Anatomy of Market Timing with Moving Averages∗

Valeriy Zakamulin†

This revision: August 26, 2015

Abstract
The underlying concept behind the technical trading indicators based on moving aver-
ages of prices has remained unaltered for more than half of a century. The development
in this field has consisted in proposing new ad-hoc rules and using more elaborate types of
moving averages in the existing rules, without any deeper analysis of commonalities and
differences between miscellaneous choices for trading rules and moving averages. In this
paper we uncover the anatomy of market timing rules with moving averages. Our analysis
offers a new and very insightful reinterpretation of the existing rules and demonstrates
that the computation of every trading indicator can equivalently be interpreted as the
computation of the weighted moving average of price changes. This knowledge enables a
trader to clearly understand the response characteristics of trading indicators and simplify
dramatically the search for the best trading rule. As a straightforward application of the
useful knowledge revealed by our analysis, in this paper we also entertain a method of
finding the most robust moving average weighting scheme. The method is illustrated using
the long-run historical data on the Standard and Poor’s Composite stock price index. We
find the most robust moving average weighting scheme and demonstrates its advantages.

Key words: technical analysis, market timing, momentum rule, price minus moving
average rule, moving average change of direction rule, double crossover method, robust
moving average

JEL classification: G11, G17.

∗
The author is grateful to an anonymous referee, Steen Koekebakker, Pete Nikolai, and the participants of
the 3rd Economics & Finance Conference (Rome, Italy) for their insightful comments. The usual disclaimer
applies.
†
a.k.a. Valeri Zakamouline, School of Business and Law, University of Agder, Service Box 422, 4604 Kris-
tiansand, Norway, Tel.: (+47) 38 14 10 39, E-mail: [email protected]

1
1 Introduction

Technical analysis represents a methodology of forecasting the future price movements through

the study of past price data and uncovering some recurrent regularities, or patterns, in price

dynamics. One of the fundamental principles of technical analysis is that prices move in

trends. Analysts firmly believe that these trends can be identified in a timely manner and

used to generate profits and limit losses. Market timing is an active trading strategy that

implements this idea in practice. Specifically, this strategy is based on switching between the

market and cash depending on whether the prices trend upward or downward. A moving

average of prices is one of the oldest and most popular tools used in technical analysis for

detecting a trend. Over the past two decades, market timing with moving averages has been

the subject of substantial interest on the part of academics1 and investors alike.

However, despite a series of publications in academic journals, the market timing rules based

on moving averages have remained virtually unaltered for more than half of a century. Modern

technical analysis still remains art rather than science. The situation with market timing is as

follows. There have been proposed many technical trading rules based on moving averages of

prices calculated on a fixed size data window. The main examples are: the momentum rule,

the price-minus-moving-average rule, the change-of-direction rule, and the double-crossover

method. In addition, there are several popular types of moving averages: simple (or equally-

weighted) moving average, linearly-weighted moving average, exponentially-weighed moving

average, etc. As a result, there exists a large number of potential combinations of trading rules

with moving average weighting schemes. One of the controversies about market timing is over

which trading rule in combination with which moving average weighting scheme produces the

best performance. The situation is further complicated because in order to compute a moving

average one must define the size of the averaging window. Again, there is a big controversy

over the optimal size of this window.

There is a simple explanation for the existing situation with market timing. First of all,

technical traders do not really understand the response characteristics of the trading indicators2
1
Some examples are: Brock, Lakonishok, and LeBaron (1992), Sullivan, Timmermann, and White (1999),
Okunev and White (2003), Faber (2007), Gwilym, Clare, Seaton, and Thomas (2010), Moskowitz, Ooi, and
Pedersen (2012), Kilgallen (2012), Clare, Seaton, Smith, and Thomas (2013), Zakamulin (2014), Glabadanidis
(2015).
2
In our definition, a “trading indicator” denotes an equation (or a formula) that specifies how the technical
trading signal is computed using the prices in the averaging window.

2
they use. The selection of the combination of a trading rule with a moving average weighting

scheme is made based mainly on intuition rather than any deeper analysis of commonalities

and differences between miscellaneous choices for trading rules and moving average weighting

schemes. The development in this field has consisted in proposing new ad-hoc rules and using

more elaborate types of moving averages (for example, moving averages of moving averages)

in the existing rules.

The main contribution of this paper is to uncover the anatomy of market timing rules

with moving averages of prices. Specifically, we present a methodology for examining how

the value of a trading indicator is computed. Then using this methodology we study the

computation of trading indicators in many market timing rules and analyze the commonalities

and differences between the rules. We reveal that despite being computed seemingly different

at the first sight, all technical trading indicators considered in this paper are computed in

the same general manner. In particular, the computation of every technical trading indicator

can equivalently be interpreted as the computation of a weighted moving average of price

changes. Consequently, the only real difference, between diverse market timing rules coupled

with various types of moving averages, lies in the weighting scheme used to compute the moving

average of price changes.

Our methodology of analyzing the computation of trading indicators for the timing rules

based on moving averages offers a broad and clear perspective on the relationship between

different rules. We show, for example, that every trading rule can also be presented as a

weighted average of the momentum rules computed using different averaging periods. Thus,

the momentum rule might be considered as an elementary trading rule on the basis of which

one can construct more elaborate rules. In addition, we establish a one-to-one equivalence

between a price-minus-moving-average rule and a corresponding moving-average-change-of-

direction rule. Overall, our analysis offers a new and very insightful re-interpretation of the

existing market timing rules.

