From the August 01, 2010 issue of Futures Magazine • Subscribe!

Using moving average envelopes in the S&P

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.

chart

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).

chart

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.

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