Simple 200-day moving average of S&P 500 Index is a widely followed indicator. When S&P 500 Index crosses its 200-day moving average, publications write about it and risk management teams take notice. Does a moving average crossover strategy hold value for a retail saver? In this article we explain the strategy and explore this question. We conclude that the strategy is not worth it.
Moving Average Crossover Strategy: We choose a number of days for the moving average, say 200. We start with some amount in cash. If the average is above the spot on the day we start we will buy SPY (NYSEARCA:SPY) ETF1 with all the cash. In future whenever the spot closes above the average we will buy SPY at the end of day. Whenever the spot closes below the average we will sell all SPY holding at the close of the day. We will pay .1% of the trade value in commissions. All dividends will be added to the cash and used to buy SPY.
Here is a plot of the strategy run for the last 5 years. It shows the performance of $100 invested.
We now repeat 5-year runs for 5-year periods starting 5y ago, 10y ago and 15y ago using 20d, 50d, 100d, 200d and 500d moving average for each. $100 invested in each strategy performs as follows:
The return metrics of each run are as follows:
What we see:
- The best performing moving average changes with the period considered. For the 2008-2013 period 100d moving average strategy performed the best. For 2003-2008 investing in SPY was better than any moving average strategy. For 1998-2003 period 500d strategy performed the best.
- In all cases, moving average strategies reduce the risk taken. So they provide some downside protection compared to holding SPY continuously. But this comes at the cost of reduced return. The strategies cut out large down moves, but also miss the up moves.
- 20d moving average results in too much trading. 500d moving average is too slow to respond to changes in spot price; it either remains in cash or remains invested for long periods. Best performance is somewhere in between.
- Buy/sell actions are clustered together. It may be possible to improve this strategy by delaying action for a few days to make sure the spot price does not crossover again. Another possibility is to add a 'make-sure' band around moving avarage line, say +/-5points, and only trade when spot crosses the band.
Overall it appears that moving average strategies provide value by reducing risk for a retail saver, but that depends on how SPY performs during the period. So far we have looked in the past. How can we choose a strategy for the future? We consider two ways.
Strategy for the future
First, we can use a very long history of the spot prices (e.g. 30 year history of S&P 500 Index), calculate how strategies perform and choose the best one. We are assuming that the long history includes all different types of movements of the price (and the relative number of times those occur) we expect to see in the future. We can modify this method to incorporate our views. For example, we can choose the periods from history where SPY performed similar to recent past and then see which strategies perform the best in the ensuing period.
The run for 200d moving average crossover strategy applied to daily history of S&P 500 Index starting in 1975 is plotted below. Of course, we assume that the index is tradable.
We run the above strategy with 20d, 50d, 100d and 500d.
The return metrics are as follows:
It appears that the 200d moving average strategy performs the best. It provides risk mitigation but at the cost of return. The strategy made ~7 trades per year gaining ~5.8% per annum. Note however, that it does not have much better reward/risk ratio (mean/stdev) than simply holding SPY continuously.
Second method is more mathematical. If we can model SPY's future movement, we can run several future simulations of SPY, run our strategies on each and check which strategy performs the best most consistently. But there is no agreed upon way to model SPY's future performance. We can try several models and see if a winning strategy emerges. I will explore this method in a future article.
Bottom-line. Moving average strategies mitigate risk, but eat into returns creating a not-that-better reward/risk ratio. 200d moving average seems to be most useful for S&P 500 Index over the long run, but in the short term we can not say. If we include the personal time cost of extra attention that this strategy requires, it does not seem to be worth it for a retail saver.
1. SPY is based on S&P 500 Index.
Disclosure: I am long SPY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: All views here are personal. This does not in any way reflect the views or positions of HBK Capital Management. These ideas are educational, not advisory.