For some time, analysts have used moving averages as indicators in different forms and levels of complexity. One innovation, offered by Murray Ruggiero Jr., writing for Futures, has used moving averages to create a window-of-opportunity envelope. The premise was the S&P often trades beyond both a short-term (fast) and long-term (slow) moving average. Periodically, price retraces to fall in the envelope between those two averages. When it does, an opportunity arises for a breakout in the original direction, providing an excellent trade.
By testing this concept in real time, we can see if improvements can be made that are particular to the S&P 500 index. The methodology employed is quite simple and all data and calculations can be easily maintained on a basic spreadsheet:
- Each week record the open, high, low and close of the S&P 500 cash index. The trading range is equal to the weekly high minus the low.
- Keep a simple three-week moving average of the trading range as the key range for the following week. Taking 25% of the key range produces the key span for the following week.
- Simultaneously, maintain an eight-week and 50-week simple moving average of the S&P 500 cash index closing price.
For example, “Envelope tracking” (below) depicts the data for the period Sept. 8, 2009, through Dec. 11, 2009. For the week beginning Sept. 28, 2009, the S&P opened at 1045.38. The trading range was 49.67. A three-week moving average of range for the weeks of Sept. 14, 21 and 28 is 42.81, which is recorded on the Oct. 5 line. Twenty-five percent of 42.81 is 10.70, which appears in the following column. The eight- and 50-week moving average based upon the closing price is also shown.
Note how during the weeks of Sept. 8 and 14, the S&P cash closes at 1042.73 and 1068.30, respectively, well above both the eight- and 50-week moving averages. The market had been rising consistently. On Oct. 2, 2009, the cash index ended at 1025.21, closing out the Sept. 28 week and falling below the eight-week moving average, but above the 50-week moving average. The index is within the envelope between the two averages and sets up the trading opportunity.
Triggering the trade
We will want to purchase the S&P cash index if it begins to ascend. But, how will we determine if and when to buy? Can we filter good trades from false signals? A simple rule for entry is: Go long the S&P cash index if price in the week following a move back below the eight week simple moving average trades above its opening price by the key span. As we saw above, the key span computed for the weeks of Sept. 14, 21 and 28 was 10.70. Consequently, during the week of Oct. 5, 2009, we will enter a long trade if the S&P cash trades at or above its opening price on Oct. 5 plus 10.70 (see “The trap is set,” below).
On Oct. 5, the S&P opened at 1026.87. Adding 10.70 to this produces a buy entry stop of 1037.57 placed immediately following Monday’s open and left in place the entire week. The index trades through this and triggers a buy signal. We immediately purchase one S&P 500 contract and enter a stop loss for the trade. Research shows the best stop loss is 5.15 times the key span for that week. This stop loss will not be changed until an exit from the trade is signaled. In this instance, it is set at 1037.57 - 55.10, or 982.46.
Provided the S&P cash closes within the envelope between the eight- and 50-week moving averages, no exit signal is given and we simply remain long. Once price closes the week above the eight-week or falls below the 50-week, a sell warning is produced for the following week. We enter a new stop based on the next week’s open less twice the key span for that week. So, the Oct. 5 week finished with the S&P at 1,071.49, well beyond the 1,056.95 computation for the eight-week, thereby setting up a sell warning. We compute the key range (44.75) and key span (11.19) for the following week. On Oct. 12, 2009, the S&P cash index opens at 1,071.63. So, we raise the stop from 984.06 to 1049.26 (1071.63 Ð 2 * 11.19).
The low for the week was 1066.71; the stop is not triggered. The S&P closes at 1087.68, still above the eight-week, giving another sell warning for the following week.
We compute a new stop each week, but never lower a pre-existing stop. The stop for the week of Oct. 19 is raised to 1067.37 and not triggered. The following week’s stop would be 1063.28, but this is lower than our existing stop, which remains in effect. During the week of Oct. 26, 2009, the stop is hit and the trade closes at a profit of 29.80 points. We do not re-enter in the same week, but can enter the following week, even in the same direction because the closing price is still within the envelope.
Short trades are executed in similar manner. Price trends lower, bounces higher and then we look to enter on a resumption of the downtrend. All of the formulae remain the same in the opposite direction -- that is, subtract the key span from the open to trigger a trade entry; add the appropriate amounts to the trade price or open to set stops.
