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The "Hawaii 5-0" trade is so called because you buy at "0", sell at "5" and retire to Hawaii on the proceeds!

Trading is based on the Hawaii 5-0 statistic, which is used to identify entry and exit points for trend traders.

It's also a fun little system for active traders. It's easy to learn for novices and makes powerful use of moving average data.

For professional and seasoned traders, the Hawaii 5-0 score is a handy summary statistic of the speed, momentum and relative position the market is at any given time.

To calculate the score, you need four moving averages: the 200 day, 40 day, 8 day and 2 day (each one 1/5th the size of its predecessor); current day closing and the previous day's closing price. Most times, moving averages are crossing over each other, diverging or converging: some are going down while others are going up, leaving investors wondering which moving average statistic to place weight on. The smallest moving average you can calculate is a 2 day moving average (2 dma), and the 200 dma is usually a good indicator of the underlying long-run trend. The Hawaii 5-0 score thus incorporates the long run and short run information and a mid-term selection in between.

To calculate the score, it is first necessary to calculate the following components:

  • Speed

  • Momentum

  • Position

Speed

If closing price is above a moving average or yesterday's closing price, add 1. Max score = 5, minimum = 0.

I'm going to use the graph below to explain. At point A the current closing price is below all 4 moving average numbers and yesterday's closing price so Speed = 0 signifying rapid deceleration in prices . At point B (peak just below the 200 dma), the closing price is above 3 of the dmas (40 dma, 8 dma, 2 dma) and yesterday's price, but not above the 200 dma - so Speed score = 4. At point C and D, speed score = 5 (rapid market acceleration).

A closing price above all moving averages and yesterday's price is going to raise the moving averages: speed indicates this. The speed component is very sensitive to the volatility in the market.

(click to enlarge)

Momentum

For each moving average, if today's' value is larger than yesterday's (upward trend) then add 1. Then add 1 if today's closing price is above yesterday's closing price. If all four moving averages are trending downwards (longest to shortest) and today's close is below yesterday's closing price, the market is in a very strong downtrend and the Momentum score = 0. On the other hand, if all averages are trending upwards and today's close is higher than yesterday's, the market is trending upwards: momentum score = 5.

At position A in the graph above, the 2 dma, 8 dma and 200 dma are trending downwards, the day's closing price is below the previous day's closing price but the 40 dma is still trending upwards. Momentum score = 1. At position D, the momentum score is 5.

Note between C and D the 200 dma is still trending downwards so the maximum momentum score = 4; and begins to hit 5 from a little before D. Note also that the Hawaii 5-0 score can only reach 0 when 200 dma is declining and 5 when 200 dma is rising.

Position

Add 1 if each moving average is above the previous moving average, today's close is above the 2 day moving average, and today's closing price is above yesterday's closing price.

Position calculates how the moving averages are aligned relative to each other, and whether closing price is above or below all moving averages (towards an extreme value compared to prior means). In a bull market, we expect the shorter the moving average, the larger is the number. Point D demonstrates this well (Position score = 5). In a bear market, we expect the reverse.

If the market was in a well established bear market, the position score would be 0. If it was a well established bull market, the position score would be 5.

The Hawaii 5-0 Score

The Hawaii 5-0 score = (Speed + Momentum + Position) / 3.

The "pure" Hawaii 5-0 is to buy at 0 and sell at 5.

Note that the way the score is constructed means it will only hit 0 (and frequently does) when in a long run downtrend (200 dma is falling) and can only hit 5 when the 200 dma is rising. Thus, you are meant to buy at the bottom of a bear market and sell at the top of a bull market. It is more a metaphor for "buy low, sell high".

The score offers great signals for entry points as the graph below illustrates. (Hawaii 5-0 less than 1 = entry point: the blue dots) The Hawaii 5-0 is plotted with the RHS as the scale against the S&P 500, from the end of its downturn and through its current uptrend.

(click to enlarge)

As can be seen from the graph, the score tends to rise and fall in a trend of its own: One way is to look at the Hawaii 5-0 is as a simplified market index: it has trends of rising up to 5 so that when the market is rising the Hawaii 5-0 rarely scores below 3. When the market is falling, it rarely scores above 3.

When the market begins to turn, the transition from the scores mainly above 3 to mainly below 3 are obvious in the graph.

Trading the Hawaii 5-0

As the graph above shows, while entry is clearly identified, establishing appropriate exit points are more problematic. The best way to use the statistic is to look at other information to identify a consistent theme about exit. The measure of any trade or trading strategy is whether it is expected to yield a higher return compared to buy and hold.

Consider as an example, two alternative and entirely mechanical Hawaii 5-0 strategies:

  • The "pure" Hawaii 5-0 of buy at 0 (< 1 in a rising market) and sell at 5.

  • An alternative 5-3-5 exit strategy: once entered into a long position, wait for the score to hit 5 then fall back to 3 (or less, signaling the uptrend is coming to an end), then exit on the next score of 5.

  • When in cash, assume a 0% return.

The graph below benchmarks the cumulative portfolio returns of these two Hawaii 5-0 strategies against the buy and hold for the period 31st October 2011 to date (same data as graph above).

Over the period, the two Hawaii strategies involved three separate long only trades. The return is flat when cash is on the sidelines. The graph shows that while the market return was 20.9%, the first Hawaii 5-0 provided a return of over 24%, while the 5-3-5 exit yielded 32.5%, a significant difference.

(click to enlarge)

Summary

There is a wealth of information in moving average data. The Hawaii 5-0 score summarizes three useful uses of that data: Speed, Momentum and Position into a single score from 0 to 5.

Each component in itself is a powerful statistic to keep track of and watching how they interact provides great insights into market activity.

Using the Hawaii 5-0 score to inform the timing of entry and exit (e.g. by 5-3-5 exit strategy) can make a valuable contribution to your trading strategy. Even using the basic Hawaii 5-0 strategy will encourage you to enter during downturns (buy low) and exit at or close to market tops (sell high).

Above all, the score should be used intelligently to gain superior returns for active traders, as it supports both long and short trading.

Finally, the Hawaii 5-0 scores are as follows for the last few trading days:

Date

S&P 500 closing price

Hawaii 5-0 score

12/02/2013

1519.43

5.0

13/02/2013

1520.33

5.0

14/02/2013

1521.38

5.0

15/02/2013

1519.79

3.3

19/02/2013

1530.94

4.7

20/02/2013

1511.95

3.3

21/02/2013

1502.42

2.7

22/02/2013

1515.6

4.3

Note that the 2.7 score on 21st February was the first time the Hawaii 5-0 fell below 3 this year. Is it time to take profits off the table?

It certainly isn't time to invest more into the market: better opportunities will come.

In any case, I hope you make it to Hawaii.

Source: The Hawaii 5-0 Trade