By Anthony Trongone Ph.D., CFP, CTA*
Posted: Sep 25, 2009

Across the three trading settings (bearish, sideways, bullish) is a simple moving average or a crossover moving average the better indicator of future performance? Most articles describe the effectiveness of using different indicators without discussing the specific trading environment. Fortunately, as of the writing of this article, the previous 294 trading days have given us the opportunity to explore these important differences.

This discussion compares the effectiveness of using an 8-day simple moving average (SMA) relative to a crossover moving average.

Figure 1. eSignal affords the user tremendous flexibility. In this case, we are using an 8-day simple moving average (SMA) of the closing price.

The Disadvantage in Using a Simple Moving Average

A simple moving average is the best known smoothing technique. Although you can use more days to produce a moving average, the more days in your analysis, the less emphasis there is on the more recent trading action. Because a simple moving average distributes the same weighting to each trading day, this causes the simple moving average to respond slowly; therefore, its signal is "lagging" behind sudden changes in the actual price of the cues (ticker: QQQQ).

For the purposes of this article, a buy signal is given when the closing price of the cues rises above the 8-day simple moving average ([=AVERAGE(previous 8 trading days)].

Addressing This Specific Shortcoming

Because the system restricts you from buying the cues until their price crosses over this smoothing line, you are missing a large portion of the upswing. One way to compensate for a moving average score lagging far behind its actual price is to give more of a weighting to the more recent scores by using two simple moving averages with a 3-day / 8-day crossover technique. Applying this strategy reduces the "lag time" of your actual trading decision.

If you have a long position and are using the traditional approach, the less responsive moving average is the signal; however, when using the crossover technique, you are using two moving averages; consequently, the longer one becomes the trading signal. In comparing the two approaches, a buy occurs when the following conditions are present:

Traditional approach: Closing price > 8-day SMA
Crossover approach: 3-day SMA > 8-day SMA

Comparison of the Two Moving Average Indicators

Figure 2. This line chart shows the closing price (blue line). When it crosses over the 8-day moving average (red line), it produces a buy. As you can see, it catches most of the bull market.

Figure 3. This is the crossover approach. By itself, it appears to provide similar results, but the findings across the three trading settings are remarkably different.

The justification for splitting the results into different trending patterns is very simple. In the 294 trading days under investigation, we open a long position at the start of trading but do not offset this position (a simple buy-and-hold strategy). The average performance in the bear market is a decline of 18½ cents per trading day, and the sideways market falls slightly (a penny per day); whereas, the average daily advance in the bull market is 14 cents.

So, how did the two moving average systems perform against a buy-and-hold strategy in each setting? In performance terms, the traditional 8-day SMA was more similar to the 294-day, buy-and-hold strategy. It was 1 1/2 cents below the average of the buy-and-hold strategy when we were in a bull market, 2 cents below the bear market; however, it was 5 cents above during the sideways trading market.

The crossover technique was as effective during the bull market; however, its performance in the sideways market was 3 1/2 cents less effective versus the buy-and-hold strategy. The largest difference was in a down-trending market. In the 121 days of the bear market, if we simply held a long position, the average daily decline was 18½ cents, but in the 36 trades, using a 3-day / 8-day crossover technique, the average decline was 41 cents.

When you disregard the 3 settings during the 294 trading days, a holding strategy had a 3-cent-per-day decline, the crossover method a 4-cent decline; however, the traditional 8-day SMA won the prize with a 2 1/2-cent daily advance for each day its signal was in play.

Some indicators appear conceptually superior because they are more complex. The findings indicate, however, that this is not always the case. Adding a new wrinkle to an indicator does not always ensure that we are getting a better forecasting model.

Once you download the historical numbers from eSignal (Tools…Data Export), run a comparative analysis. Be sure to experiment with different combinations to determine the best-performing moving average technique.

Figure 4. Although the traditional approach worked best in this study, it will not always outperform a crossover method.

As you can see, knowledge of the best-functioning method does not come without some work, but the results will be worth every penny!

*Reprinted (and modified) with permission from Anthony Trongone, Ph.D., CFP, CTA, Director of the E-MBA Programs in China for Centenary College. He is one of the trading educators featured on eSignalLearning.com. You can write him at: trongonea@gmail.com.