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Stocks & Commodities V. 40:01 (8–12): Trading A Moving Average System: Important Choices by Perry J. Kaufman

Copyright © Technical Analysis Inc. www.Traders.com

 Stocks & Commodities V. 40:01 (8–12): Trading A Moving Average System: Important Choices by Perry J. Kaufman
TRADING SYSTEMS

A Comparison Of Signals

Trading A Moving Average

System: Important Choices
Most traders have used moving average-based trading • Rule 1 (price cross): The signal occurs when
systems to derive trading signals. But how you define price crosses the moving average line.
the signal can greatly affect the outcome. Here’s a • Rule 2 (trend signal): The signal occurs where
study to help determine the best ways to apply a the trend changes direction.
moving average system.

I
For a smooth data series, we will reach into the
am sure that there is no need to explain a mutual fund world and pick LHYAX, the Lord Abbett
moving average to any of you. But there are High-Yield Fund. The reason mutual funds move in a
choices as to how they are interpreted and smoother pattern is that trading is often restricted to
executed. Here is one choice that has often a few times each year, and this particular fund tracks
gone unnoticed: interest rates, which also tend to be very trending.
We do not need to be concerned with how the Fed
• Do you enter a trade when the price crosses the manages rates; our only concern is the price pattern,
moving average trendline, or shown in Figure 1.
• Do you enter when the moving average turns
up or down? Deciding the smoothness of prices
I will only look at the past five years, starting in 2016.
And second, how important is it to enter on the close, That will make the results more timely. Now compare
that is, the time the new moving average is calculated, LHYAX with SPY, the S&P ETF, shown in Figure 2.
or is it better, or easier, to enter on the next open? Can you tell which is smoother? We can see that SPY
I find both questions remarkably important. Your has larger price swings, but we need a more scientific
choices can have a significant impact on your prof-
its.

Choices and more choices

We can’t test everything, but we can test representative
stocks. The idea is that smooth data is likely to have
a different answer than noisy, erratic data. The span
of the test can also affect the result. If we only look
at the bull market from 2009 through 2019, we can
predict the result—get in as soon as possible. But that
is probably not the answer to everything.
To examine the first question posed above about FIGURE 1: A SMOOTH DATA SERIES. The price series shown is the Lord
the trading signal, we will define the trading signal Abbett High-Yield Fund (LHYAX), 2016–2021. This fund tracks interest rates,
which tend to be very trending, and also, this mutual fund restricts trading to
for the two choices as follows:
MIKE CRESSY

a few times each year, all of which makes for a smooth price series.

by Perry J. Kaufman

Copyright © Technical Analysis Inc. www.Traders.com

Stocks & Commodities V. 40:01 (8–12): Trading A Moving Average System: Important Choices by Perry J. Kaufman

FIGURE 2: A NOISY DATA SERIES. This price series is the SPY, the S&P FIGURE 4: PRICE CROSS RULE (RULE 1) VS. TREND SIGNAL RULE
ETF, 2016–2021. Compared to Figure 1, the price series appears to have (RULE 2), LHYAX. Total profits are shown for the test of rules 1 and 2 ap-
larger swings. plied to the LHYAX fund for the past 5 years, 2016–2021. Rule 1 is in blue
and rule 2 is in orange.
0.451

0.328

LHYAX SPY
FIGURE 3: EFFICIENCY RATIO FOR EACH OF THE TWO PRICE SERIES.
The efficiency ratio for both the LHYAX and SPY is shown. The efficiency
ratio provides a way to measure noise rather than going by just simple visual
inspection of the price series. The higher values for LHYAX indicate more FIGURE 5: PRICE CROSS RULE (RULE 1) VS. TREND SIGNAL RULE
trend and less noise. (RULE 2), SPY. Total profits are shown for the test of rules 1 and 2 applied
measure, so we will use my efficiency ratio (ER). to SPY data for the past 5 years, 2016–2021. Rule 1 is in blue and rule 2
is in orange.
You might already be familiar with the efficiency ratio,
but the formula is: Testing the theory
The best way to test the theory is to run a test over a range
of calculation periods and show the results side-by-side.
The first test is LHYAX, shown in Figure 4. Rule 1, the
price crossing the moving average trendline, is better
When we apply this to the two series, LHYAX and SPY, everywhere. In general, it gets better as the trend period
using a 10-day rolling window from 2016, we get higher gets larger because the trendline will lag more and take
values for LHYAX, indicating more trend and less noise, longer to change direction. So far, so good.
as you can see in Figure 3. Before we test the validity of Now we look at the results of doing the same test for SPY,
the efficiency ratio, we will say that LHYAX will favor shown in Figure 5. The results are not as clear because the
rule 1 and SPY will favor rule 2. Why? SPY price moves are more erratic. However, rule 2, seen
as the orange line, is equal or better in most cases other
than 70 and 80 in the center. It would be more satisfying
if the results of SPY were as clear as LHYAX. The good
I find both questions news is that it makes money everywhere.
remarkably important. Your
choices can have a significant Rule 1 or rule 2?
impact on your profits. If you could only pick one rule, I would choose rule 2.
If you are using a moving average to trade mutual funds,
then a fast trend and rule 1 is clearly better, But for most

Copyright © Technical Analysis Inc. www.Traders.com

Stocks & Commodities V. 40:01 (8–12): Trading A Moving Average System: Important Choices by Perry J. Kaufman

FIGURE 6: TRADE ON THE CLOSE OR AT THE NEXT OPEN? The price series for Apple (AAPL) is on the left and the price series for Boeing (BA) is on
the right for the five-year period from 2016–2021. You can see these two stocks exhibit very different price patterns.

