signals are adjusted to progressively slower moving averages as the trend unfolds, I will still continue to track the faster moving average that I was originally using.  The objective is to eventually put the faster moving averages back in the driver’s seat.

If the market makes another correction or two that is once again contained by a faster moving average, it means that the countertrend volatility is calming down.  This allows a trader to keep “turning the radio dial” and adjusting the trade parameters back to the faster moving averages.  Perhaps this means that will be switching from a 75-day moving average to a 50-day moving average to increase the response time.  Then you might switch again from a 50-day moving average down to a 30-day or even 20-day moving average.

The end goal is to end up using the fastest moving average that is containing the trend without getting breached during the countertrend moves.  You have to be vigilant to keep dialing it in and making adjustment as the market shifts until you find the best-fit moving averages for the current market trend.

Do Your Homework

The various moving average parameters (20-day, 30-day, 50-day, 75-day, etc.) that were used in this post are not set in stone.  They are used to illustrate how the methodology works.  Go ahead and test all sorts of different parameters, from ten days to fifty days to one hundred days or even more.

Also, investigate the different types of moving averages.  Does a simple moving average meet your expectations?  If not, you can explore using this technique with exponential moving averages, displaced moving averages, and other types.

In addition, you should research how this approach performs on different timeframes.  Like any robust technical tool, this moving average parameter adjustment method works just as well on the weekly and monthly timeframes as it does on the daily and hourly charts.  You need to find the right moving average parameters, the correct types of moving averages, and the timeframes that best accommodate your own style of trading.

One Factor of Many

Moving averages have been around for eons and have helped many a trader accumulate a fortune.  They still work just as effectively today as they always have, even if the parameters have to be recalibrated from time to time.  The moving averages can serve as the core entry/exit triggers for a trading system or they could be used for a confirmation tool or some sort of filter.  There’s definitely some value to be found here by any trader.

It is important to remember, however, that the moving averages are just one of piece of the puzzle for successful trading.  By no means should they be considered the Holy Grail in trading.

To trade successfully, you need to set up the correct position-sizing matrix.  That’s created by good pyramiding rules and risk management.  Moving averages only tell you when to get in or out of a market, not how many shares, contracts, etc. to buy or sell.

What you trade is an important factor as well.  Choosing the markets that have historically worked well with your trading system certainly doesn’t guarantee future success.  But why in the world would you ever want to have exposure in trading a market or instrument that has not worked well with your system or methodology before?!

When you have selected the moving averages that best fit your trading style…

And you have created your position-sizing plan…

And you have decided upon a portfolio of which markets to trade…

Then you still have to maintain the right mindset in order to follow your plan.  Stay disciplined.  Do not stray from the Path of Righteousness.  If you can that, you’ve got a pretty good shot at trading success!

More Articles by Jason Pearce:

How to Trade with Moving Averages, Part I

Market Returns Do Not Equal Investment Returns with Leveraged ETFs

Is The Canadian Housing Market Bad for Canadian Banks?

2017: The Death Year for Stocks

Potential Bond Market Reversal Ahead

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Michael Martin speaks with trading expert Pete Renzulli. Over the course of his career, Pete has held many roles across his trading career.

He discusses how he developed his trading edge in this funny and insightful discussion.

Please leave a review and rate the podcast.

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Crude Oil Fundamentals

It’s easy to get caught up in the daily grind of price action and market sentiment.  Sometimes it’s good to take a step back and look at the week in review to bolster your conviction for the week ahead.

Inventory Overview and Discussion:

The net change in overall inventories for the week ending April 7, 2017 was a Draw of 8.0 (as seen in Figure 1 below).  For comparison, the net change for this week last year was a Build of 2.9 and 2 years ago was a Build of 1.3.

Crude Oil Stocks and Refinery Utilization EIA

Ok, so let’s take a look at where we are.

From the Utilization Rate, you can see that we are slowly exiting refinery maintenance season.  The decrease in Gulf Coast utilization rate can be attributed to a higher increase in Operable Capacity numbers relative to gross inputs, which obviously decreased the utilization rate (see Figure 2 below).

