Trading systems are collections of rules for buying and selling commodities and stocks. As useful trend-identifying techniques, moving averages are common elements in trading systems. Conventional interpretation of a moving average would generate entries as price crosses above or below the moving average. However, generating effective mechanical exits can be challenging.
The example here uses continuous E-mini S&P 500 futures data (daytime only), charted on a nine-minute bar interval. The chart below shows a 20-bar simple arithmetic average.
One possible way to address the exit challenge is to measure the extremes by which prices move beyond the moving average. The degree to which prices move up or down beyond the average may be used as a gauge of overbought and oversold conditions. This may be measured simply by subtracting the value of the moving average from the close, yielding a positive or negative number.
A method that is both more dynamic and normalized is to express that difference in terms of units of the average true range (ATR). This allows the analysis to adjust as market volatility characteristics change. The below chart shows dark red bars when the close is 2.5 times above the five-bar ATR and dark blue bars when it is the same distance below the moving average. These extremes may be areas at which to take profits within a trend.
Using typical moving-average entry signals, exits such as these using related calculations may reduce time-in-market and provide smoother performance during periods of less sustained trending.
“Scorecard” shows the results of this concept trading one contract. Entries are made when there are two consecutive closes above or below the 20-bar simple moving average. Exits are made on the open of a bar following any close that is at least two times the five-bar ATR, above or below the 20-bar simple moving average. A $1,000 stop loss is used with a $5 round-turn commission charge.
Stanley Dash is the director of technical analysis for TradeStation Securities. E-mail: email@example.com.