The real use of moving averages… or other on-chart indicators

Let’s admit it, we all wanted to become traders because of our fascination with charts. At least not the too young of us that see the current charts nowadays. But in older times, charts used to look normal. People were just using moving average signals, Bollinger bands, MACD, not too complicated stuff. Some were just drawing trend lines and were following trends. It all used to come natural.

After 2000, the situation drastically shifted. As trading has become more electronic, reaching even the basic home user, the hedge funds were already far in electronic trading, and the race was for more speed. The more speed, the more liquidity, the more uncertainty. Charts have become harder and harder to analyze, and trading systems started to take a beating.

But still, moving averages are very good indicators. Provided that you know how to use them, and throw away what the books say. This chart depicts a cross of the SMA 14 with SMA 9.

zig-zag-ma

 

So late are the signals, that the entire downward movement is missed. The benchmark (ZigZag distance) is 662 pips. Out of this movement, the crossed signals give a slight 25 pips loss.

But check the moving averages themselves. What if, these averages would represent support/resistance in decision and trailing stop loss on the current trade ? When the market reaches the moving average, enter the trade: if it crosses below, go short, if it crosses above, go long!

Well, things may go wrong because of the moving average direction, but just a bit. Look at the red 9 bar moving average, that goes slightly up the day after it intersects the market, before plunging down. If your trade was short at the time, there is no reason the move the stop loss further more in the loss area, where the moving average goes, up for that day.

The thing this strategy may have a lot of bad intrabar trades, as the price is swinging back and forth around the moving average. Once it clears out of that area, it starts to get confirmations by the moving average, moving the stop loss, by each bar, further more into the profit territory. It is mandatory that this strategy is managed on an intraday basis.

Why this way? Because anything can happen anytime. How many times didn’t you see great trades that you didn’t take because the indicator didn’t give the right signal ? This time you don’t take any assumption: you only hang on to the moving average level and trade depending on the territory of the market.

Therefore the issues of this strategy are:

  • How much it costs, in pips, to switch the trade direction ?
  • How many swings could be expected and how would that influence the costs until the strategy makes a buck?
  • How can the costs be recovered ?
  • What are the filling options for this?
  • How to handle weekends and holidays ?

It should cost about 2 pips (regular four digits) or less, to switch the trade direction. Of course, unless you would define a slight channel of a few pips that is a no-trade zone around the moving average. However, a no-trade zone around the moving average would hike the cost per switch.

The number of swings could pretty high: there may be even 50 a given day. This is why there are two ways to combat it: picking very slow timeframes (like daily or above), where the moving average moves slowly and allows a trade to make hundreds of pips ; also, by using a partial take profit.

It would be a bad idea to apply this strategy on a sub-daily chart. The moving average would give less profits per movement. There won’t be hundreds of pips… but up to 20-40 pips, while there would be a lot of direction switches, as the moving average would intersect the chart a lot of times in a day. Therefore , it would be a really bad idea. It would actually looks like this:

ma

Notice several hours where the moving average is intersected by the market, and its tiny profit window, of about 20-30 pips.

The cost can be recovered by using a partial take profit. This can be done, in the order-based platforms, by using two orders instead of one: a main order, that would be closed only at a moving average cross, and a “hedge” order, on the same direction, with a take profit equal with previous losses (losses produced while switching directions).

trade

Check the first picture: see that after July 29, each day, the market intersects the 9 day moving average. But that’s an interval of about 100 pips. Each swing will have its corresponding hedge trade, that will have a tight take profit, and the losses will be swiftly recovered: -2, -4, -8, 0, -2, 0, -2, -4, -8, -12, 0 …

Notice the danger in the second picture, 5 minute chart .The market moves so less around the moving average that it wouldn’t give enough territory to the hedge to actually reach take profit quickly.

Now, what would the probability be to have such situations happening around the daily moving average versus the 5-minute moving average? And let’s not forget the daily swings around the moving average that can be powerful enough for the reach of take profit on the hedge trade.

The filling method is a special discussion itself. In a trading platform that supports event programming, it would seem quite natural to use pending orders where one’s stop loss is on the other’s entry level. However, as the bid is below the ask, that is quite of a problem when the spread is dynamic, as both long and short trades could fire at the same time. Market execution could work, but it would be imprecise and it would leak slippage, and imposing more territory, such as bid beyond buy level and ask below sell level would increase the switch costs.

 

execution

Weekends and holidays pose a problem. Keeping trades beyond weekend could be either good, or bad, if the market opens on the wrong side of the moving average, triggering an automatic close with pretty big losses. The slight advantage is that the weekend/holiday would act as a take profit, but re-entry after the weekend may not happen at all, and could result in a lost major opportunity.

Don’t forget that whatever your implementation, this strategy still needs adequate backtesting, preferably at tick level, as well as some forward demo testing, before being put in production!

 

 

By | 2013-12-03T20:56:39+00:00 December 3rd, 2013|Blog, Forex|0 Comments

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