The Operable Capacity is based on the ‘latest reported monthly operable capacity’ to the EIA.  Since the prior EIA report week ended on March 31, it would reflect reported capacity levels for March, whereas this weeks’ report would be updated with April  levels.  The reported Operable Capacity for April most likely includes updated capacity expectations that may not have fully taken place yet, which is why it ‘appears’ that the Utilization Rate went down in this latest report.   This could also account for the slight build to Cushing inventories.  I would look to see this ‘catch up’ in the next two week, meaning more inputs of oil into the system.  Continue to keep an eye on this.

Crude Oil Refining Capacity

Price Overview and Discussion:

This week we saw roughly a 3.60% average rally across the board in crude oil prices,building on last weeks’ 3.25% increase (see Figure 3 below). In addition, there was a slight narrowing of the Brent/Dubai spread for the balance of 2017.

As noted last week, the Brent/Dubai spread is an indicator of crude oil movements.  For example, Middle Eastern and Russian Crudes tend to be priced relative to Dubai, and West African crudes tend to be priced relative to Brent.  Since Middle Eastern crudes (Dubai and Oman) are viewed as lower quality (less ‘sweet’) than Brent and WTI, the narrower the Brent/Dubai spread, the more likely Brent, WTI or even West African crudes will be chosen as an option by Asian and other refiners.  These market-driven global flows of oil ultimately impact the ‘supply’ available to any individual region.  Of course, freight rates are a key factor as those with access and ability to these logistics will ultimately ‘arb’ out any market disparities.                                                                                                                         


This is worth noting due to the upcoming OPEC meeting in May.  As you know, the cuts that OPEC put in place at the beginning of this year translated to tighter sour crude supply in the Middle East.  This is because the bulk of the cuts have come from members that produce and export medium and heavy sour oils.  This resulted in a collapse of the “Light/Heavy” oil spreads.  Futures spreads between Brent and Dubai/Oman were $6.00+ last year and are now well under $2.00.  Watch this spread as we near the May meeting for any big moves indicating market sentiment/positioning.

Many refineries blend light and heavy crude oil to achieve the optimal blend for their refinery.  In the US this has been achieved by blending heavier Canadian crude with lighter Bakken oils in an aim to create a cheaper barrel than the price of sour crude in the Gulf Coast.  This might be a good time to remind everyone that back in 2009/10 the Saudi’s and other Middle Eastern countries dropped WTI as a benchmark and replaced it with US Gulf Coast Sour (“ASCI”).  Couple that with the recent OPEC cuts focused more on heavier crude, and it’s a good time to ponder the REAL strategy and how that might play out in light/heavy spreads if the cuts continue.

Spreads to watch:

  1. Brent/Dubai spread.
  2. WTI/LLS spread (as an ultimate destination for WTI Cushing barrels is the Gulf Coast)
  3. Light/Heavy spreads

Crude Oil Prices, Crude Oil Spreads

Moving on to refined product and related markets (Figure 4 below).

The past week, we saw benchmark Distillate prices for the balance of 2017 increase an average of 3.30% while Gasoline (the leader as of late) increased roughly 2.50% for the same time period.  Gasoline prices have been enjoying a combination of seasonal strength coupled with refinery outages.  Those refining outages are beginning to wind down, so it’s now up to global demand to do the heavy lifting.

There are so many grades of global refined products that the amount of logistical movements of products to/from the best priced markets are too many to cover in one report.  Needless to say, there is a lot going on.  There are more than 50 unique spreads related to Gasoil alone listed on exchanges.

One item I will point out this week is the Heating Oil/Gasoil (HOGO) spread.  Gasoil futures dropped briefly from around $500/MT at the beginning of March to around $450/MT towards the end of the month.  However, since then prices have regained the $500/MT level.  Strong demand from Latin America and other counties is diverting US distillate away from Europe.  Demand was forecasted to recede the first quarter of 2017, however, in the last EIA report that includes US exports through Jan, 2017, there was no sign of that as of yet.  Watch for a widening of the HOGO spread to indicate the potential for steady to increased distillate exports.  Things could also get interesting if we start to see an increase in Freight rates.

