Bulletin # 43
Moving Average Crossovers May Not Be The Best Entry Signals
There are many ways of using moving averages to trade but by far the most common method is to trade when a short-term moving average crosses over a longer term moving average. For example, if the 10-day MA crosses above the 30-day MA we typically assume that we have a new buy signal.
Let's stop for a minute and think about what exactly is occurring at the point of a crossover. When the 10-day MA and the 30-day MA are at the same price, the trend is not nearly as clear as it should be. What we are really observing at the crossover point is that the average of the last 30 prices is exactly the same as the average of the last 10 prices. If we are looking for trends to trade, this equal relationship of the two moving averages is not a reliable or logical indication of a trend. In an upward trending market the average prices over the last 10 days should be much higher than the average of the last 30 days. By implementing new trades at crossover points we are limiting our trading to points that may not clearly reflect what we should be doing. For best results in a trend-following system we want to be trading when the trend is clear and reliable; not when the trend is confused and questionable.
Instead of trading at crossovers we should be implementing our trades when the moving averages are parallel or when the short-term moving average is moving farther away from the longer-term moving average. Perhaps the short term MA should remain a minimum of some units of Average True Range above the longer term MA for several days. I believe that this procedure would give us more reliable and more frequent entry signals in the direction of the prevailing trend, which is exactly what we want. To identify the most reliable trends we want to see the slopes of various moving averages all moving steadily in the same direction and not crossing back and forth.
Take a look at a chart of any market with a strong trend. You will see that the moving averages are not crossing back and forth repeatedly. They will be moving in the same general direction in a more or less parallel fashion. Now look at a chart of a non-trending market. As this market moves sideways the moving averages will be crossing back and forth very frequently. Look at the implications of this simple examination of the charts. If we are trading the crossovers we will be trading most frequently in non-trending markets and trading most infrequently in strongly trending markets. Is that what we want? No, it's obviously not what we want. We want just the opposite. We want frequent entry opportunities in trending markets and we want to avoid as many trades as possible in non-trending markets.
The error in the logic of trading moving average crossovers also extends to some interpretations of MACD (Moving Average Convergence and Divergence) and DMI (Directional Movement Indicator). If we are looking at MACD we want to see both lines (each line reflects a moving average relationship) moving in the same direction. We don't want to see them crossing. When looking at DMI we want to see the Plus DI lines and the Minus DI lines moving in opposite directions and definitely not crossing. Remember, when the Plus DI and the Minus DI lines intersect it is telling us that the market is in balance and has no direction; the amount of upward and downward directional movement are exactly equal. What makes our favorite indicator, the ADX, so effective is that it rises only when the Plus DI and the Minus DI are moving in opposite directions and the distance between the two indicators is widening.
With a little thought and effort I'm sure we can design some reliable entry signals that are based on moving averages but avoid the typical crossover signals. For example we could measure the slope of several moving averages and when all the averages slope upward we would have a buy signal.
We could also measure the distance between several moving averages and implement our trades when the averages are all headed in the same direction but start getting farther apart. This procedure would give us a series of entry signals within the same original trend. This should provide an excellent entry and re-entry strategy.
Give these suggestions some thought and see what ideas you come up with. Post your comments and ideas on our FORUM at http://www.traderclub.com/discus/board.html. I'm sure we will have an interesting discussion.
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Workshop Review and Next Workshop Scheduled
Based on our observations and the many favorable and enthusiastic comments we received, our first-ever Workshop in November was a big success. We covered a great deal of material in two exciting days and we had a great time doing it. We had eager participants who traveled from Australia, New Zealand, Switzerland, Austria, Canada, Poland and Singapore as well as various parts of the US. There were multi-million dollar fund managers and professional stock and options traders attending as well as individuals trading their private accounts. Our small but very lively and enthusiastic group was able to share many helpful ideas and we all enjoyed working on an actual trading system as a learning experience. Watching the various tests projected on the screen and analyzing the results together served to demonstrate and reinforce the valuable system development procedures that were presented at the Workshop.
Our next Workshop will be at the same accommodating and comfortable location: The Renaissance Los Angeles Hotel near the Los Angeles International Airport on Saturday and Sunday, January 27 and 28. The price of the Workshop will remain a very reasonable $1500. Send an e-mail to Chuck@Traderclub.com if you have any questions or if you want to reserve a spot. My direct phone number is (310) 265-9776.
As before, we will limit the number of attendees so everyone can participate and get the most out of the Workshop.
We will be sending out additional announcements and reminders in the next week or two but in the meantime be sure to make your Workshop reservation right away and firm up your travel plans as soon as possible. We look forward to presenting another exciting and educational Workshop on How To Design, Test, Evaluate and Implement Profitable Trading Systems.
Note to Southern California members: This may be our only local Workshop for some time. Be sure to attend while you have the opportunity to participate without traveling thousands of miles. You will meet some very interesting fellow traders from all parts of the world.
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TradeStation Pro on the web. OmegaResearch has finally unveiled their newest product. To have a look, go to http://www.tradestationpro.com/default_logon.shtm Be sure to check our Forum for comments and reviews from our members. I'm sure this new product will prompt some interesting discussions.
To read the many interesting messages and to participate in our lively FORUM go to: http://www.traderclub.com/discus/board.html
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If you need more information send email to:
Chuck Le Beau's System Traders Club http://www.traderclub.com ph 310-265-9776 fax 310-265-9556