We look at simple moving averages and moving average crossovers.
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Today we look at the book; Five Moving Average Signals That Beat Buy And Hold.
We take a ride through the research and back tested results, using the 20, 50, 100, 200 and 250-day moving averages, including crossover combinations.
The book demonstrates that by using a systematic approach, you will know when to be in the market, or when to get out the market, and cash in before a market downturn.
The question is posed, can you beat buy and hold?
The efficient market hypothesis would have you believe that all known data is reflected in current asset prices, and it is therefore impossible to beat the market.
Conversely, traders like myself and other gurus covered on this channel know the market can be beaten, and the moving average indicator is just one of the tools we can use to do it.
The book uses the S and P 500 (or SPY ETF) as the benchmark when comparing the moving averages.
The 1st to be covered is the 200-day moving average, described as the most popular and used by the likes of market wizard Paul Tudor Jones.
In this study, we use daily stock prices and the crossing of the 200-day moving average to determine our position. The back tested results are produced from the year 2000 through to 2016 and captures bull, bear, and sideways moving markets.
A signal should only be acted upon once per month, at the end of each month. Therefore, a maximum of twelve trades could be generated per year.
To enter a long position, we need to see price cross above the 200-day moving average, which we see here, although we need to wait until the end of the month to confirm and place a trade.
The end of month approaches, and we confirm our long position and enter a trade.
We then sit and wait out the whole month to determine our next trade decision. Notice how price could drop below the 200-day moving average but remain above it at the end of the month. In this situation we would hold onto our long position and therefore leave the trade alone.
If the price continued and closed below the 200-day moving average at the end of the next month, we would sell our position and remain in cash, whilst waiting for the end of the next month to see if price crossed and remained above the 200-day moving average, at which point we would re-enter a long position.
The back tested results of this simple moving average, index tracking strategy, against a buy and hold strategy are remarkable.
If we bought the S and P 500 index in 2000 and simply held it until 2016, we would have seen a total gain of 125.2%, accompanied by a maximum drawdown 55.2%.
If, however we followed the 200-day moving average strategy over the same period, we would have seen a return of 317.7%, with a maximum drawdown of 17.3%. In effect tripling the returns of buy and hold whilst reducing the drawdowns by more than two-thirds.
In essence, a rather simple but effective trend following strategy.
Next, we have the 250-day moving average, using the same S and P 500 index as the benchmark.
The signal to buy for this strategy is when price crosses and closes above the 250-day average, and unlike the previous strategy we do not wait for the end of the month, we wait for the close of the day instead.
Once the trade is entered, we watch the price either continue its trajectory or cross back below the moving average line. If at the end of any given day price closes below the line, we close our position.
Due to the requirement of reacting to daily price movement, there is the possibility of creating multiple false signals, unlike the previous strategy which required a reaction only once per month.
There are however pro’s and con’s to reacting faster. Clearly numerous false signals add to our trading costs, but these are often compensated by the reducing impact of a significant drawdown. Ultimately, using a moving average we can skew the asymmetric risk/reward into our favour by minimising risk and allowing for multiple reward, arguably the most important metric in any form of trading or investing.
Let us look at the results of this strategy against buy and hold, over the same 16-year period.
The S and P 500 index achieved a buy and hold return of 127.4%, and the maximum drawdown over the same period was 55.2%.
The 250-day moving average strategy returned marginally more than buy and hold, achieving 128%, although the maximum drawdown was cut by more than half at 23.1%.
In theory, this strategy works best in a trending bull market, but perhaps more importantly, in a declining market or even a crash, it helps reduce risk.
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Next, we have a moving average crossover system, using the 50-day moving average and the 200-day moving average. Also known as the gold and death crosses.
The trigger to enter a position is determined by the direction of the crossover, for example, if the 50- day moving average crossed below and closed under the 200-day moving average we would want to be in a cash only position. If the 50-day moving average crossed above the 200-day moving average, we move from a cash position and buy the index.
Unlike the previous examples, this system relies on the moving average lines only and not the daily price action.
Using the same time horizon as before, we can compare buy and hold with this simple 50 and 200-day crossover strategy.
From the point of the first crossover signal, buy and hold returned a gain of 167% with a maximum drawdown of 55.2%.
Using the crossover system, we would have generated a 205% return, with a maximum drawdown of 19.2%, considerably less risk than buy and hold.
Here we have another popular crossover system, this time using the 20 day and the 200-day moving averages.
The same principle as the previous strategy but with faster buy and sell signal generation.
Once again, let us compare buy and hold over the same time frame against this crossover signal.
Since the first crossover signal was generated, buy and hold provided a return of 161%, with a maximum drawdown of 55.2%.
The simple crossover strategy provided a return of 193% with a maximum drawdown of 17.3%, again considerably less risk than a buy and hold strategy alone.
Before we check how each system reacted to the 2020 pandemic crash, we look at our final crossover system, this time using the 50 day and the 100 day moving averages.
The returns of buy and hold, from the point of the first crossover signal, accrued to 104%. The maximum drawdown was once again 55.2%.
The crossover system achieved a return of 127%, against a maximum drawdown of 19.4%. Again, continuing the theme of minimising risk.
We can summarise each of the moving average systems here.
The best excessive return over a buy and hold strategy, was the simple 200-day moving average, with an excess return of 192% and a maximum drawdown of 17.3%, making this the most appealing strategy of them all.
But how would they have reacted 4 years later during the 2020 pandemic crash?
A buy and hold strategy would have seen a drawdown from peak to trough of 34%, between the end of February to the end of March.
The slowest strategy to react was the 50 and 200 day crossover strategy, enduring the full 34% drawdown.
Next, the 50 and 100 day crossover with a 32.5% drawdown. The 20 and 200 day crossover with a 29% drawdown. Whilst both the 200 and 250 day moving average strategies endured just a 12.4% drawdown, perhaps reinforcing the 200 day moving average strategy as the most appealing.
The author Steve Burns summarises the analysis by saying:-
“The purpose of these systems is to give entry signals that get you into uptrends and out before strong downtrends”.
The evidence certainly reinforces his theory and answers the initial question of; Can you beat buy and hold.
Hopefully, this review has giving you food for thought regarding either investing into an ETF, or simply helping to time your individual trades.
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