Petroleum Product Prices - Gasoline, Gasoil and Heating Oil

Week Ahead – Expectations and Wild Cards:

As noted above, the key items to watch in the upcoming week are:

  1. Refinery Utilization rates, gasoline demand and Oil inventories
  2. Crude spreads (WTI/LLS, Brent/Dubai, Light/Heavy)
  3. Distillate spreads (HOGO)

We should expect to see support for WTI above $50 unless there is a material shift in one of the above items.

Implied volatility is LOW across the complex.  As noted last week, the Open Interest in WTI options is almost twice that of the underlying futures.  Add to all of this the amount of OTC structured ‘costless collar’ type of hedges that have been written out there that never hit the exchange numbers.  With prices remaining in a narrow range, low volatility and option strikes being written closer and closer to the money, one has to keep looking for the catalyst that will veer us off this long, narrow road.

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Cornelius Luca is a forex expert and the author of Trading the Global Currency Markets. His most recent research report lists his 6 best forex trading ideas.

•Majors: Short euro/dollar…
•Commodity dollars: Short Australian dollar/dollar…
•Crosses: Short euro/yen…
•Asia: Long dollar/Korean won…
•FX LatAm: Short dollar/Mexican peso…
•FX Eastern Europe: Long dollar/Turkish lira…

Listen to my interview with Luca about how Brexit is effecting currency exchange rates.

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By Jason Pearce

The Basics

A moving average is exactly what it sounds like: It’s the average market price of the last “X” number of time intervals, whether that’s hours, day, weeks, months, etc. and it’s called a moving average because the average price is updated every time there is a new time interval recorded.  Therefore, the data set moves to always stay with the most current data set.

For example, let’s say that the 20-Year Bond ETF (TLT) closed at $131.58, $130.57, $131.74, $130.62, and $130.09.

The average closing price of these five days is $130.92.

Then the next day, TLT plunges and closes at a price of $124.57.

So we would take the prices of the most recent five days and calculate the average price all over again.  Since we now have a new data point ($124.57), we simply drop the oldest data point in our series ($131.58) and recalculate.

The new five-day moving average of the closing price is $129.52.

It’s important to establish right up front that a moving average is a lagging indicator.  It tells you where the market has been; it does not tell you where the market is going.  This isn’t some mystical map to lead you into a magical forest full of money trees.  It’s not even a fool-proof market indicator.  Moving averages are simply a guide.

Where the moving averages do prove their worth is by helping a trader identify when a market is in a trend.  After all, finding a market trend and getting positioned on the right side of it is the first step to making money!

Up or Down

A market is considered to be in an uptrend when it’s above the moving average price and it’s considered to be in a downtrend when it’s below the moving average price.  In other words, you want to buy a market that is performing above average and sell a market that is closing below average.

You can also compare two different moving averages to determine when to buy and when to sell.  This is known as a moving average crossover.  When a faster (shorter-term) moving average closes above a slower (longer-term) moving average, it’s a buy signal.  When the faster (shorter-term) moving average closes below a slower (longer-term) moving average, it’s a sell signal.

This is pretty simple stuff, right?

The Path of Righteousness

Years ago, I had a mentor who used to tell me, “Follow the path of righteousness.”  No, he wasn’t my guru or spiritual mentor.  He was a trading mentor.  The Path of Righteousness that he was referring to was the market’s moving average.

This mantra was his very simple way of telling me to follow the trend and patiently stay in the trade as long as the market continued to close above the moving average that I was using.

Likewise, if the market finally cracked the moving average that had been supporting the move higher, it was my cue to exit the position stage right.  “Take the money and run” as the song says.  In some cases, the break of the moving average was even my prompt to reverse and get positioned on the short side of the market.

Perhaps trading a system with the moving averages is a bit like Zen after all.  It’s deceptively simple to understand, yet it takes continuous practice and self-discipline to keep at it.

Pick Your Weapon

There are several types of moving averages out there.  The one we already discussed is called a Simple Moving Average as it gives equal weight to all of the data points in the series.