The second contribution of this paper is a straightforward application of the useful knowl-

edge revealed by our analysis of timing rules based on moving averages of prices. Previously, in

order to select the best combination of a trading rule with a moving average weighting scheme

and a size of the averaging window, using relevant historical data a trader had to perform

the test of all possible combinations in order to find the combination with the best observed

3
performance in a back test.3 Our result allows a trader to simplify dramatically this procedure

because one needs only to test various combinations of weighting schemes (used to compute

the moving average of price changes) and averaging periods. Yet, we argue that this procedure

to selecting the best trading combination has two potentially very serious flaws. In particu-

lar, we find that there is no single optimal size of the averaging window.4 On the contrary,

empirical evidence suggests that there are substantial time-variations in the optimal size of

the averaging window for each weighting scheme. In addition, Zakamulin (2014) demonstrated

that the performance of a market timing strategy, relative to that of its passive counterpart,

is highly uneven over time. Therefore, the issue of outliers is of concern. This is because in

the presence of outliers (extraordinary good or bad performance over a rather short historical

period) the long-run performance of a trading combination does not reflect its typical per-

formance over short and medium runs. As a result of these two issues, the best performing

trading combination in the past might not perform well in the near future.

We entertain a novel approach to selecting the trading rule (specified by a particular moving

average weighting scheme) to use for the purpose of timing the market. The motivation for this

approach is twofold. First, we acknowledge that there is no single optimal size of the averaging

window. Second, we acknowledge that the performance of a trading rule is highly uneven

through time and over some relatively short particular historical episodes the performance

might be unusually far from that over the rest of the dataset. Based on these premises, we find

the most robust moving average weighting scheme. By robustness of a weighting scheme we

mean not only its robustness to outliers. Robustness of a weighting scheme is also defined as

its ability to generate sustainable performance under all possible market scenarios regardless

of the size of the averaging window. Our approach is illustrated using the long-run historical

data on the Standard and Poor’s Composite stock price index.

The rest of the paper is organized as follows. In the subsequent Section 2 we present the

moving averages and trading rules considered in the paper. Then in Section 3 we demonstrate

the anatomy of trading rules with different moving averages. Section 4 describes our method-

ology for finding a robust moving average, presents the most robust moving average weighting
3
Even though this approach to selecting the best trading combination is termed as “data-mining”, this
approach works and the only real issue with this approach is that it systematically overestimates how well the
trading combination will perform in the future (Aronson (2006), Zakamulin (2014)).
4
To shorten the paper, these results are not reported.

4
scheme, and demonstrates its advantages. Finally, Section 5 concludes the paper.

2 Moving Averages and Technical Trading Rules

2.1 Moving Averages

A moving average of prices is calculated using a fixed size data “window” that is rolled through

time. The length of this window of data, also called the lookback period or averaging period, is

the time interval over which the moving average is computed. We follow the standard practice

and use prices, not adjusted for dividends, in the computation of moving averages and all

technical trading indicators. More formally, let (P1 , P2 , . . . , PT ) be the observations of the

monthly5 closing prices of a stock price index. A moving average at time t is computed using

the last closing price Pt and k lagged prices Pt−j , j ∈ [1, k]. It is worth noting that the time

interval over which the moving average is computed amounts to k months and includes k + 1

monthly observations. Generally, each price observation in the rolling window of data has

its own weight in the computation of a moving average. More formally, a weighted Moving

Average at month-end t with k lagged prices (denoted by M At (k)) is computed as

∑k
wt Pt + wt−1 Pt−1 + wt−2 Pt−2 + . . . + wt−k Pt−k j=0 wt−j Pt−j
M At (k) = = ∑k , (1)
wt + wt−1 + wt−2 + . . . + wt−k j=0 wt−j

where wt−j is the weight of price Pt−j in the computation of the weighted moving average.

It is worth observing that in order to compute a moving average one has to use at least one

lagged price, this means that one should have k ≥ 1. Note that when the number of lagged

prices is zero, a moving average becomes the last closing price, that is, M At (0) = Pt .

The most commonly used types of moving averages are: the Simple Moving Average (SMA),

the Linear (or linearly weighted) Moving Average (LMA), and the Exponential Moving Average

(EMA). A less commonly used type of moving average is the Reverse Exponential Moving
5
Throughout the paper, we assume that the price data comes at the monthly frequency. Yet the results
presented in the first part of the paper are valid for any data frequency.

5
Average (REMA). These moving averages at month-end t are computed as

∑k
1 ∑ − j + 1)Pt−j
k
j=0 (k
SM At (k) = Pt−j , LM At (k) = ∑k ,
k+1
j=0 j=0 (k − j + 1)
∑k j
∑k k−j P
(2)
j=0 λ Pt−j j=0 λ t−j
EM At (k) = ∑k , REM At (k) = ∑k ,
j k−j
j=0 λ j=0 λ

where 0 < λ ≤ 1 is a decay factor.

As compared with the simple moving average, either the linearly weighted moving average

or the exponentially weighted moving average puts more weight on the more recent price ob-

servations. The usual justification for the use of these types of moving averages is a widespread

belief that the most recent stock prices contain more relevant information on the future direc-

tion of the stock price than earlier stock prices. In the linearly weighted moving average the

weights decrease in arithmetic progression. In particular, in LM A(k) the latest observation

has weight k +1, the second latest k, etc. down to one. A disadvantage of the linearly weighted

moving average is that the weighting scheme is too rigid. In contrast, by varying the value of

λ in the exponentially weighted moving average, one is able to adjust the weighting to give

greater or lesser weight to the most recent price. The properties of the exponential moving

average:

lim EM At (k) = SM At (k), lim EM At (k) = Pt . (3)

λ→1 λ→0

Contrary to the normal exponential moving average that gives greater weights to the most

recent prices, the reverse exponential moving average assigns greater weights to the most oldest

prices and decreases the importance of the most recent prices. The properties of the reverse

exponential moving average:

lim REM At (k) = SM At (k), lim REM At (k) = Pt−k . (4)

λ→1 λ→0

Instead of the regular moving averages of prices considered above, traders sometimes use

more elaborate moving averages that can be considered as “moving averages of moving aver-

ages”. Specifically, instead of using a regular moving average to smooth the price series, some

traders perform either double- or triple-smoothing of the price series. The main examples

of this type of moving averages are: Triangular Moving Average, Double Exponential Moving

6
Average, and Triple Exponential Moving Average (see, for example, Kirkpatrick and Dahlquist

(2010)). To shorten and streamline the presentation, we will not consider these moving aver-

ages in our paper. Yet our methodology can be applied to the analysis of the trading indicators

based on this type of moving averages in a straightforward manner.

