Using Moving Averages Effectively – Part 2

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Last week we introduced a popular indicator called the moving average (MA). This superb indicator is widely used by both amateur and professional alike. Simple to compute; easy to use.

This week, we highlight two more applications of the MA for investment and trading. The first is the so-called Ivy Portfolio – introduced by Mebane Faber (see here). The second is the Coppock Indicator. In both, the critical component is the MA.

Ivy Portfolio

This is an investment strategy that uses the monthly MA as the guiding point. Simply, you buy the market index (e.g. FTSE 100 or S&P 500) when it advances above its 12-month MA and sell into cash when the index drops below the MA.

By restricting the rebalancing frequency to a monthly basis, you have only twelve chances per year to change your portfolio. Low trading activity reduces transaction costs.

How did the strategy perform?

A cursory look at the FTSE 100 Index and its 12-month MA shows clearly that the strategy kept you in bull markets and, more importantly, out of devastating bear markets. For example, you would have been out of the market during the global financial crisis in 2007-8 when the index plunged from 6,500 to 4,000.

This is an important point. Avoiding big bear markets is as important as – if not more important than! – riding bull markets. It is a fact that you accumulate capital faster when you don’t lose too much money during a downturn.

Of course, you will point out that, since 2009, the strategy had generated a few whipsaws – meaning that the trend shows a buy signal then a sell signal two months later, and then another buy signal shortly after  – so on. This is unavoidable. Simply because UK’s equity market did not product a clear runaway trend after the ’08 crisis like it did in 2003-’07.

Coppock Indicator

The second application of the MA is the Coppock Indicator, namely after the author ES Coppock. It was first published in 1962.

Calculations of the indicator are very simple. It uses monthly prices. And sums two rate of change (of closing prices) and apply an weighted moving average method to it. You can read about this here.

What is this indicator use for, you wonder? To find entry signals for long-term buys.

To show how this is used, we compute the Coppock indicator of the FTSE 100 Index and plot it below the monthly closing prices. The conditions for the buy signal are: (1) A turning point at the bottom (e.g., -50, -100, -20) and (2) The turning point must occur at negative levels.

Coppock buy signals do not come by every month. For example, in the last twenty years we saw only six such signals. The last three signals were May-2009, Jul-2012, and May-2016.

How did these signals do? Quite well. In each signal, the FTSE 100 Index rallied shortly after and was kept in uptrend for months. Profits were sizeable.

An important point worth mentioning about the timing of the signals. They emerged when the market sentiment was still very negative. In May’09, for instance, stock markets around the world were reeling from the banking crisis. In May’16, uncertainties about Brexit were very high. But if you had followed the Coppock signals you would have bag plenty of gains.

Conclusion

This week, we show you how derivatives of the moving average are used. They are simple – but highly effective. You could use the monthly MA to determine your positions in the market and use the Coppock to add or confirm positions.

On a last note, when using MA indicators you must be discipline enough to use each signal, simply because you will never know how profitable the signal will be. Using stops is crucial when the signal is not working. When the signal is working, simply let the position run.

Ten things to understand before you start trading…

1.    How to use support and resistance levels in trading
2.   Using Moving Averages Effectively – Part 1
2.5 Using Moving Averages Effectively – Part 2
3.   Momentum indicators and trends change
4.   Understanding Price Breakouts and its Significance
5.   Q&A On Price Patterns With Jackson Wong PhD
6.   The Importance of Group Analysis
7.   Three Chart Characteristics That Precede A Trend Change
8.   Thoughts on trading the market via Breadth
9.   Six Market Trends To Look For Outside Individual Price Action
10. The Key To Long-Term Investment Success – Know Yourself…

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Jackson has over 10 years experience as a financial analyst. Previously a director of Stockcube Research as head of Investors Intelligence providing market timing advice and research to some of the world largest institutions and hedge funds.

Expertise: Global macroeconomic investment strategy, statistical backtesting, asset allocation, and cross-asset research.

Jackson has a PhD in Finance from Durham University.