Moving Average Crossover – a deeper introspection

One of the often repeated arguments I have heard with regard to trading systems is to be keep it simple (K.I.S.S) with there being no reason for extra complication. To me, that is a lie of the n’th order. Think about it for a moment in the logical sense, if everyone could easily follow a method to endless riches, why should anyone bother to take any risk elsewhere or even strain muscles / brains by working for someone else. All you would need is a PC with Internet connection and you would be good to go.

In the world of Finance, nothing comes without risk. Risk is always lurking in the background, ready to pounce on at a moment’s notice. But since not all risks are evident, we tend to basically ignore that very important aspect.

While there is no such thing as Risk Free investment, some investments do come close in that regard. Bank Fixed Deposit is one of them. If you have placed a deposit in any PSU or even Private Sector bank, the probability of losing money is next to nil (but not nil). Even when private sector banks have collapsed, depositors have not suffered losses thanks to RBI which would force some public sector bank to take it up (remember Global Trust Bank for instance).But there is risk, just that the probability at the current juncture of something on those lines happening being very low.

Other than Bank FD, the simplest way to invest money elsewhere is in Gold and Real Estate. Since cycles in both these asset classes are long, for quite some time, it’s being felt that these are the only two asset classes to own. Unfortunately in the world of cycles, after a big run up, there is a big sideways action or worse a big downside action. Either way, the returns over a long term isn’t great especially if one invested at the top of the previous peak.  But for those who invested prior to 2005, returns have been magnificent to say the least. But the profits one is sitting on is notional and unless removed, the returns can actually dilute over time if prices move either sideways or downward.

So, that leads us to the markets. There are basically two ways to invest in the markets. One is via Mutual Funds who pool the money, hire a professional fund manager and who hopes to beat the market over an extended period of time.  Second is by way of direct investing where you decide what to buy, when to buy and how much to buy as well as when, how and where to sell. Once again, the attempt is to make more money than what can be achieved by either investing in a Mutual Fund or Fixed Deposit though neither is a good benchmark given that risks and returns are different for each of them and most importantly, both of them do not require a significant amount of personal time to monitor.

The set of investors who invest in markets directly can be further separated on the basis of what kind of analysis they do. Most either fall into Fundamental or Technical while quite a few do not have any analysis to speak of but are more or less dependent on their brokers or the talking heads on TV to give them something by which they can make a penny.

While there have been plenty of successful investors whose approach was based on picking up value stocks at a cheap price, the overwhelming fact is that we look at the winners and ignore the losers. Sanjay Bakshi in his interview with Safal Niveshak (Link: http://is.gd/txIPLX ). He says and I quote

“You just have to see how people have got rich in stocks. If you look at genuinely successful people in the stock market, you will find that an over-whelming majority of them bought stocks of good companies at attractive prices and just sat on them for a long-long time.”

Well, the point that is overlooked here is that if you bought a great share which subsequently tanked, you would not be rich by just sitting on it. It also brings to question as to how much part of the success can be allocated to skill and how much to Luck. As Nassim Taleb says “it’s so easy to confuse luck with genius” you may never know the lucky breaks they had which made them the persons they are now. And for a live example, one needs to go not too far but look at the picks of a guy who was once said to the Warren Buffet of India.

Value Investing requires a lot of work, determination, patience and a fistful to luck. Without one of the ingredients, you can always have value stocks but one that never seems to be noticed by the markets. There is nothing simple in terms of work and at the end of the day, you hope that the light you see at the end of the tunnel is the opening to freedom rather than headlight of an oncoming train engine.

That leaves me with only Technical Analysis to talk about. Being a practitioner of technical analysis for more than a decade now, it’s a field that has interested me a lot and one that has provided me the bread and butter over the years. Even among technical analysts, you can find a clear demarcation. There are one set of guys who trade based on discretion and another who wants to follow a tried and tested mechanical approach to trading markets. While there are quite a few guys who are good at reading charts, most of those I know aren’t actually full time traders in the sense that even if the markets provide them with nothing, life goes on as usual.

On the other hand, there is this set of traders (which includes me) who believe that while its acceptable to trade small money based on views, when it comes to managing money professionally or even if you want to take higher risks in anticipation of higher rewards, one cannot blindly bet on our reading of charts and instead would love to have something tried and tested to work with.

But mechanical trading system for many starts and ends with Moving Average Crossovers. It’s not that there is anything wrong with MA cross, many random numbers do somehow come out with positive outputs but the question is, is the positive output alone worth the risk and the efforts that go into making that effort.

Unlike fundamental investing where you buy the shares of a company and sit tight hoping you are right, technical trading requires more attention (depending on the kind of time frame one chooses). While technical analysis offers many tools, due to the ease of use, MA Cross seems to attract the highest attention of investors and traders alike.

But unfortunately the fact of the matter is that the probability of making big money using a MA Cross is very low and if one adjusts the risks taken to get that reward, it does not even start making any sense.

Every one of us has limited time but unlimited requirements and it’s important that the time we have is well utilized instead of being wasted in a venture where the net output was zilch.

I had recently tested out MA Cross on daily time frame and given the results in an attempt to show that it does not make sense. To make it even more hard hitting, I have now tested 19208 combinations under every time frame – starting at 15 minutes to Monthly. As can be seen in the results, nearly every one of them have under-performed the Buy and Hold which suggests that one would have done nearly as well by just sitting as Jesse Livermore is quoted as saying.

In addition to the normal back-test metrics, I have also calculated Expectancy (Link for more on that: http://www.tradermike.net/2004/05/trading_101_expectancy/ ) and if you were to take the best (which you would not possibly have known when you started to trade – Hindsight bias), you shall see that even that under-performs a normal Buy and Hold. And this despite me not taking into calculation any brokerage (since High and Low is taken as entries, slippage can be taken as being included).

The testing was done on Nifty since it absolves one of many biases which can ruin any test if done on any stock or a set of stocks.

You can download the results here (Link: https://dl.dropboxusercontent.com/u/19628087/EMA-Crossover-Intra-D-W-M.zip )- file size is around 40~MB

To conclude, if you are trading on a MA Crossover idea, I would urge you to think deep as to whether it’s worth the time and effort and whether you are better off investing the same into a Index fund and using the time for other pursuits.