2.2 Technical Trading Rules

Every market timing rule prescribes investing in the stocks (that is, the market) when a Buy

signal is generated and moving to cash or shorting the market when a Sell signal is generated.

In the absence of transaction costs, the time t return to a market timing strategy is given by

( )
rt = δt|t−1 rM t + 1 − δt|t−1 rf t , (5)

where rM t and rf t are the month t returns on the stock market (including dividends) and the

risk-free asset respectively, and δt|t−1 ∈ {0, 1} is a trading signal for month t (0 means Sell and

1 means Buy) generated at the end of month t − 1.

In each market timing rule the generation of a trading signal is a two-step process. At the

first step, one computes the value of a technical trading indicator using the last closing price

and k lagged prices

T R(k)
Indicatort = Eq(Pt , Pt−1 , . . . , Pt−k ), (6)

where T R denotes the timing rule and Eq(·) is the equation that specifies how the technical

trading indicator is computed. At the second step, using a specific function one translates the

value of the technical indicator into the trading signal. In all market timing rules considered

in this paper, the Buy signal is generated when the value of a technical trading indicator is

positive. Otherwise, the Sell signal is generated. Thus, the generation of a trading signal can

be interpreted as an application of the following (mathematical) indicator function to the value

of the technical indicator

( )
T R(k)
δt+1|t = 1+ Indicatort , (7)

7
where the indicator function 1+ (·) is defined by



1 if x > 0,
1+ (x) = (8)


0 if x ≤ 0.

We start the presentation of trading rules considered in the paper with the Momentum rule

(MOM) which is the simplest and most basic market timing rule. In the Momentum rule one

compares the last closing price, Pt , with the closing price k months ago, Pt−k . In this rule a

Buy signal is generated when the last closing price is greater than the closing price k months

ago. Formally, the technical trading indicator for the Momentum rule is computed as

MOM(k)
Indicatort = M OMt (k) = Pt − Pt−k . (9)

Then the trading signal is generated by

MOM(k)
δt+1|t = 1+ (M OMt (k)) . (10)

Most often, in order to generate a trading signal, a trader compares the last closing price

with the value of a k-month moving average. In this case a Buy signal is generated when the

last closing price is above a k-month moving average. Otherwise, if the last closing price is

below a k-month moving average, a Sell signal is generated. Formally, the technical trading

indicator for the Price-Minus-Moving-Average rule (P-MA) is computed as

P-MA(k)
Indicatort = Pt − M At (k). (11)

Some traders argue that the price is noisy and the Price-Minus-Moving-Average rule pro-

duces many false signals (whipsaws). They suggest to address this problem by employing two

moving averages in the generation of a trading signal: one shorter average with averaging pe-

riod s and one longer average with averaging period k > s. This technique is called the Double

8
Crossover Method6 (DCM). In this case the technical trading indicator is computed as

DCM(s,k)
Indicatort = M At (s) − M At (k). (12)

It is worth noting the obvious relationship

DCM(0,k) P-MA(k)
Indicatort = Indicatort . (13)

Less often, in order to generate a trading signal, the traders compare the most recent value

of a k-month moving average with the value of a k-month moving average in the preceding

month. Intuitively, when the stock prices are trending upward (downward) the moving average

is increasing (decreasing). Consequently, in this case a Buy signal is generated when the value of

a k-month moving average has increased over a month. Otherwise, a Sell signal is generated.

Formally, the technical trading indicator for the Moving-Average-Change-of-Direction rule

(∆MA) is computed as

∆MA(k)
Indicatort = M At (k) − M At−1 (k). (14)

3 Anatomy of Trading Rules

3.1 Preliminaries

It has been known for years that there is a relationship between the Momentum rule and the

Simple-Moving-Average-Change-of-Direction rule.7 In particular, note that

Pt − Pt−k M OMt (k)

SM At (k − 1) − SM At−1 (k − 1) = = . (15)
k k

Therefore
∆SMA(k−1) MOM(k)
Indicatort ≡ Indicatort , (16)

where the symbol “≡” means equivalence. The equivalence of two technical indicators stems

from the following property: the multiplication of a technical indicator by any positive real num-
6
Also known as the Moving Average Crossover.
7
See, for example, http://en.wikipedia.org/wiki/Momentum (technical analysis).

9
ber produces an equivalent technical indicator. This is because the trading signal is generated

depending on the sign of the technical indicator. The formal presentation of this property:

1+ (a × Indicatort (k)) = 1+ (Indicatort (k)) , (17)

where a is any positive real number. Using relation (16) as an illustrating example, observe

that if SM At (k − 1) − SM At−1 (k − 1) > 0 then M OMt (k) > 0 and vice versa. In other words,

the Simple-Moving-Average-Change-of-Direction rule, ∆SMA(k − 1), generates the Buy (Sell)

trading signal when the Momentum rule, M OMt (k), generates the Buy (Sell) trading signal.

What else can we say about the relationship between different market timing rules? The

ultimate goal of this section is to answer this question and demonstrate that all market timing

rules considered in this paper are closely interconnected. In particular, we are going to show

that the computation of a technical trading indicator for every market timing rule can be

interpreted as the computation of the weighted moving average of monthly price changes over

the averaging period. We will do it sequentially for each trading rule.