Results over time
Since May 23, 1994, this system would have traded 86 times. It shows a hypothetical profit of 1,211.4 gross S&P points, the average is 14.08 S&P points. Allowing 0.30 points for slippage and commissions ($150), that is a net profit of $592,801, or roughly $6,893 per trade. Fifty-five of the 86 (63.9%) trades were profitable. Because the S&P 500 futures contract generally trades at some variation from the cash index, slippage may be more than 0.30. The typical trade lasted 4.67 weeks, counting the weeks of entry and exit as full weeks.
Fifteen of 23 short trades (65.2%) were profitable, producing an average of 28.23 net S&P points. Forty of 63 (63.4%) of the long trades were profitable, yielding an average of 9.2 S&P points. The worst trade loss was 74.91 S&P points, while the best gain was 295.68 points. Eleven trades (12.8%) lost more than 40 total S&P points, while 20 gained more than 40 S&P points. Half of the trades gained at least 6.27 S&P points after slippage and commissions.
Four of the losses that exceeded 50 points resulted from the initial stop being hit, and in each of those cases the stop minimized a greater potential loss. The worst series of losses (five) resulted in a 94.52 S&P point drawdown, or $56,711 before slippage.
This is an excellent system for the intermediate term position trader willing to withstand some significant drawdowns (see “A nice run,” below). There is a substantial likelihood of being profitable in the next trade and roughly a one-in-five chance of hitting a $20,000 profit. For the smaller trader, similar results can be achieved using a mini-S&P futures contract, reducing the maximum drawdown to $11,342 and still yielding $118,560 in hypothetical profit.
For short-term traders, the same methodology, with minor modifications, can be employed using nearest futures data. Daily data based on the pit session prices can be used to signal an entry or exit for the next day. The entry stop is placed immediately following the open of the S&P futures at 9:30 a.m. EST and is good through the pit session close. If triggered, the initial stop loss is expanded to 6.0 times the key span.
Once the trade is in progress, a second contract in the same direction is permitted as a scalp trade if the underlying signal is repeated on any subsequent day. The second signal is executed in the same manner as the initial entry -- that is, a stop of the open price plus or minus the key span. However, once triggered, a profit target is entered equal to theoretical entry price plus twice the key span. If the scalp trade is successfully completed, another may be entered on any following day provided the underlying trade is still in place. The initial stop is used for both positions, as is any subsequent exit stop.
Trade data were kept from Aug. 20, 2007 forward. It is necessary to maintain duplicate data starting roughly 30 days prior to each contract expiration. For example, begin recording both March and June contract data starting mid-February. Use one master spreadsheet, and extend it for both contracts. As March expires, roll forward into June using the new spreadsheet and the various moving averages will be reasonably accurate. Don’t roll too soon because the opening price and daily range of the outer months tend not to reflect the true daily range until volume begins to increase for the next contract.
This system traded 104 times between Aug. 20, 2007, and Jan. 26, 2010 . The average trade gained 7.42 S&P points before slippage, and 73.8% of the trades were winners (see “Inside the number,” right). Using the mini-S&P and allowing one point for slippage and commission, that is a profit of $33,384 in roughly 30 months -- about $321 net per trade. Half the trades had net profits in excess of 9.72 gross points. The worst loss was roughly 51 points. The best gain was just more than 85 points. About 10% of the trades lost 20 or more points, while 17.5% gained 20 or more. More than 85% of the scalp trades were profitable and may merit two mini contracts each, depending upon a trader’s risk tolerance.
The average trade lasts about three full days, with the longest taking 14 to complete. The scalp trades often enter and exit on the same day. Time involvement for the trader is relatively minimal. Daily data are recorded after the 4:15 p.m. EST close, and the key span is computed for the following day. About 35% of the time, a trade warning is given. At 9:30 a.m. EST, the opening price of the pit session S&P is recorded, and the entry stop computed and entered. The stop loss also can be entered at this time as a day order, and converted to an open order if the trade occurs. If a scalp trade is possible, the entry, stop loss and profit targets all can be entered immediately following the pit session open.
All data are based on the large S&P 500 contract. Allowance must be made for the variation between the mini-S&P and its larger cousin if a trader prefers the smaller contract. It is suggested all stops be placed at least 0.50 points beyond the trade signal because the E-mini often experiences more volatility. Even then, it is possible a stop is hit in the E-mini market, which is not triggered in the big contract. Traders must watch for this. Consequently, a trader who is not focused on the market throughout the day may wish to allow even more slippage in the E-mini executions to avoid a false entry.
Arthur M. Field, Ph.D., is a former commodities broker and co-manager of Fidelity’s Pacific Fund. He wrote “The Magic 8: The Only 8 Indicators You Ever Need to Make Millions.” E-mail him at TheMagicEight@hotmail.com.