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Trading ETFs with the Moving Average

Trading ETFs with the Moving Average
April 10
17:25 2012

The moving average is a powerful tool in technical analysis, but it is often insufficient as a standalone trading indicator and therefore used mostly as a confirmation signal. However, if you are interested in short-term trading of exchange-traded funds (ETFs), much can be accomplished with just a couple of moving averages. While these are appropriate for trades with relatively short horizon, they certainly can also apply across longer-term trades.

Both of these techniques use the simple moving average (SMA), and all backtesting was performed using the SMA rather than the exponential moving average (EMA) or any other variety.

The first indicator is the 200-day moving average. A simple trading rule for this moving average is to enter long positions only when the ETF is above the 200-day MA. Backtesting of a large number of ETFs shows that when the price is above the 200-day MA, the ETF will generally tend to continue upward, bouncing back from minor corrections along the way. Conversely, once the price falls below the 200-day MA, the ETF will trend strongly downward despite any brief bounces along the way.

For an illustration of this phenomenon, we’ll consider the SPDR S&P 500 ETF (SPY). As you can see in this chart of 2008 to early 2012, SPY behaved just as we describe. Had you taken a long position in the ETF once the price confirmed a strong cross above the 200-day MA and exited as it crossed downward, you would have profited consistently. The importance of waiting for confirmation of the upward cross can be seen on two occasions in mid-2010 and again in late 2011, when the price bumped just above the moving average before falling back.

It is plain to see how you can profit from a short-term trade of an upward cross. Consider the summer of 2009, the fall of 2010, and the beginning of 2012 to see how strongly the ETF moved upward after crossing the MA—but let the spring of 2009, when SPY drifted along the 200-day MA for a while before breaking out, serve as another demonstration of why you should trade only once the ETF has clearly broken away from the moving average.

This meandering along the 200-day MA in 2009 also shows why using a moving average in concert with at least one other indicator is a better approach. In this case we’ll consider the relative strength indicator (RSI). During the period when SPY crossed above the MA but then lingered there for a while and drifted downward, the RSI was middling, showing no definite trend. It was not until the RSI fell into “oversold” territory that SPY shortly afterwards broke out.

A second moving average strategy—and one applicable to trades with a five- to seven-day duration—uses the 5-day moving average. It is used specifically for trades in which a long position has been taken in an ETF during a correction, meaning the buy was made while the price was below the 5-day MA.

In this case you can use an upward cross of the 5-day MA as a sell signal. As this chart of the PowerShares DB Agriculture ETF (DBA) shows, this is the most conservative technique, since the upward cross shows that the price trend has turned higher. If you choose to remain in your position until a downward cross follows the upward cross, you may capture greater profits. This approach would have done just that in the second half of December, the second half of January, and the second half of February. However, you must recognize that this technique is more aggressive. If the ETF gaps downward, as it did in early November and early March, you will lose on the trade. It can also be problematic if the ETF slides sideways along the 5-day MA with no clear direction.

Remember that short-term trading is about the consistent capture of more modest profits. It is easy to be led by greed when prices are moving in your favor, but always focus on the trader’s maxim: plan your trade and trade your plan.

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