By Manish Khatta on June 18, 2019
When I started in this industry, in the early 2000’s, the mainstream media stayed away from talking about technical analysis. It was considered financial voodoo as the investment community was heavily focused on the concept that company fundamentals solely drove stock prices.
If you fast forward 18 years, after two crushing bear markets and a massive bull market, things are drastically different. Companies like Uber and Airbnb don’t make any money yet still command lofty valuations. The line between value and growth has been dramatically blurred as company fundamentals disengage from the reality of price.
Technical analysis is now being embraced as an important risk management tool as more people embrace the truth behind price.
For example, the financial media has fallen in love with the 200-day moving average as a punchline for what stocks are about to do. It goes without saying that you should never take financial advice from a news channel.
However, their reach is wide and deep, so it behooves us in the financial community to discuss its merits.
WHAT IS A 200 DAY MOVING AVERAGE TRADING SYSTEM?
The concept of a 200-day moving average is quite simple as it's nothing more than comparing the daily price on an index against its 200-day (10-month moving average).
In theory, if the price is above the 200-day moving average, we are in a market uptrend. While if we go below, then the momentum is to the downside as the market could be losing momentum.
If this holds true, investors should be able to create a trading strategy that buys the S&P 500 when that index moves above its 200-day MA and then sell when it drops below its 200-day MA. The assumption being that you will be sitting in cash when not invested.
It’s not very difficult to skew data to prove a point because your starting conditions matter tremendously. When doing these studies, it’s important not to cherry pick your dates but it’s also impossible to cover every single date range.
For purposes of brevity I went back to 1980 as my starting date then added 10 years for each additional period through 2018.
To be frank, I tested over 100 random time periods and the story was all the same.Using the 200-day moving average as a trading strategy underperformed just holding the S&P 500 three out of the four periods tested. Only during the period that did not include a bear market, was the underperformance significant.
However, the trading strategy was able to avoid massive drawdowns and was less risky in every scenario tested. In fact, in three out of four periods tested the strategy was over 50% less risky than just holding the S&P 500.
There a tons of tweaks that can be added to this like delaying the trade for a certain amount of time or putting rules to only trade when the level is a certain percentage above or below the band. While this could have a significant impact on the results, I think the overall risk to reward relationship would be similar. I am going to run these tests soon and report back!
Investment success is personal and is in the eye of the beholder. This exercise is no different!
If investment return is your only guideline this strategy would be a failure, but if risk adjusted returns are important to you this could be beneficial.
For full disclosure this is simply to illustrate a point. This is not financial advice and these numbers do not reflect trading costs, taxes, fees, or anything else that is important.
CAN THIS WORK IN REAL LIFE AND NOT JUST ON MY COMPUTER?
The data proves trading around a moving average like the 200-day is a good risk reduction tool.
Can this be realistically implemented? Very unlikely!
To get these results the first important assumption is perfect execution; i.e. you execute every trade on the exact day the system indicates. We are not including the costs of executing these trades or the tax ramifications of capital gains.
Any schmuck can take a chart and overlay a 200-day moving average on it but knowing how to use it in real life is a totally different skill set.
It also takes a ton of discipline to follow any trading strategy. You must be laser focused to ignore the news, social media, your neighbors hot stock tip or just straight FOMO.
Investment managers usually have a wide array of tools in their arsenal such as the Advance Decline Line. Depending on their philosophy something like moving averages can play a big role in assessing the investment landscape.
But one tool doesn’t make an investment strategy.
While great for a chat at the water cooler, it’s important to remember that there are many factors that go into a trading strategy including using a wide variety of systems and processes.
What I know from experience is that your trading system should never just be “your gut” or a one-click chart.
Disclosure: This information is prepared for general information only and should not be considered as individual investment advice nor as a solicitation to buy or offer to sell any securities. This material does not constitute any representation as to the suitability or appropriateness of any investment advisory program or security. Please visit our FULL DISCLOSURE page.