Sunday 26 February 2012

Comments

Red line represents 200 day MA
I am delighted to have had a couple of comments from readers. The topics are moving averages; and how to get on top of this trading business. In response to the latter I recommended two books which were instrumental in getting me going on a largely successful path many years ago now. (See last post)

I like Richard Koch's book because it gets you to look at yourself and choose an investment style that matches your personality. For me the best approach was finding value shares. Jim Slater's Zulu Principle was invaluable in getting me going on that road. Benjamin Graham has written several more advanced books on the same topic.

Going back to moving averages, Terry showed interest in moving average crossovers as signals for getting in and out of trades. I did a quick test on Unilever and found that simple MA xovers would have lost money consistently. (details in the comments on the last post).

I mentioned that I almost always show a 200 day moving average on my charts. I don't use this as a signal but as a guide to where the instrument I am looking at is going. 200 day MA above the price indicates a downtrend. A big and growing gap suggests that there is a good chance that a recovery in price is likely in order to narrow the gap. In an uptrend the opposite is true.

Red line is 200 day MA
Today's chart is chosen to show the value of the 200 day MA. I've chosen IRobot Corp. A share which I bought because it had demonstrated a big fall from its trend. It had just announced excellent results for the past year but had also issued a profits warning for the fallowing quarter and year. I bought it on 21 February several days after the big gap down and when some recovery had already taken place. It is a risky trade because there is nothing to guarantee a recovery, but a potentially profitable one. A recovery to the top of the open on the first day following the profit warning would represent a 12% return. The share price dove through the 200 day MA and there was what looked like mass panic. A classic opportunity to make money as wiser heads begin to prevail and see that the market fall has been overdone.

Looking at the second chart we can see that the 200 day MA has been a helpful guide for the past 5 years with consistent price movements that demonstrate that the MA acts as a magnate for the price, always pulling it back when it strays too far. I don't know if you find this helpful. I do but I do not see it as a reliable signal. Choosing your entry and exit point is a matter of judgement. Hope that helps Terry. Remember I recommend nothing. I just point shares out that might be of interest.

6 comments:

Terry said...

A big thanks for your thoughts on the m.a. and how you use them in your trading,i am always looking at the many things that can be used to build up a good winning strategy.
Terry.

David said...

Hi Paul,
Interesting article...I agree very much with you point about looking at yourself and choosing your own strategy.
With regard to MA's....the price will invariably revert to the mean...therefore the longer the period of the MA , the longer it takes to do so.... and vice versa. The MA is, of course,and of course a lagging indicator and this should be kept in mind.
Regards
Than

Andy said...

> I did a quick test on Unilever and found
> that simple MA xovers would have lost
> money consistently.

Does this mean that taking a contrarian approach - ie, buying when the signal is to sell, and vica-versa - would have made money consistently?

paulus said...

Hi Andy,

In theory yes. In practice I'm not so sure. The period of my test was relatively short and might not have been typical. The theoretical return on the most profitable example the 6 and 21 day MA would have yielded a gross 8% in a roughly six month period. But to make that you would have had to spread bet, or buy CFDs in order to take the short positions as well as the long. The cost of taking each trade works out at about 0.5% so that's 4% in costs - half your profit gone. Taking just the long positions would have yielded 5% of which 2% would have been swallowed up in costs. The returns on the 20/50 were much lower.

For me the risk reward is not worth it. I would rather seek out undervalued shares where the potential rewards are many times greater than what we are looking at here.

I have actually got a position in Unilever at present. It is a small stake and was an ill designed attempt to take advantage of a fairly regular swing in the price. Ill designed because there was not enough potential profit in the trade to make the risk worthwhile. It is showing a modest loss at present. Taking this type of trade requires a share with a bit more drama in its up and down movement.

Any thoughts? Paul

Andy said...

I was being a little mischevious, really.

In back-testing that I've run, it seems that if a large bunch of traders each run a portfolio using some sort of moving average system, about half will do better than buy-and-hold, and half will do worse. OK, a few more will do worse because of the trading costs that you point out.

If it were not so - if it was really this easy to make money trading stocks - we'd all be doing it full time!

That said, I do allow Sharescope to nudge me every time FTSE's 160 SMA crosses its 65 EMA. That's not because i think I'll return more than a buy-and-hold strategy, but it does seem to reduce a portfolio's volatility, which definitely helps me sleep better.

Andy

paulus said...

Hi Andy

It's good to have some lightness thrown in. I only looked at MAs because I was asked the question and felt, but did not know the answer.

There are many out there seeking the magic bullet. I've never understood the Elliot Wave crowd who seem constantly to change their rules to try to make the theory fit.

I confess to using Fibonacci in a superstitious manner. When I have a trade that is not going quite right I shove on retracements to bolster my resolve.

I do not believe a technical magic bullet exists. I mostly use charts to warn me of big changes to come and work with chart patterns and with support and resistance lines.

I am currently testing out surfing - described in the next post - which seems to be yielding a decent return and will do better when I learn how to select my candidates.

Beyond that I believe that fundamentals are the road to big profits and there I do have something which approaches a magic bullet. It has kept me fed clothed and very well watered for thirteen years. I described the outline in yesterday's post. Terry asked for more details but I guess he knew he was pushing his luck.

I am seeking something that does even better and is more flexible than my filter search. It needs upward trending markets to work and I wonder whether we will have those for long periods any more.

I will look at your nudge test.

Thanks again for your thoughts.

Keep in touch, kindest regards P