3.2 Momentum Rule

The computation of the technical trading indicator for the Momentum rule can equivalently

be represented by

MOM(k)
Indicatort = M OMt (k) = Pt − Pt−k
∑
k (18)
= (Pt − Pt−1 ) + (Pt−1 − Pt−2 ) + ... + (Pt−k+1 − Pt−k ) = ∆Pt−i ,
i=1

where ∆Pt−i = Pt−i+1 − Pt−i denotes the monthly price change. Consequently, using property

(17), the computation of the technical indicator for the Momentum rule is equivalent to the

computation of the equally weighted moving average of the monthly price changes:

1∑
k
MOM(k)
Indicatort ≡ ∆Pt−i . (19)
k
i=1

10
3.3 Price-Minus-Moving-Average Rule

First, we derive the relationship between the Price-Minus-Moving-Average rule and the Mo-

mentum rule:
∑k ∑k ∑k
P-MA(k) j=0 wt−j Pt−j j=0 wt−j Pt − j=0 wt−j Pt−j
Indicatort = Pt − M At (k) = Pt − ∑k = ∑k
j=0 wt−j j=0 wt−j
∑k ∑k
j=1 wt−j (Pt − Pt−j ) j=1 wt−j M OMt (j)
= ∑k = ∑k .
j=0 wt−j j=0 w t−j

(20)

Using property (17), the relation above can be conveniently re-written as

∑k
P-MA(k) j=1 wt−j M OMt (j)
Indicatort ≡ ∑k . (21)
j=1 wt−j

Consequently, the computation of the technical indicator for the Price-Minus-Moving-Average

rule, Pt −M At (k), is equivalent to the computation of the weighted moving average of technical

indicators for the Momentum rules, M OMt (j), for j ∈ [1, k]. It is worth noting that the

weighting scheme for computing the moving average of the momentum technical indicators,

M OMt (j), is the same as the weighting scheme for computing the weighted moving average

M At (k).

Second, we use identity (18) and rewrite the numerator in (21) as

∑
k ∑
k ∑
j
wt−j M OMt (j) = wt−j ∆Pt−i = wt−1 ∆Pt−1 + wt−2 (∆Pt−1 + ∆Pt−2 ) + . . .
j=1 j=1 i=1

+ wt−k (∆Pt−1 + ∆Pt−2 + . . . + ∆Pt−k ) = (wt−1 + . . . + wt−k )∆Pt−1 (22)

 
∑
k ∑k
+ (wt−2 + . . . + wt−k )∆Pt−2 + . . . + wt−k ∆Pt−k =  wt−j  ∆Pt−i .
i=1 j=i

The last expression tells us that the numerator in (21) is a weighted sum of the monthly
∑
price changes over the averaging window, where the weight of ∆Pt−i equals kj=i wt−i . Thus,

another alternative expression for the computation of the technical indicator for the Price-

11
Minus-Moving-Average rule is given by

∑k (∑ )
k
w ∆Pt−i ∑k
P-MA(k) i=1 j=i t−j xt−i ∆Pt−i
Indicatort ≡ ∑k (∑k ) = i=1
∑k . (23)
i=1 j=i wt−j i=1 xt−i

where
∑
k
xt−i = wt−j (24)
j=i

is the weight of the price change ∆Pt−i . In words, the computation of the technical indicator

for the Price-Minus-Moving-Average rule is equivalent to the computation of the weighted

moving average of the monthly price changes in the averaging window.

It is important to note from equation (24) that the application of the Price-Minus-Moving-

Average rule usually leads to overweighting the most recent price changes as compared to the

original weighting scheme used to compute the moving average of prices. If the weighting

scheme in a trading rule is already designed to overweight the most recent prices, then as a

rule the trading signal is computed with a much stronger overweighting the most recent price

changes. This will be demonstrated below.

Let us now, on the basis of (23), present the alternative expressions for the computation

of Price-Minus-Moving-Average technical indicators that use the specific weighting schemes

described in the preceding section. We start with the Simple Moving Average which uses the

equally weighted moving average of prices. In this case the weight of ∆Pt−i is given by

∑
k ∑
k
xt−i = wt−j = 1 = k − i + 1. (25)
j=i j=i

Consequently, the equivalent representation for the computation of the technical indicator for

the Price-Minus-Simple-Moving-Average rule:

∑k
P-SMA(k) i=1 (k − i + 1)∆Pt−i k∆Pt−1 + (k − 1)∆Pt−2 + . . . + ∆Pt−k
Indicatort ≡ ∑k = . (26)
i=1 (k − i + 1)
k + (k − 1) + . . . + 1

This suggests that alternatively we can interpret the computation of the technical indicator

for the Price-Minus-Simple-Moving-Average rule as the computation of the linearly weighted

moving average of monthly price changes.

12
 We next consider the Linear Moving Average which uses the linearly weighted moving

average or prices. In this case the weight of ∆Pt−i is given by

∑
k ∑
k
(k − i + 1)(k − i + 2)
xt−i = wt−j = (k − j + 1) = , (27)
2
j=i j=i

which is the sum of the terms of arithmetic sequence from 1 to k − i + 1 with the common

difference of 1. As the result, the equivalent representation for the computation of the technical

indicator for the Price-Minus-Linear-Moving-Average rule

∑k (k−i+1)(k−i+2)
P-LMA(k) ∆Pt−i
Indicatort ≡ i=1
∑k
2
(k−i+1)(k−i+2)
. (28)
i=1 2

Then we consider the Exponential Moving Average which uses the exponentially weighted

moving average or prices. In this case the weight of ∆Pt−i is given by

∑ ∑ λ ( i−1 )
k k
xt−i = wt−j = λj = λ − λk , (29)
1−λ
j=i j=i

which is the sum of the terms of geometric sequence from λi to λk . Consequently, the equivalent

presentation for the computation of the technical indicator for the Price-Minus-Exponential-

