Using Moving Averages for Buy and Sell Signals

by: Tom Lydon

We use the 200-day exponential moving average to determine buy and sell points for various ETFs. Likewise, many investment professionals have adopted similar strategies to adapt to today’s more fearful and volatile markets. In the following paragraphs, we will take an in-depth look at what the moving average really is.

Investopedia defines the simple moving average as “An indicator frequently used in technical analysis showing the average value of a security’s price over a set period.” So the 200-day moving average would be the average price of a security over the past 200 days. Pretty simple.

One disadvantage to this simple measure is that it does not react well to dramatic market movements, says Mack Courter in a recent Journal of Indexes piece. According to Robert D. Edwards and John Magee, co-authors of Technical Analysis of Stock Trends, “The smoother the curve (longer cycle) one has, the more inhibited it is in responding to recent important changes of trend.”

That is why a more sophisticated spin on the moving average has become popular: the exponential moving average (EMA). This essentially gives more weight to recent prices, thereby allowing the indicator to react more quickly to price fluctuations.

200-day EMA strategy – buy when the price breaks the EMA and sell when the price falls below the EMA.

Over a long period of time, the advantage of the 200-day EMA is clear; it reduces annual volatility without reducing gains. From 1971 to 2009, the 200-day EMA on the S&P 500 would have lowered volatility by 26% a year when compared to a buy-and-hold strategy, and would have returned 6.68% annually; a buy-and-hold strategy would have returned 6.62% annually.

During a bear market, the advantages become even more pronounced. From 1973-74, 2000-02 and 2008, a buy-and-hold strategy on the S&P 500 would have resulted in annualized losses of 48.20, 49.15 and 56.78%, respectively. The 200-day EMA would have resulted in a decline of just 10.40, 11.30 and 15.60%, respectively.

50-day EMA strategy – buy when the price breaks the EMA and sell when the price falls below the EMA.

From 1971-2009, the 50-day EMA would have returned significantly less than a buy and hold strategy on the S&P 500, returning just 5.39% annually. However, like the 200-day EMA, it would have significantly reduced volatility.

When looking at the three bear market periods mentioned above, the 50-day EMA would have protected an investor much like the 200-day EMA, losing just 7.00, 31.80 and 15.20%, respectively.

50/200-day EMA Crossover strategy – buy when the 50-day EMA breaks the 200-day EMA and sell when it falls below the 200-day EMA.

Using this approach would have returned 7.02% a year during 1971-2009 with 33% less volatility than a buy-and-hold approach to the S&P 500.

Looking at the bear markets mentioned above, the 50/200-day EMA would have cost investors 15.30, 8.50 and 11.20%, respectively. The numbers are somewhat comparable to the other two strategies and much better than a buy-and-hold strategy.

Overall, the 50/200-day EMA had the least number of incorrect signals.

In conclusion, using any of the three strategies above can help reduce portfolio risk without sacrificing too much or, in some cases, any gains, when compared to a buy-and-hold strategy on the same index.

Sumin Kim contributed to this article.