Are Moving Averages Financial Sorcery?

As an investor who uses moving averages (along with breakouts) all the time, I have a lot of respect for what moving averages can provide. Proper use of moving averages, combined with other factors, can help an investor be very profitable in their trades.

A lot of investors have a great misunderstanding of moving averages and see them as a predictive tool or just simple market nonsense. They’re compared to a sort of financial sorcery or necromancy—using an interpretation of some abstract force or past information to predict future events. Moving averages are not magical and they certainly do not predict anything with any certainty.

While moving averages are not necessarily predictive, they do help traders filter noise and identify larger price movements. By smoothing the prices of a certain investment over time, it’s easier to see if prices are going up or if they are going down. When the price of an investment is regularly moving higher, it must trade at a price higher than a historical moving average. The inverse is also true.

In itself, this doesn’t mean anything. If you buy when the price moves above a historical long-term moving average, there’s maybe a 50% chance the price will stay above the moving average long enough to be meaningfully profitable. That shouldn’t frustrate you! Winning half of your bets is a great way to play the investing game if your profits are much larger than your losses.

This is where patience and risk management—the important psychological factors in trading—come into play. A trader looking to buy or sell every month or week or day or hour will certainly go broke. A trader that doesn’t size their positions carefully will go broke as well. To be successful you must limit your losses when you’re wrong (trades you make that don’t go your way), while patiently letting your correct trades run on to big profits. In this manner, moving averages help a trader get an idea of when to make bets in an easily controllable way—like betting carefully on a poker hand only when you’re dealt a pair, or two cards that could form a straight.

You could also think of moving averages like a hockey net. A hockey game has only 60 minutes of play, so a team gets a limited amount of puck time and a limited number of potential shots. If a player shoots only at the net, less than half the shots they make will go in. A team could take many, many shots if their players take random shots in all directions every time they get the puck. They will still score every now and then, but the odds drop substantially and there would be a phenomenal amount of wasted energy and effort. Focusing on shooting only at the net when inside the blue-line means limited opportunities, but the odds of scoring are also more favourable.

Trading with Moving Averages

Moving averages—especially when plotted on a chart—can be very confusing for an amateur trader. Lines following other lines, bars, or candlesticks with daily or weekly closing prices bouncing above and below. Traders should limit the number of moving average lines you look at. I prefer just one or two myself. Always keep the chart simple, clean, and specific to your objective.

If all the lines and noise on a chart are clouding your judgement, track daily or weekly closing prices on an Excel spreadsheet instead. Then use an averaging formula to get your moving average price.

If that price was below the moving average line and moves across the line, it could be time to make a buy trade with a stop-loss to limit the downside if you were wrong. Likewise, if you were holding a position that was trading above the moving average line and the price falls below the line, it could be time to sell your position. Using daily or weekly closing prices only is often a good way to limit the price noise that occurs during the trading day.

To use moving averages successfully when trading, you also need to adjust your investing mindset. Many investors start by always looking for a deal, counting it a win if they buy at the lowest price of the day, week, or month. To be a profitable trader, you should instead be happy to buy into rising prices. Purchase aggressively into a rising price environment and try to take advantage of a continued move higher.

“It isn’t as important to buy as cheap as possible as it is to buy at the right time” – Jesse Livermore

Moving Average Timing Periods

First, it’s important to understand there is no magical moving average number to use. There’s a lot of noise out there about the 50-day or 200-day moving average. These are just arbitrary numbers that are designed to sound nice to the ears. Sure, a price falling below the 200-day moving average can indicate a longer-term down movement. Same could be said for the price falling below the 207-day moving average. It’s just that 207 is an odd number.

I often hear professionals make market comments around these popular numbers, saying something like, “Bad things happen when the price is below the 200-day simple moving average.” Well of course! Bad things also happen when the price is below the 5-day, 19-day, 106-day, or 221-day moving averages. I can likewise say the opposite, “Good things often happen when the price is above the 42-day moving average.” That doesn’t make me helpful to anyone—it makes me obvious.