Moving-Average rule

∑k ( )
P-EMA(k) i=1 λi−1 − λk ∆Pt−i
Indicatort ≡ ∑k . (30)
i=1 (λ
i−1 − λk )

If k is relatively large such that λk ≈ 0, then the expression for the computation of the technical

indicator for the Price-Minus-Exponential-Moving-Average rule becomes

∑k i−1 ∆P
P-EMA(k) i=1 λ t−i ∆Pt−1 + λ∆Pt−2 + . . . + λk−1 ∆Pt−k
Indicatort ≡ ∑k = , when λk ≈ 0.
i=1 λ i−1 1 + λ + . . . + λk−1
(31)

In words, the computation of the trading signal for the Price-Minus-Exponential-Moving-

Average rule, when k is rather large, is equivalent to the computation of the exponential

moving average of monthly price changes. It is worth noting that this is probably the only

trading rule where the weighting scheme for the computation of moving average of prices is

identical to the weighting scheme for the computation of moving average of price changes.

13
 The weight of ∆Pt−i for the Reverse Exponential Moving Average is given by

∑
k ∑
k
1 − λk−i+1
xt−i = wt−j = λk−j = , (32)
1−λ
j=i j=i

which is the sum of the terms of geometric sequence from 1 to λk−i . Consequently, the

equivalent representation for the computation of the technical indicator for the Price-Minus-

Reverse-Exponential-Moving-Average rule

∑k ( )
P-REMA(k) 1 − λk−i+1 ∆Pt−i
Indicatort ≡ i=1
∑k . (33)
i=1 (1 − λk−i+1 )

3.4 Moving-Average-Change-of-Direction Rule

The value of this technical trading indicator is based on the difference of two weighted moving

averages computed at times t and t − 1 respectively. We assume that the size of the averaging

window is k − 1 months, the reason for this assumption will become clear very soon. The

straightforward computation yields

∑k−1 ∑k−1
∆MA(k − 1) i=0 wt−i Pt−i wt−i Pt−i−1
Indicatort = M At (k − 1) − M At−1 (k − 1) = ∑ k−1
− i=0
∑k−1
i=0 wt−i i=0 wt−i
∑k−1 ∑k
i=0 wt−i (Pt−i − Pt−i−1 ) i=1 wt−i+1 ∆Pt−i
= ∑k−1 = ∑k .
i=0 wt−i i=1 wt−i+1

(34)

Consequently, the computation of the technical indicator for the Moving-Average-Change-of-

Direction rule can be directly interpreted as the computation of the weighted moving average

of monthly price changes:

∑k
∆MA(k − 1) i=1 wt−i+1 ∆Pt−i
Indicatort = ∑k . (35)
i=1 wt−i+1

Note that the weighting scheme for the computation of the moving average of monthly price

changes is the same as for the computation of moving average of prices. From (35) we easily

recover the relationship for the case of the Simple Moving Average where wt−i+1 = 1 for all i

∑k
∆SMA(k − 1) i=1 ∆Pt−i MOM(k)
Indicatort ≡ ≡ Indicatort , (36)
k

14
where the last equivalence follows from (19).

In the case of the Linear Moving Average, where wt−i+1 = k − i + 1, we derive a new

relationship:

∑k
∆LMA(k − 1) i=1 (k − i + 1)∆Pt−i
Indicatort ≡ ∑k ≡ IndicatorP-SMA
t (k), (37)
i=1 (k − i + 1)

where the last equivalence follows from (26). Putting it into words, the Price-Minus-Simple-

Moving-Average rule, Pt − SM At (k), prescribes investing in the stocks (moving to cash) when

the Linear Moving Average of prices over the averaging window of k − 1 months increases

(decreases).

In the case of the Exponential Moving Average and Reverse Exponential Moving Average,

the resulting expressions for the Change-of-Direction rules can be written as

∑k i−1 ∆P
∆EMA(k − 1) i=1 λ t−i
Indicatort = ∑k i−1
, (38)
i=1 λ

∑k k−i ∆P
∆REMA(k − 1) i=1 λ t−i
Indicatort = ∑k k−i
. (39)
i=1 λ

Observe in particular that if k is rather large, then, using result (31), we obtain yet another

new relationship:

P-EMA(k) ∆EMA(k − 1)
Indicatort ≡ Indicatort , when λk ≈ 0. (40)

In words, when k is rather large, the Price-Minus-Exponential-Moving-Average rule is equiv-

alent to the Exponential-Moving-Average-Change-of-Direction rule. As it might be observed,

for the majority of weighting schemes considered in the paper, there is a one-to-one equivalence

between a Price-Minus-Moving-Average rule and a corresponding Moving-Average-Change-of-

Direction rule. Therefore, the majority of the moving-average-change-of-direction rules (and

may be all of them) can also be expressed as the moving average of Momentum rules.

