|
The act of stock investing is not something that should be based on gut feelings but something that should be well thought out, methodical and strategic. A lot of investors do not have a trading strategy therefore lacking in entry and exit strategies. Such traders are those most affected whenever there is crisis in the market. By definition, a trading strategy is a predefined set of rules for making trading decisions. There are three important elements to developing a trading strategy. They are entries, exits and filters. While entries are signals that lead a trader or investor to initiate or generate a buy or sell (in situations where short selling is allowed) orders for new positions, exits signal to the investor when the expected value of a trade has diminished to the point that the trade should be closed. Filters on the other hand caution the investor to only take the entries with highest profit potential over the life of the strategy.
Some of
the entry methodologies in use in modern day trading
include moving averages, channel breakouts, momentum
indicators, volatility breakouts, oscillators and price
patterns. Though there are more complex new entry
methodologies, a good understanding of these basic ones
will go along way. You may have heard the saying” Always
trade in the direction of the trend”. Trend following
methods generate buy signals when a trending market is
in a period of strength and generates a sell signal
during periods of weakness in the market. Most trend
followers use moving averages, channel breakouts, or
volatility breakouts to generate entry signals.
Moving
Averages
Moving
average has been used by traders and investors for over
50 years. Without going into the explanation of what a
moving average is and how it is calculated, it is
important to state that the basic trading signal for
moving averages are triggered when prices cross above or
below a moving average. This is because when prices
cross above the moving average, higher prices are most
likely, and it signals that it is time to buy. On the
other hand, when prices cross below the moving average,
a declining market is predicted or expected signaling
that it is time to sell. Ordinarily, moving average of
20 to 100 days are used to generate buy or sell signals,
however, shorter averages respond quicker to recent
price movements but they are prone to generating false
signals (or noise). Longer averages, while producing
infrequent trading signals are not so prone to false
signals. It is therefore advisory to strike a good
balance between the need to capture recent price moves
and the ability to deal with false signals especially
where trading commissions are involved. Depending on the
length of the average you decide to use, the trading
rule should be:
Buy when
today’s closing price crosses above “t” day moving
average and sell when today’s closing price crosses
below “t” day moving average, where “t” is the moving
average length of your choice, in days.
As can be seen from the above chart
which shows 10 day simple moving average (SMA) of
Guinness, the closing price crossed above and below the
moving average at many points. Notice that around June
15th, the closing price crossed below the 10
day moving average signaling a sale, however, 2 days
later, on the 17th it crossed above signaling
a buy. Another sell signal was generated or triggered on
or around August 10th as that day’s close
crossed below the moving average. As can be seen below,
when a 20 day moving average is used, it becomes
apparent that the August 10th signal was
indeed a false signal
because the day’s close did not
actually cross below the 20 day moving average.
According to the 20 day moving average, trading signals
were generated on May 18th (a sell signal),
June 15th (another sell signal) and June17th
(a buy signal). It is instructive to note that the
longer the trend, the more profitable the moving average
strategy. This can be seen from the above charts that a
buy entry on June 17th looks quite profitable
given the length of the trend since then. One draw back
with moving average method is that when markets are
choppy or trend side ways, as happed between 9th
and 16th of June, longs are liquidated, most
times at a loss. Care should therefore be taken in
situations where the market shows no discernable trends
as this may lead to losses. Under such a situation, it
may be better to use longer length moving averages to
cut out the whipsaws.
In the next article we shall look
at using channel breakouts to generate trading signals.
About The Author
I work as
Assistant Vice President, Portfolio/Hedge Fund
Accounting and Valuation Analysis for JP Morgan Fund
Services in New York. I hold the Chartered Alternative
Investment Analyst (CAIA) certificate and am also a
professional Risk manager (PRM) having met the
conditions required by the Professional Risk Managers
International Association (PRIMIA). I am a certified
QuickBooks Pro Advisor and I have an MBA from the
University of Phoenix, Arizona.
Uchey Ndimele,
Bs (Econ) Ms (Econ) MBA (Acct), CAIA, PRM
|
Published
Augus 26th, 2010
