As technical traders, we need to develop several tools for entry and exit. A good entry tool is worthless without a reliable exit method. And while high profits are attractive in any indicator, if the win/loss ratio is poor, it is unlikely a trader has the stamina to hold on through multiple losses. Even if there is sufficient capital, the psychological effect of sustaining hit after hit can be debilitating. It is often difficult to find a trustworthy tool that’s robust over the long term in both directions in a particular market. But, like Ponce de’ Leon hunting for the Fountain of Youth, we keep searching.
Several years ago, Futures published an article concerning two moving averages acting as a “collar” that inspired additional research (see “Using moving average envelopes in the S&P,” July 2010). The attraction to this tool is its simplicity for the trader and its robustness across various market conditions. Longer-term trading is appealing because it eliminates the statistical “noise” associated with intraday events. However, the concept described here may be applied to any market and any time frame.
For purposes of this demonstration, we’ll use the S&P 500 (CME:SP.C) cash index on a weekly basis and look at the set of weekly open, high, low and close data. Reliable data are readily available. We shall begin our test with data from 20 years ago in 1994, providing 1,032 data sets—a huge sample space and one designed to give us high confidence in the results.
We shall employ two simple moving averages of the weekly closing price: Periods of eight weeks and 50 weeks. The range is defined as the week’s high minus the week’s low. To smooth the range, we use a three-week simple moving average. The trigger range is 25% of the smoothed range. Armed with only these calculations we can build our entire model.
We begin by identifying a psychological foundation for the model; no technical tool should be used if it lacks a reasonable real-world basis. We know that the S&P 500 moves in a zig-zag fashion. A strong move in any direction is often followed by a Fibonacci-like retracement. That retracement often, but not always, precedes another substantial move in the original direction. Robert Prechter, the guru of Elliott Wave analysis, characterized this as a Wave 3-4-5 pattern.
Our goal is to translate the concept into hard and fast, yet simple, trading rules and test them across the giant data set. For ease of explanation, let us look at a long position. (The same rules are applicable on the short side of the market.) These rules do not change over time or price level, adding to the robust nature of the model.
Our entry rule consists of a two-step setup and then a trigger, easily calculated at the close of each week and based upon the opening S&P 500 cash index price of the following week.