The key to choosing a timing period is to consider how much you want to trade. If you choose a 10-day moving average, you will probably trade at least once a week. If you choose a 300-day moving average, you may only trade once or twice a year.

There’s a lot more variance in trading frequencies when comparing two short-term moving averages than two long-term moving averages. For example, both the 250-day and 300-day moving averages might signal 2 trades per year within a week or two of each other. Meanwhile, the 5-day moving average could signal a trade twice a week while the 50-day moving average might signal a trade only once every month or two.

Many trading signals is likely to mean more “false signals”—or whip-saw trades. This means you need to be more careful about limiting your losses on each trade by running tighter stop prices. You might be able to risk 10% of your position on a long-term moving average that provides a 50% gain in one-third of signals. But you probably can only risk 4% of a similar sized position if the moving average only provides a 15% gain on one-third of trade signals. There should be a positive expectancy between size of losses, size of wins, and percentage of wins.

Long Time Periods

I don’t like the idea of sitting behind my computer everyday watching multiple markets waiting to buy or sell. If I follow 10 different assets and I expect any given asset to send me a trade signal once a week, I could potentially be trading more than once a day. That doesn’t leave any time for golf, reading, cooking, hiking, biking, or naps.

For this reason, I choose long-term moving averages. The 250-day is a good place to start—not because it’s magical or meaningfully different from the 216-day or 262-day, but because it’s a long-term, round number that I’ll easily remember. Also, I know it will send me signals only once every few weeks on all the investments I watch (which are not that many).

Source: TheRichMoose.com, Yahoo Finance

As seen in the 1-year chart above, in a nice upwards trending market I can be in a single position for more than a year without worrying about selling. That’s nice peace of mind! I can go on vacation or otherwise ignore the market for a week without a problem. These big trends are nice and come around often enough. It allows me to catch the big part of a long-term rising (“bull”) market while avoiding those catastrophic year-after-year down (“bear”) markets.

Most traders are probably best served by choosing long-term moving averages. This means at least 100-day, probably more than 150-day, and likely longer than that. It reduces noise and the number of bets you will make.

Short Time Periods

I don’t use short-term moving averages for entering and exiting positions—making those big bets with tens of thousands of dollars each time. The stress and focus I would need to move that much of my net worth around on a daily basis would drive me crazy. I execute all me trades myself; I’ll leave the frequent, big money trading to the nerds running machine algorithms located in offices right next to the exchanges.

After doing some research, I believe short-term moving averages can be very useful to me in risk management—something I’ve been thinking a lot more about in the last few months. For several years I’ve been running a hot portfolio with lots of testosterone and leverage. The big gains were quite nice and paired well with our aggressive savings strategy. But how does one keep those gains while participating in the market? Risk management.

Limiting the size of potential drawdowns through position sizing is important. If your positions are too big, they have an outsized impact on the total portfolio. If they’re too small, they’re not worth holding in the first place. As a position gets really big, thanks to nice gains in an up-trending market, you need a systematic way of bringing the impact of that position back into line considering your overall portfolio equity and risk tolerance.

Short-term moving averages can help with this. Over a period of a few weeks, the price of any given security tends to oscillate around a 10-day moving average. Using a 10-day moving average can identify powerful short term up-trends—a market that climbs very rapidly. We saw a perfect example of this in January 2018 where, from January 2 to 29 (a period consistently above the 10-day moving average), the S&P 500 climbed an incredible 5.86% (104% annualized).

Source: TheRichMoose.com, Yahoo Finance

These big short-term trends come around once or twice a year and should not be missed. However, once the trend is over and the price falls back below the 10-day moving average, it can be a great time to take risk off the table by paring back your position a bit. It probably doesn’t make sense for someone with a moderate portfolio to reduce a position size by just 10%, but if the risk adjustment calculation calls for sale of 25% or more of your position, it is a great time to take some profits.

