6533b85afe1ef96bd12b94f2

RESEARCH PRODUCT

Market Timing with Moving Averages: Anatomy and Performance of Trading Rules

subject

description

The underlying concept behind the technical trading indicators based on moving averages of prices has remained unaltered for more than half of a century. The development in this field has consisted in proposing new ad-hoc rules and using more elaborate types of moving averages in the existing rules, without any deeper analysis of commonalities and differences between miscellaneous choices for trading rules and moving averages. The first contribution of this paper is to uncover the anatomy of market timing rules with moving averages. Our analysis offers a new and very insightful reinterpretation of the existing rules and demonstrates that the computation of every trading indicator can equivalently be interpreted as the computation of a weighted moving average of price changes. Therefore the performance of any moving average trading rule depends exclusively on the shape of the weighting function for price changes. The second contribution of this paper is a straightforward application of the useful knowledge revealed by our analysis. Specifically, we evaluate the out-of-sample performance of 300 various shapes of the weighting function for price changes using historical data on four financial market indices. The goal of this exercise is to suggest answers to long-standing questions about optimal types of moving averages and whether the best performing trading rule can beat the passive counterpart in out-of-sample tests.