Finally it is worth commenting that the traders had long ago taken notice of the fact that,

for example, very often a Buy signal is generated first by the Price-Minus-Moving-Average rule,

then with some delay a Buy signal is generated by the Moving-Average-Change-of-Direction

rule. Therefore the traders sometimes use the trading signal of the Moving-Average-Change-

15
of-Direction rule to “confirm” the signal of the Price-Minus-Moving-Average rule (see Murphy

(1999), Chapter 9). Our analysis provides a simple explanation for the existence of a delay

between the signals generated by these two rules. Specifically, the delay naturally occurs be-

cause the Price-Minus-Moving-Average rule overweights more heavily the most recent price

changes than the Moving-Average-Change-of-Direction rule computed using the same weight-

ing scheme. Therefore the Price-Minus-Moving-Average rule reacts more quickly to the recent

trend changes than the Moving-Average-Change-of-Direction rule.8

3.5 Double Crossover Method

The relationship between the Double Crossover Method and the Momentum rule is as follows

(here we use result (20))

DCM(s, k)
Indicatort = M At (s) − M At (k) = (Pt − M At (k)) − (Pt − M At (s))
∑k k
∑s s (41)
j=1 wt−j M OMt (j) j=1 wt−j M OMt (j)
= ∑k − ∑ s s .
w k
j=0 t−j j=0 w t−j

Different superscripts in the weights mean that for the same subscript the weights are generally

not equal. For example, in case of either linearly weighted moving averages or reverse expo-
k
nential moving averages wt−j ̸= wt−j
s , yet for the other weighting schemes considered in this

k
paper wt−j s . In order to get a closer insight into the anatomy of the Double Crossover
= wt−j

Method, we assume that one uses the exponential weighting scheme in the computation of

moving averages (as it most often happens in practice). In this case the expression for the

value of the technical indicator in terms of monthly price changes is given by (here we use
8
Assume, for example, that the trader uses the simple moving average weighting scheme in both the rules. In
this case our result says that the Price-Minus-Simple-Moving-Average rule is equivalent to the Linear-Moving-
Average-Change-of-Direction rule. As a consequence, it is naturally to expect that the Price-Minus-Simple-
Moving-Average rule reacts more quickly to the recent trend changes than the Simple-Moving-Average-Change-
of-Direction rule.

16
results (22) and (29))

∑k (∑ )
∑k ∑j ∑s ∑j k j
DCM(s, k) j=1 λj i=1 ∆Pt−i j=1 λj i=1 ∆Pt−i i=1 j=i λ ∆Pt−i
Indicatort = ∑k − ∑s j
= ∑k
j=0 λ
j j
j=0 λ j=1 λ
∑s (∑ )
s j ∑k ( ) ∑s ( i )
i=1 j=i λ ∆Pt−i λi − λk+1 ∆Pt−i i=1 λ − λ
s+1 ∆P
t−i
− ∑s = i=1
− .
j=1 λ
j 1 − λk+1 1 − λs+1
(42)

If we assume in addition that both s and k are relatively large such that λs ≈ 0 and λk ≈ 0,

then we obtain

DCM(s, k)
∑
k ∑
s ∑
k
Indicatort ≈ λ ∆Pt−i −
i i
λ ∆Pt−i = λi ∆Pt−i . (43)
i=1 i=1 i=s+1

The expression above can be conveniently re-written as

∑k i−s−1 ∆P
DCM(s, k) i=s+1 λ t−i
Indicatort ≡ ∑k when k > s, λs ≈ 0, λk ≈ 0. (44)
i−s−1
j=s+1 λ

In words, the computation of the trading signal for the Double Crossover Method based on

the exponentially weighted moving averages of lengths s and k > s, when both s and k are

rather large, is equivalent to the computation of the exponentially weighted moving average

of monthly price changes, ∆Pt−i , for i ∈ [s + 1, k]. Note that the most recent s monthly price

changes completely disappear in the computation of the technical trading indicator. In other

words, in the computation of the trading indicator one disregards, or skips, the most recent

s monthly price changes. When the values of s and k are not rather large, the most recent

s monthly price changes do not disappear in the computation of the technical indicator, yet

the weights of these price changes are reduced as compared to the weight of the subsequent

(s + 1)-th price change.

3.6 Discussion

Summing up the results presented above, all technical trading indicators considered in this

paper are computed in the same general manner. We find, for instance, that the computation

of every technical trading indicator can be interpreted as the computation of a weighted average

17
of the momentum rules computed using different averaging periods. Thus, the momentum rule

might be considered as an elementary trading rule on the basis of which one can construct

more elaborate rules. The most insightful conclusion emerging from our analysis is that the

computation of every technical trading indicator, based on moving averages of prices, can also

be interpreted as the computation of the weighted moving average of price changes.

Our main conclusion is that, despite being computed seemingly different at the first sight,

the only real difference between miscellaneous rules lies in the weighting scheme used to com-

pute the moving average of price changes. Figure 1 illustrates a few distinctive weighting

schemes for the computation of technical trading indicators based on moving averages. In par-

ticular, this figure illustrates the weighting schemes for the Momentum rule, the Price-Minus-

Reverse-Exponential-Moving-Average rule (with λ = 0.8), the Price-Minus-Simple-Moving-

Average rule, the Price-Minus-Linear-Moving-Average rule, and the Double Crossover Method

(based on using two exponential moving averages with λ = 0.8). For all technical indicators

we use k = 10 which means that to compute the value of a technical indicator we use the most

recent price change, ∆Pt−1 , denoted as Lag0, and 9 preceding lagged price changes up to lag

∆Pt−10 , denoted as Lag9. In addition, in the computation of the technical indicator for the

Double Crossover Method we use s = 3.

Apparently, the Momentum rule assigns equal weights to all monthly price changes in the

averaging window. The next three rules overweight the most recent price changes. They are

arranged according to increasing degree of overweighting. Whereas the Price-Minus-Simple-

Moving-Average rule employs the linear weighting scheme, the degree of overweighting in the

Price-Minus-Reverse-Exponential-Moving-Average rule can be gradually varied from the equal

weighting scheme (when λ = 0) to the linear weighting scheme (when λ = 1), see property (4).

