In what follows we discuss the intuition of our Moving Average criteria modifications without using any math formulas. For reasons of simplicity we mainly focus on the long-only approach using a simple MA of the last 20 observations (blue line). We use the closing prices of SPY ETF (black line) from Nov. 22, 2006 to Oct. 17, 2007.
In a nutshell, our modification uses the entry signal from a standard MA criterion but it exits if and only if the current price is below the entry price. In the meantime, if the standard criterion exits and re-enters the entry price of the modified criterion is updated. If the improved MA criterion is out, then enters if and only if the standard MA provides a BUY signal.
A discussion of the graph follows.
Step-by-step guide to the above modified strategy
- Let’s assume we have two investors: Investor A who forms her strategy using a standard MA rule and Investor B who forms her strategy using the modification of the above standard MA rule. Let’s also assume that there are no transaction costs (however, one could subtract these costs from the return and make this example even closer to reality).
- Mar. 19, 2007. The standard MA returns a BUY signal (first grey dashed line). Both investors observe it and prepare themselves to buy in the following period.
- Mar. 20, 2007. Investor A buys at $131.3. Investor B uses the standard MA as well and buys at $131.3 too. She stores the entry Price for the modified criterion which is $131.3 (Bubble Box 1. on the graph, green vertical line, the entry price is marked by the black dashed horizontal line).
- Jun. 06, 2007. The standard MA returns an EXIT signal (grey dashed line). Investor A prepares herself to sell in the following period.
- Jun. 07, 2007. Investor A sells at 138.87 (Bubble Box 2. on the graph, grey dashed line). Investor B still keeps track of the standard MA signal but she does not exit (given that the current price -$138.37- is still higher than her entry price -$131.3-).
- Jun. 14, 2007. The standard MA returns a BUY signal. Investor A prepares herself to buy in the following period. Investor B still observes the standard MA signals.
- Jun. 15, 2007. Investor A buys at $143.18. Investor B (who is still long since Mar. 19, 2007) updates her entry price to $143.18 (this is depicted by the 2nd black dashed horizontal line). Now, investor B will exit the market if and only if the current price is less than the updated $143.18. (Bubble Box 3. on the graph)
- Jun. 18, 2007. Price=$143.01. The modified rule returns an EXIT signal given that current price -$143.01- is less than the updated entry price -$143.18- (grey dashed line). Investor B observes this and prepares herself to sell in the following period.
- Jun. 19, 2007. Investor B sells at $143.47 (Bubble Box 4. on the graph, red vertical line). Investor A (who follows the standard MA rule) is still long.
- Jun. 20, 2007. The standard MA rule returns an EXIT signal. Investor A prepares herself to sell in the following period.
- Jun. 21, 2007. Investor A sells at $142.16. (Bubble Box 5. on the graph, purple vertical line)