Trendfollowing Setup for the Buy and Hold Investor: Part 2

Yesterday marked the first time since early 2008 that the 200 day simple moving average (dsma) of (SPY: 97.89 -0.47%) turned up.

As I noted yesterday, I had been waiting for that development to test a very simple trendfollowing strategy. The strategy will go long if the 200dsma is higher than the previous day and will sell the long position and go short if the 200dsma is lower than the previous day.

But before I get to this final test, I want to examine and discuss some variations.

The Method:

Variation 1: Buy the SPY if the close is above the 200dsma and the 200dsma is higher than the day before.

Results for Variation 1 are  here.

Variation 2: Buy the SPY if the close is X % or more above the 200dsma and the 200dsma is higher than the day before.

Variation 3: Buy the SPY if the 200dsma is higher than the day before. Sell short if the 200dsma is lower than the day before.

The exit signal is generated if the 200dsma is lower than the day before. For variation 3, the exit signal is also the short entry signal.

All variations compound gains (this is to make for an accurate comparison to buy-and-hold investing) but do not include commissions and slippage.

Variation 2:

The following graphs represent the results of buying this setup when price is stretched X% above the 200dsma. I have included this study because the close of the SPY was more than 10% above the 200dsma when the moving average turned up. Lets look at what this might mean for this particular trade. Of course, the usual caveats about a small sample size apply!

The numbers across the bottom represent the percentage that price was stretched above the moving average. 1.01 = 1% stretch.

It is fairly useless to look at Net Profit in this study due to the fact that Net Profit is simply the sum of the trades, and as the number of trades decreases the more that price is stretched above the average, we would expect Net Profit to fall off as a by-product of decreased opportunity. Why did I include the chart then? I don’t know.

The graph above shows us that there have been 3 other instances when this system entered with price stretched 10% or more above the 200dsma.

The graph above is the one I consider to be the most helpful. I assumed that the Avg. % Profit/Loss would decrease as the stretch above the moving average increases. I assumed this because it made intuitive sense (to me at least) that if the SPY ran up 10% above the 200dsma, that perhaps a large portion of any possible gain had already been achieved before entry.

The large increase corresponding to the 1.15 multiple (15% stretch) was only one trade and should be considered an outlier.

The big takeaway is that it certainly does not seem to hurt performance to enter this trade when price is stretched above the 200dsma.

Again, small samples, but price being stretched 10% or more above the 200dsma does not seem to hurt the % of Winners.

Summary:

Initially, I was concerned about allocating a small part of my capital to this trade, due to the price being stretched 10% above the 200dsma. However, based on the data, I’m not seeing that it makes that much difference.

I know that I said I would publish Variation 3 in Part 2, but it looks like Variation 3 will have its own post, which will be coming soon.

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