Formally this can be expressed by

P-REMA(k) MOM(k) P-REMA(k) P-SMA(k)

lim Indicatort = Indicatort , lim Indicatort = Indicatort .
λ→0 λ→1
(45)

Comparing to the Price-Minus-Simple-Moving-Average rule, a higher degree of overweight-

ing can be attained by using the Exponential-Moving-Average-Change-of-Direction rule. The

degree of overweighting in this rule can be gradually varied from the linear weighting scheme

(when λ = 1) to the very extreme overweighting where only the most recent price change has

18
 0.25
Lag0
Lag1
Lag2

0.20
Lag3
Lag4
Lag5
Lag6
0.15

Lag7
Lag8
Lag9
0.10
0.05
0.00

MOM P−REMA P−SMA P−LMA DCM

Figure 1: Weights of monthly price changes used for the computations of the technical trad-
ing indicators with k = 10. MOM denotes the Momentum rule. P-REMA denotes the
Price-Minus-Reverse-Exponential-Moving-Average rule (with λ = 0.8). P-SMA denotes the
Price-Minus-Simple-Moving-Average rule. P-LMA denotes the Price-Minus-Linear-Moving-
Average rule. DCM denotes the Double Crossover Method (based on using two exponential
moving averages with λ = 0.8 and s = 3). Lag(i − 1) denotes the weight of the lag ∆Pt−i ,
where Lag0 denotes the most recent price change ∆Pt−1 and Lag9 denotes the most oldest
price change ∆Pt−10 .

a non-zero weight (when λ = 0), see property (3). Formally this can be expressed by

∆EMA(k) MOM(k) ∆EMA(k)

lim Indicatort = Indicatort , lim Indicatort = ∆Pt−1 . (46)
λ→1 λ→0

When λ ≈ 0.82, the degree of overweighting the most recent price changes in the Exponential-

Moving-Average-Change-of-Direction rule is virtually the same as in the Price-Minus-Linear-

Moving-Average rule. Therefore, we demonstrate only the weighting scheme in the Price-

Minus-Linear-Moving-Average rule.

In contrast to the previous rules, the weighting scheme in the Double Crossover Method

underweights both the most recent and the most old price changes. In this weighting scheme

the price change ∆Pt−s−1 = ∆Pt−4 has the largest weight in the computation of moving

19
average.

Our alternative representation of the computation of technical trading indicators by means

of the moving average of price changes, together with the graphical visualization of the weight-

ing schemes for different rules presented in Figure 1, reveals a couple of paradoxes. The first

paradox consists in the following. Many traders argue that the most recent stock prices contain

more relevant information on the future direction of the stock price than earlier stock prices.

Therefore, one should better use the LM A(k) instead of the SM A(k) in the computation of

trading signals. Yet in terms of the monthly price changes the application of the Price-Minus-

Simple-Moving-Average rule already leads to overweighting the most recent price changes. If it

is the most recent stock price changes (but not prices) that contain more relevant information

on the future direction of the stock price, then the use of the Price-Minus-Linear-Moving-

Average rule leads to a severe overweighting the most recent price changes, which might be

suboptimal.

The other paradox is related to the effect produced by the use of a shorter moving average

in the computation of a trading signal for the Double Crossover Method. Specifically, our al-

ternative representation of the computation of technical trading indicators reveals an apparent

conflict of goals that some traders want to pursue. In particular, on the one hand, one wants

to put more weight on the most recent prices that are supposed to be more relevant. On the

other hand, one wants to smooth the noise by using a shorter moving average instead of the

last closing price (as in the Price-Minus-Moving-Average rule). It turns out that these two

goals cannot be attained simultaneously because the noise smoothing results in a substantial

reduction of weights assigned to the most recent price changes (and, therefore, most recent

prices). Figure 1 clearly demonstrates that the weighting scheme for the Double Crossover

Method has a hump-shaped form such that the largest weight is given to the monthly price

change at lag s. Then, as the lag number decreases to 0 or increases to k − 1, the weight of

the lag decreases. Consequently, the use of the Double Crossover Method can be justified only

when the price change at lag s contains the most relevant information on the future direction

of the stock price.

20
4 A Robust Moving Average Weighting Scheme

4.1 Data

In our applied study we use the capital appreciation and total return on the Standard and

Poor’s Composite stock price index, as well as the risk-free rate of return proxied by the

Treasury Bill rate. The sample period begins in January 1857, ends in December 2014, and

covers 158 full years (1896 monthly observations). The data on the S&P Composite index

comes from two sources. The returns for the period January 1857 to December 1925 are

provided by William Schwert.9 The returns for the period January 1926 to December 2014

are computed from the closing monthly priced of the S&P Composite index and corresponding

dividend data provided by Amit Goyal.10 The Treasury Bill rate for the period January 1920

to December 2014 is also provided by Amit Goyal. Because there was no risk-free short-term

debt prior to the 1920s, we estimate it in the same manner as in Welch and Goyal (2008) using

the monthly data for the Commercial Paper Rates for New York. These data are available for

the period January 1857 to December 1971 from the National Bureau of Economic Research

(NBER) Macrohistory database.11 First, we run a regression

Treasury-bill ratet = α + β × Commercial Paper Ratet + et (47)

over the period from January 1920 to December 1971. The estimated regression coefficients

are α = −0.00039 and β = 0.9156; the goodness of fit, as measured by the regression R-square,

amounts to 95.7%. Then the values of the Treasury Bill rate over the period January 1857 to

December 1919 are obtained using the regression above with the estimated coefficients for the

period 1920 to 1971.

4.2 The Methodology for Finding a Robust Moving Average

We say that a moving average weighting scheme is robust if it is able to generate sustainable

performance under all possible market scenarios regardless of the size of the averaging window.

Consequently, in order to find a robust weighting scheme, we need to evaluate the performances
9
http://schwert.ssb.rochester.edu/data.htm
10
http://www.hec.unil.ch/agoyal/
11
http://research.stlouisfed.org/fred2/series/M13002US35620M156NNBR

21
of all different trading rules (where each rule is specified by a particular shape of the weighting

scheme), using all feasible sizes of the averaging window, and over all possible market scenarios.