FIGURE 7: RESULTS, AAPL. Compare the results from testing the ap- FIGURE 8: RESULTS, BA. Compare the results from testing the approaches
proaches of when to enter (on the close or at the next open for both rules of when to enter (on the close or at the next open for both rules 1 and 2, a
1 and 2, a total of four tests) on AAPL. Results aren’t better or worse when total of four tests) on BA. Results were more erratic here than in Figure 7
entering on the close or at the next open. since the stock price is more erratic. As in Figure 7, the trendline signal is
better than the price cross signal for slower trends.

of us, prices are not that smooth. All the other numbers remain the same.
As a mathematician, I see the purpose of the moving If today’s close is going to be higher than the close 20
average as identifying the direction of prices. It uncovers days ago (not including today), the trend will be up. If it
the direction by eliminating the noise. With that in mind, is lower, the trend will be down.
I want to trade the direction of the trendline. Another Now that you know how to trade on the close, do you
consideration is that the price may reverse back and forth want to do that? This time, we’ll look at two different
across the trendline, causing lots of trades. In general, rule stocks, Apple (AAPL) and Boeing (BA) for that past 5
1 has twice as many trades as rule 2. Even though there years, shown in Figure 6. Clearly, they exhibit very dif-
are no commission costs these days, slippage can chip ferent patterns.
away at your profits. The four tests for examining the question of when to
enter are as follows:
Trading on the close or the next open?
Our second problem is one of timing. Let’s say you could Test 1: The price crosses the new moving average value
know that your trend signal will be triggered on today’s on today’s close. Execute on the close.
close. Should you enter on the close or wait for the next Test 2: The trend turns up using today’s close. Execute
open? on the close.
For most algorithmic traders, data is updated after the Test 3: The price crosses the trendline. Execute on the
close and then the strategies are calculated. Trading on next open.
the close does not seem like an option. But it is not that Test 4: The trendline changes direction. Execute on the
difficult to figure out when the moving average turns up or next open.
down. If you are using a 20-day moving average, simply
compare today’s close (or expected close) with the price 20 Looking first at AAPL, Figure 7 shows the four tests
days ago, which will be dropped off from the calculation. together for comparison. On the left of Figure 7, we see

Copyright © Technical Analysis Inc. www.Traders.com

Stocks & Commodities V. 40:01 (8–12): Trading A Moving Average System: Important Choices by Perry J. Kaufman

that the blue and gray bars, tests 1 and 3, are better through
the 50-day average. Results are mixed in the middle, and
the orange and yellow bars (tests 2 and 4) are best at the Smooth data is likely to
right. That says for faster moving averages we want to have a different answer
use rule 1, where we enter when the price crosses the than noisy, erratic data.
trendline. For slower averages we use the change in the
trendline, rule 2. I cannot see that the results are better or
worse entering on the close or the next open. new trendline or if the trendline is going to turn up. You
For BA we see more erratic results (Figure 8), but then, can download your data at the end of the day and trade
Boeing prices were more erratic. What is clear is that the next open.
for slower trends, we have the same results as we did for
AAPL—that following the trend change signal is better than Perry J. Kaufman is a trader and financial engineer. He is
the price cross. At the fast end, they all perform about the the author of many books on trading and market analysis,
same, and in the middle, the trend direction shows some including the sixth edition (2020) of Trading Systems and
profits, while the price cross posts more losses. Methods (with the first edition published in 1978 as a
seminal book in the field of technical analysis), and Kauf-
Summary man Constructs Trading Systems (2020). For questions or
What is the best way to execute a moving average trade? I comments, please go to www.kaufmansignals.com.
am tempted to say “it depends” but I believe that there is
a small difference between using rule 1 (the price cross) Further reading
versus rule 2 (the trend change). If you are a fast trader, Kaufman, Perry J. [2020]. Kaufman Constructs Trading
the price cross has an advantage. Slow traders should use Systems (print and ebook editions), Amazon.
the direction of the trend. [2020]. Trading Systems and Methods, 6th Edition,
What about the question of executing on the concur- Wiley.
rent close or the next open? The good news is that the [1995]. Smarter Trading, McGraw-Hill.
next open is just as good, so you do not have to sit at your
desk and try to figure out if the price is going to cross the

Copyright © Technical Analysis Inc. www.Traders.com

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