Another popular type of moving average is an Exponential Moving Average.  This one puts more weight on the more recent data points, which causes it to react faster than the Simple Moving Average does.  The belief is that the more recent data points are more important than the older ones; hence, they should carry more influence.  This is why a lot of the professional traders favor the Exponential Moving Average over the Simple Moving Average.

If you wish, you can continue to go even further down the rabbit hole and research Weighted Moving Averages (where each piece of the data set is assigned different weights), Displaced Moving Averages (a moving average that is pushed forward in time in order to filter out potential whipsaws), Triangular Moving Averages (where the heaviest weighting is assigned to the midpoint of the data set), and some other complex formulas.  You can even create your own proprietary moving averages if you don’t see one that suits your fancy.

Also, you can choose to calculate the moving average of the market highs…or lows…or even the openings.  A trader could even get really cute by calculating some average of the day’s range and making a moving average out of that!

Those most common metric for the calculation is the moving average of the closing price.  This makes sense as it focuses on what I believe to be is the most important price of the day.  The reason for this is because the market’s final settlement is where the traders with the most conviction -and also the bankroll to hold it- are willing to go home with the position.  The day traders and the HFT algos are cashed out by the time the closing price is established.

Looks like things are getting a little less simple now…

Popular Metrics

In addition to the different types of moving averages, you also have to determine the length of the moving average that you’re going to use.  The proper length of moving average for you is directly correlated to the type of move you’re playing for.  Are you more of a hit & run day trader?  Or are you a trend follower who starts to look like a Buy & Hold investor when the trend is moving favorably?

If you are trading the fast, strong momentum moves, the short-term moving averages are where you should concentrate your efforts.  This is because a smaller data set, say five days instead of one hundred days, will change at a much faster rate.  This is exactly what the doctor ordered for someone who’s only looking to scalp a fraction of the move out of a market.

However, if you are surfing a macro trend and playing for the long haul, you’d want to use a long-term moving average.  Since a long-term moving average has a lot more data points, each new data point has a much smaller impact on the change in the average price than the short-term moving averages will.  By making it slower to change, it is less likely to generate less false signals during a market hiccup and shake you out of a position prematurely.

Some of the popular parameters for the short-term trading crowd are the 5-, 10-, and 13-day moving averages, while swing traders will slow it down a notch and go for the 20-day moving average.  One of the pioneers of trend following, Richard Donchian, used a combo with a moving average crossover system that relied on the 5-day MA and 20-day MA.

Medium-term traders tend to gravitate toward the 50-day moving average and the long-term guys normally follow the 200-day moving average.  As a matter of fact, Paul Tudor Jones said that his metric for everything (stocks, commodities, currencies, etc.) is the 200-day moving average.  He has a standing rule to get out of anything that falls below the 200-day moving average.

The 50-day MA and the 200-day MA can also be combined to be used as a widely-followed crossover system to identify long-term market trends.  When the 50-day MA crosses above the 200-day MA, it’s referred to as a Golden Cross.  Time to go long because the bull market is roaring!  Conversely, when the 50-day MA crosses below the 200-day MA, it’s referred to as a Death Cross.  This ominous-sounding signal indicates further downside ahead.

The Best Pick

Some guitar players looking to emulate their hero may know that Stevie Ray Vaughn used unbelievably thick guitar string gauges that start at .013.  So they slap a set of heavy gauge strings on their Strat and expect to start playing just like him.  However, Al Di Meola uses a more reasonable 10-gauge set.  On the other end of the spectrum, Chuck Berry and Jimmy Page both favored 8-gauges (think “banjo strings”) that allowed them to play almost effortlessly.

So what’s a player to do?

The answer is simple: you need to find the gauge that suits your own playing style the best.  It’s safe to say that the string gauge was not the defining factor of success for any of these guys.  But they did find the gauge that best suited their needs.

In the same way, traders have to do a little bit of research and testing to determine which moving average type best fits their own style and personality.  Your goal is to find the moving average parameters that make the most sense to you, not blindly follow the same one that your trading hero uses.  Like Polonius said in Hamlet, “To thine own self be true.”

