From the August 01, 2011 issue of Futures Magazine • Subscribe!

Shocking moving average systems

A trader’s arsenal includes many weapons. Some are extremely useful, and some have limited utility. A successful trader will understand the strengths and weaknesses of many techniques to combine various tools so the combination proves greater than the individual parts.

Success in the trading business may be defined as simultaneously increasing net profits while reducing overall risk. So, if trading tool A produces net profits of 240 points and has a winning ratio of 61%, and trading tool B produces net profits of 150 points and has a winning ratio of 72%, then a new tool AB certainly will be quite successful if it can produce net profit of 275 points with a winning ratio of 74%.

We even might consider the new trading tool successful if it does one or the other — increase net profits or increase winning percentage. The assessment depends on many factors, including individual trading personality, goals and risk tolerance. Nevertheless, we always seek to improve on our tools in search of perfection.

Methods at hand

The two-part series, "Using price shocks to time the market" (Futures, November 2009) and "Shocking profits in new markets" (Futures, December 2009), discussed the concept of entering a market in the opposite direction when an extreme price level, in the context of the most recent price action, had been reached.

We examined various commodities and compared monthly closing prices to those occurring during the previous two years. It was hypothesized that a trader could enter such markets safely when those markets exhibited signs of momentum deterioration and then hold the position long-term until the pendulum swung in the opposite direction. This tool is quite useful, but the challenge is quantifying the level of extreme that a market can reach.

As the articles pointed out, analysis demonstrates a market has a natural floor because commodities have real production costs. However, as demonstrated by the recent price increase in cotton exceeding 550% over the November 2008 low of 36.70¢, sometimes the sky is the limit on the upside.

In "S&P 500: Moving averages provide a simple solution" (Futures, April 2011), a useful improvement on a basic tool was developed. By shifting a simple 15-period moving average forward by 14 periods, the trading results improved dramatically, both in terms of profitability and accuracy. In addition, the refinement reduced overall risk exposure while retaining the best trades realized using the simple moving average tool.

The challenge before us is to combine both concepts to determine if we can realize an improvement.

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