A Simple Risk Filter

One of the inputs I rely on to control risk is the simple moving average, more specifically, the 200 day simple moving average. This is a deceptively simple technique, but don’t be misled. The quantified results of this indicator make it one of the easiest and most powerful filters around. Many would do well to heed its signals.

How it works?

I avoid stocks on the long side that exhibit long-term down trends, or stocks that are trading below their 200 day moving average. I chose 200 days because of its popularity with traders, but really my testing shows that anything from 100 days up to 400 days is effective. As a high level overlay nothing could be easier to apply. Basically, if you’re a short-term trader don’t open new long positions in stocks trading below their 200 day moving average.

Why it works?

The simple moving average is the average price over 200 rolling periods. Every time a new data point is added, the tail data point gets dropped; Hence the name moving average. This calculation has some very admirable properties. The first, when today’s price is performing better than its average price over the past 200 days, it will have a value greater than its moving average. Similarly, if today’s price is performing worse than its average price over the past 200 days, it will trade below its moving average. This mathematical fact guarantees that the price of any company facing financial strain will begin trading below its moving average. Said another way, every single company that has delisted from the JSE due to poor performance first saw its price trade below its moving average. Using this filter will significantly reduce the risk of being caught in stock headed for bankruptcy. ABIL (ABL) is a case in point. We removed the stock from our tradable universe in 2012, two years before it imploded. This turned out to be the right thing to do, protecting our capital from unnecessary risk. It’s worth noting however, that the stock continued to be a part of our shortable universe.

The second desirable attribute, because the moving average filter is applied at the individual stock level, it reduces risk long before the indices begin to show signs of weakness. In the final stages of a bull market we typically see only a handful of large cap stocks performing well. Because of the size of these stocks and their weight in the index, we often see the index continue to post new highs while the broad market begins to deteriorate. By employing a long-term moving average filter you allow your portfolio to continue to gain exposure to the strong stocks, while at the same time removing weak ones. You basically have a built-in breadth filter. The chart below of the JSE Top 40 nicely demonstrates this. The indicator in the top pane is the percentage of stocks trading above their 200 day moving average. The negative divergence with the index before the crisis began in 2008 is very clear. This simple overlay would have slowly started reducing risk by removing equities from the long side long before the crisis began, and despite new highs in the index.

Quantified Evidence

As always, we like to see the proof! I ran a test this morning to compute the average five day returns for stocks trading above and below their 200 day moving averages. The results are very significant and based on well over 200 000 trades. In the short-term, you’re doing yourself an injustice by trading against this data. If you’re looking to reduce risk and improve your results then follow this simple rule: Avoid stocks on the long side if they’re trading below their 200 day moving average (experienced traders may consider shorting).

Average Five Day Returns

Above 200 day MA: 0.28%
Below 200 day MA: 0.18%

As always, I welcome your comments and feedback.

Happy Trading,
PJ

Passionate about generating and sharing quantified trading models that empower individuals to trade successfully. I founded www.sutherlandresearch.com to realise my passion.

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