This use of short-term moving averages is still something I’m experimenting with currently, but I’m liking the results so far. To me it makes sense and is a logical way of addressing the position size problem.

Summary

Moving averages don’t predict anything with any certainty. However, that doesn’t mean they should be discounted as “market voodoo” by investors. They're simply a systematic way of limiting the number of trades you make to try maximize long-term profitability.

Even with proper use of moving average signals, an investor would be lucky to have more than 50% of trades become profitable. However, combined with good risk controls, that could translate to a very successful investment portfolio over time.

Moving averages are a logical way of filtering out market noise and making better, more parameterized bets. A price movement above a long-term moving average can tell you it’s time to make a bet with an appropriate stop-loss. This is because bull markets are always markets where the price trades above a historical moving average. A price movement below a short-term moving average can be a great time to take some profits and reduce your portfolio risk.

Comments & Questions

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Leveraged Barbell Portfolios

The more I research and back-test different types of portfolios, the more certain I have become that using leverage over long periods of time with adequate protection for your situation is one of the best ways to invest. Even if you are not looking for long-term alpha (performance that beats the index), leveraged strategies can also offer really nice downside protection and add stability to your portfolio.

Leverage is best used by more advanced investors with larger accounts and more experience. It requires a lot of discipline to introduce leverage and maintain your portfolio without blowing it up. You must be able to invest with logic, ignoring our natural desire to get greedy during bull markets and fearful in bear markets.

A Leveraged Barbell Portfolio

The protection element will form the larger part of your portfolio equity. You should never open up your portfolio to a loss greater than 50% of your equity.

Protection can be achieved with short-term bonds, T-bills, broad bonds, or some other type of bond strategy. More advanced investors might even introduce a bond barbell with tail-risk approach. This large bond portion will generate a steady 1-3% annual inflation-adjusted return over time.

The bonds will consist of 50% to 80% of your portfolio equity. The percentage of your portfolio that you put into bonds will depend on your risk tolerance. While 50% bonds might be appropriate for an aggressive saver with a high risk tolerance, 80% bonds is better for a retiree or more cautious investor.

Then, with the remaining portion of your portfolio equity (50% to 20%), you invest in a stock ETF and leverage it up 2:1 or even 3:1. You take advantage of bull markets by letting the leveraged stock portion propel your portfolio ahead. But during down markets, you are prepared to let the stock portion go down to nothing.

When you buy your stock ETF with leverage, you will always put in a limit stop-loss order. The price would be set at the number where your stock portfolio drops to nothing. This is 50% of the purchase price where you are leveraged 2:1, or 67% of the purchase price where your portfolio is leveraged 3:1. You could also set it as a trailing limit stop-loss. This means your stop price will go up as your stock ETF increases in price.

Historical Results

Here is a graph of the estimated historical results of various Leveraged Barbell Portfolio strategies going back to 1970. To keep the back-test simple, I used U.S. stocks (total return) and 1-year T-bills (yield averaged). The simulation based on re-balancing your portfolio at the beginning of every year.

Growth of $100 - Comparison of Leveraged Strategies (Log Chart). Source: TheRichMoose.com, MSCI Inc., FRED (Federal Reserve Bank St. Louis)

Disclaimer: These are models, not realized investor returns. Past model returns do not translate to future real returns. No adjustments were made for taxes or transaction costs.

As you can see, all the Leveraged Barbell Portfolios significantly outperformed the basic U.S. stock index. Apart from the green line (50% bonds / 50% stocks leveraged 3:1) and red line (50% bonds / 50% stocks leveraged 2:1), all the portfolios were more stable than investing in stocks only.

