Thursday, April 16, 2009

Simple Moving Average Crosses as Profitable Trading Systems

As you may know by now, this week I have been dedicated to finding profitable simple trading systems. One of the first trading systems that new traders are exposed to is the moving average cross. A moving average is simply a line drawn on the screen that reflects the price average of the past x number of periods for each bar. A moving average cross strategy is simply entering or exiting the market when two moving averages cross or when price itself moves above or below the moving average.

Why does this make sense ? The moving average cross strategy makes sense because what it basically implies is that if the price is moving above it's average, then price should be increasing and vice versa. The same when you trade the cross of two different moving averages. If the average of a small number of periods is above the average of a bigger number of periods then this means that price is increasing and so forth.

But well, things are not that simple. The problem with the moving average strategy is that the price movement needs to be long enough in order for the lagging quality of the indicator to be minimal. Since the moving average lags the market because it takes time to react to market moves (because it is an average of past periods after all), then if price movements are too small you will always get in too late and exit with loses. This is why moving average strategies fail to work long term on all the smaller time frames. In smaller time frames, trends are not long lasting and they quickly reverse, whipsaw and send us a bunch of mixed and false signals which make the strategy a losing one.

So where are moving averages profitable ? Well, higher time frames with very slow moving averages are the greatest because you catch extremely large market moves (sometimes even 2000 pips !) and you get very few trades, about one or two each year. This strategy greatly diminishes the amount of money you pay in spreads and guarantees a long term stable profit. This strategies can be easily traded with the unviersalemacross ea found at forex-tsd which let's you trade ma crosses.

Below you can see a backtesting chart for the EUR/USD, the GBP/USD and the USD/JPY (from 1999, on daily charts). This strategy is very good and really catches those year long market trends. Modelling quality is n/a because of some chart mismatch errors due to volume but again, the erros of this backtesting are almost none because we are trading very long term, in fact, you can easily visually backtest the strategy and see that the results are indeed what they are.
Even though this strategy has long term profitability and has a few trades every year, most traders will never even consider it because they still think that 20-50% is a real profit target in forex automated trading. If we look at the trades of the EUR/USD (200 slow ma and 20 fast ma) we see that each trades takes an anormous amount of profit. In fact, the average win is more than 5 times the average loss because of this. Below you can see a sample trade with the moving averages drawn, on the next chart you see a higher time frame (weekly) in which you can see how the ea caught all the long term trend perfectly.
This system can generate you a profit of about 40-50% a year with a draw down not exceeding 30%. Again, even though this is better than the best fund managers in the world, most retail traders (most of them not being profitable) will argue that this profit target is too small for them and that they "know" that that quantity can be made in a monthly basis. This is true, a person can make 40-50% for a month or two, but the market exposure needed to make this amount of money will wipe the account. What I aim for is constant, consistent, stable, long term profits. I do not mind trading 2 or 3 times a year, in fact, I consider this better than entering positions everyday.
If you want to learn more about other commercial and free automated trading systems I have used and reviewed as well as expert advisors I have programmed to follow long term stable strategies, such as the 4 week breakout, turtle system and the 8and8 system please consider buying my ebook on automated trading or subscribing to my weekly newsletter to receive updates and check the live and demo accounts I am running with several expert advisors. I hope you enjoyed the article !

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