Ultimately, if a market really is trending, all of these different types of moving averages should eventually generate similar buy and sell signals to get you on-board the move.  So it shouldn’t make too much of a difference which kind you are using.  There will be some variance, of course, such as one producing more false signals or one is getting in/out of the market earlier than another, but sooner or later they should all be participating in the same trend.

Moving Averages Work Great…

Except when they don’t.  Moving averages will only work their magic when the market in focus is trending.  Otherwise, they will get chopped to death.  A market with no trend will pop above the moving average for a few days, go back under it for a few days, jump back above if for a few more, etc.  A trader who keeps buying the closes above the moving average and selling the closes below the moving average in this type of environment could see their account bled dry…all while the market that is simply spinning its wheels and going nowhere.

Markets will cycle through both types of environments, trending and non-trending.  Therefore, no trading system works all the time.  To expect otherwise is unrealistic.

Unfortunately, markets tend to trade in choppy ranges a lot more than they make sustained trends.  Some statisticians say the markets only trend about one-third of the time.  Some say it’s even less.  That’s bad news if you’re a trend follower.  And if you’re trading with moving averages, regardless of the timeframe, a trend follower is exactly what you are.

There is some good news, though.  The markets don’t all have to trend together or get held hostage in a trading range at the same time.  When some of the markets are trending, others are choppy and vice versa.  With all the available investment vehicles we have nowadays, the candidates for a potential trade seem nearly unlimited.  Heck, you can even spread one market against another and create even more potential trading candidates!  Therefore, you can afford to be picky and ignore any market that’s not currently in an obvious trend.

Rule of Thumb

Here’s one simple, but effective, rule that a trader could implement to avoid getting suckered into some of the choppy trading environments: Don’t trade any market where the moving average has gone flat!

We’ve already established the fact that a moving average is a lagging indicator.  It’s useful to wait for these laggards to start moving north or south before committing to any trades.  At the very least, we will know that the move in the underlying market has been sustained long enough to start pulling the moving averages with it.  As we all learned in physics class 101, a body in motion tends to stay in motion.

If this lag is unacceptable to you because you’re looking to get in right at the bottom or sell out right at the top, then you are not interested in trend following, anyways.  You are looking for a leading indicator and something that has predictive power.  That’s fine.  Just don’t try to accomplish this with a lagging indicator like moving averages!

Using a tool improperly is hazardous to your wealth and sometimes even your health.  You need to learn how to use your tools safely and effectively like Bob Vila did on This Old House, not like Tim “the Tool Man” Taylor did on Home Improvement.

Adapt or Die

It is very important for traders to remember that the market price can never be wrong.  It is what it is.  The market is the dog and the trade indicators (moving averages, stochastics, MACD, etc.) are simply the tail.  The dog wags the tail, not the other way around.

So when a moving average starts giving failed signals, it could mean one of two things: either the market trend has finally come to an end or else the volatility of the trend has expanded.  Either way, something has changed.

Leon Megginson, a LSU professor of business management, said, “It is not the strongest of the species that survives, nor the most intelligent, but the one most responsive to change.”  This quote is perfectly fitting for a trader.  To survive the market’s behavior change, a trader must adapt to the new reality.  It can be accomplished by making trade parameter adjustments, relying on good risk management, using multiple non-correlated trading systems, practicing portfolio diversification, and any combination of all of these.

By the way, true diversification does not just mean that you are trading in several different markets, but that you are trading in non-correlated markets.  Having a position in the S&P 500, the NASDAQ, and the Russell 2000 is not very diversified, while having a position in copper, lean hogs, and some foreign currency (usually) is.

Coming Attractions

One thing that I have found success with in trading the moving averages is making parameter adjustments that adapt to changes in the market.  This allows me to recalibrate when a whipsaw or false reversal signal manifests during a trending market and throws everyone off the horse.

In an upcoming article, I will reveal my strategy for determining when and how to adjust the parameters to get back on the horse or, at the very least, continue to ride the bull or the bear.

More Articles by Jason Pearce:

Market Returns Do Not Equal Investment Returns with Leveraged ETFs

Is The Canadian Housing Market Bad for Canadian Banks?

2017: The Death Year for Stocks

Potential Bond Market Reversal Ahead










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