Moving Averages, But How Long?

One of the puzzles of finance is why momentum seems to work so well. I’ve often called the 50-day moving average “the dumb rule that works for very smart reasons.”

The idea is that once a stock gets set in motion in one direction, it has a strong tendency to keep moving. I’ve always been curious if there’s an ideal time limit at which the moving average “works.” Why have we settled on 50-day and 200-day moving averages?

I had just been thinking about this when CXO Advisory highlighted this academic paper: Technical Analysis with a Long Term Perspective: Trading Strategies and Market Timing Ability by DuĊĦan Isakov and Didier Marti. Here’s the abstract:

This article extends the literature on the profitability of technical analysis in three directions. First, we investigate the performance of complex trading rules based on moving averages over longer horizons than those usually considered. The different trading rules are simulated on daily prices of the S&P 500 index over the period 1990 to 2008 and we find that trading rules are more profitable when signals are generated over longer horizons. Second, we analyse if financial leverage can improve the profitability of the different strategies. It appears to be the case when leverage is achieved with debt. Third, we propose a new test of market timing that assesses whether a trading strategy is able to generate signals corresponding to longer market phases. According to this test, the signals generated by the complex rules investigated in this article coincide strongly with bull and bear markets.

Posted by on May 16th, 2011 at 8:35 am


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