Here’s a trading paradox for you: the easiest indicator to understand – the venerable “moving average” – is also the most commonly misunderstood and misused.
Just in case you are a complete neophyte to the trading arena, “Hi, my name is Jay”, and let me be the first to say, “Gird your loins” (trust me on this one). Also, let me explain what a simple moving average is. A 50-day simple moving average involves adding the closing price for a given security for each of the last 50 trading days and then dividing by 50. A 100-day moving average involves, yes, 100 days, and a 200-day moving average involves – wow, you are a fast learner – 200 days, and so on.
Like I said, it is pretty easy to understand. Just in case there is any question, Figure displays ticker SPY with the 50-day and 200-day simple moving average overlaid.
Figure 1 – Daily SPY with 50-day and 200-day simple moving average
Standard moving average interpretation goes as follows:
-Price above moving average = Good
-Price below moving average = Bad
Unfortunately – and here is where the aforementioned misunderstanding comes in – too many investors (and financial writers) take this to mean that one should buy whenever price moves above moving average “x”, and should sell and/or sell short whenever price drops below that same moving average. Now there actually was a time way back when (think late 70’s) when this approach sort of worked, particularly in the commodity markets.
Thanks to the fact that inflation was soaring, a given commodity would pop up above a given moving average and just keep going to way higher levels. Eventually all the buying was done and the darn thing would turn down and drop below the chosen moving average and just keep falling hard until it eventually landed with a thud.
So a person who happened to be using just the right moving average could make a lot of money by buying when the commodity rose above it and selling short when the commodity fell below it. I think part of this was due to the fact that roughly only about 6 guys had computers back then and everyone else had to update moving averages for everything by hand – a real pain in the you know what, so most people didn’t bother. So those 6 guys had a huge edge on everyone else.
OK, that’s a fairly simplistic explanation but it may be closer to the truth than you might think. Needless to say, now any person with a computer (all 6 bazillion of them) has easy access to all the moving averages they could ever want and then some. As a result, there is no edge – and hasn’t been for a very long time – to buying and/or selling a given security based on a close above or below a given moving average.
Yet, interestingly – in my opinion at least - moving average remain extremely valuable.
The Improper Way to Use Moving Averages
Every once in awhile an intrepid financial writer will file a report “definitively debunking the usefulness of moving averages.” Typically this report involves:
-Quoting some market analyst who purports to follow a given moving average to track a given security.
-Testing the historical results that one might have achieved by buying and selling (and/or selling short) the security in question every time its price closed above or below the moving average in question.
-Reporting (somewhat gleefully) that the moving average “did not work” because the test results were inferior to a simple buy and hold approach, and that, therefore, moving averages are useless. Case closed!!!!!
Except for one thing. As I mentioned earlier, no one has really made a living trading that way since about the late 1970’s. So testing a system that everyone who has ever tested systems (Hello again, my name is still Jay) already knows does not outperform on a mechanical basis, is sort of like saying, “Aha! This thing that everyone already knows doesn’t work on a standalone mechanical basis doesn’t work on a standalone mechanical basis!”
Gee, thanks for the tip. By the way, you’ve entirely missed its actual value.
The Proper Way to Use Moving Averages
So here is what you need to know about moving averages.
Jay’s Trading Maxim #77: Moving averages are most useful not as “precision timing” tools, but rather as “perspective” tools.
Now for the record it is possible to use moving averages as a timing method (http://www.optionetics.com/marketdata/article.aspx?action=detail&aid=24623) although not in the mechanical “always long or short” sense. But the real power of the moving average is not in its ability to tell you what “will happen next” (which by the way is virtually nil), but in its ability to tell you “what is happening right now.”
For there is a phrase that goes like this – “The trend is your friend.” If you are a complete neophyte to the trading arena my advice is to get used to hearing that phrase – a lot. Also know that there is great wisdom built into that simple phrase. Which I think is encapsulated quite nicely in:
Jay’s Trading Maxim #37: Recognizing the trend right now is worth far more than a thousand predictions on what will happen next.