Compound Annual Returns (1970–2017)

Blue (100% U.S. Stocks only):  10.57%
Red (50% 2:1 Stocks & 50% Bonds):  13.10%
Yellow (40% 2:1 Stocks & 60% Bonds):  11.72%
Green (50% 3:1 Stocks & 50% Bonds):  17.51%
Purple (40% 3:1 Stocks & 60% Bonds):  15.56%
Cyan (30% 3:1 Stocks & 70% Bonds):  13.30%

Worst Year (1970–2017)

Blue (100% U.S. Stocks only):  -37.14%
Red (50% 2:1 Stocks & 50% Bonds):  -36.32%
Yellow (40% 2:1 Stocks & 60% Bonds):  -28.73%
Green (50% 3:1 Stocks & 50% Bonds):  -49.19%
Purple (40% 3:1 Stocks & 60% Bonds):  -39.02%
Cyan (30% 3:1 Stocks & 70% Bonds):  -28.86%

The worst-case scenario for a Leveraged Barbell Portfolio of this type is a prolonged multi-year drawdown—particularly if there is no tail-risk hedge in place. For example, if you have stocks leveraged 3:1 in a 50/50 split and we have two years of back-to-back 33%+ drops in stocks, you could see your portfolio get cut in half twice (75% total drawdown from peak).

It’s also dangerous to re-balance too frequently, particularly during drawdown periods. Re-balancing once a year is a good number, every eighteen months is acceptable as well.

Leveraged ETFs or Leverage with Margin

Both leveraged ETFs or using margin to leverage up traditional ETFs are acceptable ways of implementing this strategy. There are pros and cons to both methods. Leveraged ETFs get a bad rap, but it's hard to know if that reputation is deserved or not. They've only existed since 2007 and their performance is pretty comparable to what one would expect.

I would probably use leveraged ETFs in a registered account and standard ETFs with margin in a non-registered account.

Leveraged ETFs Pros

  • Never goes down to $0/unit
  • No stop loss required
  • Outperforms in low-volatility markets
  • Easier to implement
  • Only way to use strategy in a registered account

Leveraged ETFs Cons

  • Higher hidden expenses (MER)
  • Potentially not as tax efficient in a margin account
  • Can track the index poorly in high volatility markets

Standard ETFs Leveraged with Margin Pros

  • More cost-effective ETFs
  • More choice in ETF providers
  • Great for margin account with low interest expenses
  • Better tracking of underlying index

Standard ETFs Leveraged with Margin Cons

  • Interest must be tax-deductible to manage costs
  • Requires a stop-loss mechanism
  • More management of accounts for taxes

Words of Caution

As with any strategy, it's important that you ensure your portfolio is set up appropriately for your risk tolerance. This differs for each individual. There is nothing more reckless than believing you can handle an aggressive strategy only to see yourself panic during even the smallest market downturns.

Periodic re-balancing is very important due to the leverage aspect. However, frequent re-balancing is actually harmful and will hurt your performance. It makes no sense to re-balance more than once per year. In a way, Leveraged Barbell Portfolios incentivize you not to play with your portfolio.

It’s important to understand you must treat each account like its own portfolio. You cannot put a leveraged stock ETF in your TFSA and your bonds in your RRSP for “tax efficiency”. Since the contributions to a registered account are limited, you will not be able to re-balance effectively. In the above example, you could easily see your TFSA go down to $0 with no way to fill it. That would be like starting your TFSA from square one again. All that potential of tax-free growth would be lost.

Using leverage in a portfolio is only for a more advanced investor who understands risk. This is because you must have the appropriate safeguards in place and manage them correctly. Safeguards include use of stop-losses, establishing an appropriate margin of safety, and completely understanding the strategy and how it will perform in up and down markets. Leverage can do significant harm to your wealth when you try to chase quick returns.

Improper use of leverage is the fastest way I know to become broke very quickly. This is called "blowing up your account". Even so-called professionals do this all the time. Leverage is why newspapers run sob-stories about former investment bankers flipping burgers at McD's after every big market correction. It happened in 1974, 1987, 1990, 1998, 2001, 2008, and will happen again.

Comments & Questions

This is an archived post and all comments are disabled for management efficiency. You can email me for direct questions.

Please visit my new website and blog for current posts on financial topics. DArends.com