To conduct our test, we chose a market at random — copper on a monthly basis. Our data set begins in January 1989 and ends in March 2011, providing 267 data points. To perform the test, we shall begin by using the methodology developed in the displaced moving averages article.
That is, we buy copper when the second monthly close exceeds the shifted moving average. We sell any long positions and go short when the second monthly consecutive close is beneath the moving average. This will be our control system.
As demonstrated in "Control system" (below), the results were not satisfactory for this system by itself. A total of 10 trades were taken over the 21-year period, including one open trade at the time of this writing. Of those, only 40% were winners, and the overall loss before slippage trading one contract is 16.7¢, or a gross loss of $4,175. The average trade lost $417.50 before slippage and commissions. Because the last trade is still open, chances are good these results will worsen.
To address these poor results, we will introduce the concept of a profit target suggested in the moving averages article and, borrowing from the price shock series, an opposite side entry if it is determined that price has exceeded its historical price pattern in either direction.
This is where discretion comes into play. These levels are based on observation of recent price action and reading the patterns. If testing demonstrates that 95% of the data fall within a certain range, by definition, 5% will fall outside with reasonable statistical probability and less chance of error. Naturally, the exact range is an estimate, not a certainty, and its accuracy will depend upon the number of data points available to formulate the estimate.
For this test, chart analysis suggests we use approximately 25% of the range as our profit target and approximately 50% of the range as our threshold for an extreme price move.
We will buy copper as before, but exit the long position when it has achieved a price equal to 25% above the displaced simple moving average. Similarly, we exit shorts when they drop to a price 25% beneath the displaced average. This is triggered on a market-if-touched basis, and these levels change monthly in relation to the movement of the displaced average itself.
We integrate the price shock concept by entering an opposite direction trade based on the 50% level. So, if price closes at least two months beyond the 50% upper level and then closes beneath that level in a subsequent month, we enter a short trade. We hold that short and look to exit at the profit target.