Let’s talk about the stock market specifically for one moment, since that is the market most investors are familiar with. During any prolonged bull market investors are confronted by an endless stream of “foreboding” information. “The Top” is always just a few ticks away, or so it seems we are told. There is always enough bad news available to create doubt and even fear. And yet the stock market continues to creep higher – often for months or years at a time - in spite of it all. Yes, eventually there is “A Top” and the market then declines. But too many people get spooked and miss out on large profit opportunities in the meantime. The 1990’s were a classic case in point.
Figure 2 displays ticker SPY with a 21-month moving average. I learned of this useful moving average from Alan Kuenhold and also from Humphrey Lloyd, both colleagues of mine in the American Association of Professional Technical Analysts (AAPTA).
Figure 2 – Ticker SPY with 21-month moving average
Note in Figure 2 that in 1995 the stock market broke out to new high ground and in the next five years tripled in value. Yet along the way investors were told time and time again by the financial press that there “was reason to doubt” the advance. Yes, the 2000-2002 bear market eventually unfolded and was painful. Nevertheless, the person who:
-Bought the upside breakout in 1995 and
-Sold at the exact bottom of the 2000-2002 bear market (i.e., at the worst possible time)
-Still enjoyed a gain of about 60%.
Using the 21-month moving average on a mechanical basis with SPY would have yielded some pretty good results over the past 19 years. But the truth is that there is nothing “magical” about a 21-month moving average and like any other moving average, it will experience “whipsaws” from time to time.
So take another look at Figure 2. And instead of looking at the points when price crosses the moving average and saying “buy here” and “sell here”, look instead at those times when price was above the moving average and ask:
-“What if I gave the bullish case the benefit of the doubt here?”
And then look at those times when price was below the moving average and ask:
-“What if I gave the bearish case the benefit of the doubt here?”
Adopting this utterly simplistic way of looking at things will help keep you on the right side of the market far more often than not.
Recent Case in Point: Gold
Figure 3 displays the price of spot gold along with the same 21-month moving average. A close look at the 1995-1996 and 1999-2001 periods reveals a fair number of whipsaws, i.e., times when a mechanical approach to buying and selling would have led one to sell at a lower price and to buy back in at a higher price. So let’s define:
The problem with a mechanical approach to using moving averages: Every whipsaw is kind of like a hard slap across the face. After a few “hits” the vast majority of investors lose interest and stop following their approach.
Figure 3 – Spot Gold with a 21-month moving average
For years now we keep hearing that gold will eventually go up to $3,000 an ounce or more. But look at Figure 3 and once again ask the question, “what if I gave the bullish case the benefit of the doubt when price is above the moving average, and vice versa?”
In an nutshell, you would have had a lot of time to make money playing the long side of gold between 2001 and 2012. And you might have avoided the pain of playing the long side of gold during the sell-off of 2013.
You see, “The trend [really] is your friend.” (I warned you that you’d better get used to hearing this a lot).
So let’s be very clear about what I am and am not trying to say:
-I AM NOT saying that you should buy a given security or commodity when its price moves above its 21-month moving average (or any other average for that matter).
-I AM saying give the bullish case the benefit of the doubt – i.e., block out as much of the “gloom and doom” noise as possible and focus on playing the long side of the given security.
-Likewise, I AM also saying to be careful and to give the bearish case the benefit of the doubt when price moves below its 21-month moving average (or whatever average you deem most useful).
Occasionally you will absolutely, positively end up missing the first part of a rally. But you will also avoid the harrowing – not to mention potentially financially and emotionally debilitating – experience of riding the stock market or the gold market or whatever down to its bear market low.
“It is easier and wiser to float with the current than to try to swim upstream.” Anonymous
Wow, that Anonymous guy (gal?) sure was smart.
Staff Writer and Trading Strategist
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