Then we need to compare the performances and select a trading rule with the most stable

performance.

By performance we mean a risk-adjusted performance. Our measure of performance is the

Sharpe ratio which is a reward-to-total-risk performance measure. We compute the Sharpe

ratio using the methodology presented in Sharpe (1994). Specifically, the computation of the

Sharpe ratio starts with computing the excess returns, Rt = rt − rf t , where rt is the period

t return to the market timing strategy given by equation (5), and rf t is the period t risk-free

rate of return. Then the Sharpe ratio is computed as the ratio of the mean excess returns to

the standard deviation of excess returns. Because the Sharpe ratio is often criticized on the

grounds that the standard deviation appears to be an inadequate measure of risk, we also use

the Sortino ratio (due to Sortino and Price (1994)) as an alternative performance measure to

check the robustness of our findings.

In practice, the most typical recommended size of the averaging window amounts to 10-12

months (see, among others, Brock et al. (1992), Faber (2007), Moskowitz et al. (2012), and

Clare et al. (2013)). However, empirical evidence suggests that there are large time-variations

in the optimal size of the averaging window for each trading rule. Therefore, we require that

a robust moving average weighting scheme must generate a sustainable performance over a

broader manifold of horizons, from 4 to 18 months. That is, to find a robust moving average

we vary k ∈ [4, 18]. Note that the number of alternative sizes of the averaging window amounts

to m = 15.

Technical analysis is based on a firm belief that there are recurrent regularities, or patterns,

in the stock price dynamics. In other words, “history repeats itself”. Based on the paradigm

of historic recurrence, we expect that in the subsequent future time period the stock price

dynamics (one possible market scenario) will represent a repetition of already observed stock

price dynamics over a past period of the same length.12 The problem is that we do not know
12
It is worth noting that very popular nowadays block-bootstrap methods of resampling the historical data
are based on the same historic recurrence paradigm. Specifically, block-bootstrap is a non-parametric method
of simulating alternative historical realizations of the underlying data series that are supposed to preserve all
relevant statistical properties of the original data series. In this method the simulated data series are generated
using blocks of historical data. For a review of bootstrapping methods, see Berkowitz and Kilian (2000). Block-
bootstrap is now widely used to draw statistical inference on the performance of active trading strategies (see,
for example, Sullivan et al. (1999)).

22
what part of the history will repeat in the nearest future. Therefore we want that a robust

moving average weighting scheme generates a sustainable performance over all possible histor-

ical realizations of the stock price dynamics. We follow the most natural and straightforward

idea and split the total sample of historical data into n smaller blocks of data. These blocks

of historical data are considered as possible variants of the future stock price dynamics.

We need to make a choice of a suitable block length that should preferably include at least

one bear market. Our choice is to use the block length of l = 120 months (10 years) and is

partly motivated by the results reported by Pagan and Sossounov (2003). In particular, these

authors analyzed the properties of bull and bear markets using virtually the same dataset as

ours. The mean durations of the bull and bear markets are found to be 25 and 15 months

respectively. Therefore with the block length of 10 years we are almost guaranteed to cover a

few alternating bull and bear markets. In order to increase the number of blocks of data and

to decrease the performance dependence on the choice of the split points between the blocks

of data, we use 10-year blocks with a 5-year overlap between the blocks. Specifically, the first

block of data covers the 10-year period from January 1860 to December 1869; the second block

of data covers the 10-year period from January 1865 to December 1874; etc. As a result of this

partition, the number of 10-year blocks amounts to n = 30.

The generation of different shapes of the moving average weighting scheme is based on

the following idea. Even though there are various trading rules based on moving averages of

prices and various types of moving averages, there are basically only three types of the shape of

weighting scheme: equal weighting of price changes (as in the MOM rule), underweighting the

most old price changes (as in the P-MA rule or in the most ∆MA rules), and underweighting

both the most recent and the most old price changes (as in the DCM). In order to generate

these shapes, we will employ three types of weighting schemes based on exponential moving

averages: (1) convex EMA weighting scheme produced by ∆EMA(k) trading rule, (2) concave

EMA weighting scheme produced by P-REMA(k) trading rule, and (3) hump-shaped EMA

weighting scheme produced by DCM(s, k). There is an uncertainly about the proper choice

of the size of the shorter window s in the DCM rule. Since the most popular combination in
1
practice is to use a 200-day long window and a 50-day short window, we set s = 4k for all

values of k.

For some fixed number of price change lags k, the shape of each moving average weighting

23
 0.20 0.08
Decay, λ Decay, λ

0.8 0.6

0.9 0.9
0.15 0.06
Weight

Weight
0.10 0.04

0.05 0.02

0.00 0.00

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17
Lag Lag

Panel A: Convex EMA weighting scheme Panel B: Concave EMA weighting scheme

Decay, λ
0.15
0.7

0.9

0.10
Weight

0.05

0.00

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17
Lag

Panel C: Hump-shaped EMA weighting scheme

Figure 2: The types of the moving average weighting schemes used for finding a robust moving
average. Panel A illustrates the convex exponential moving average weighting scheme pro-
duced by ∆EMA(k) trading rule. Panel B illustrates the concave exponential moving average
weighting scheme produced by P-REMA(k) trading rule. Panel C illustrates the hump-shaped
exponential moving average weighting scheme produced by DCM(s, k) trading rule. λ denotes
the decay factor. In all illustrations the number of price changes k = 18. Lag denotes the
weight of the lag ∆Pt−i , where Lag0 denotes the most recent price change ∆Pt−1 and Lag17
denotes the most oldest price change ∆Pt−18 .

scheme depends on the value of the decay factor λ. In order to generates many different shapes

of the weighting function, in each trading rule we vary the value of λ ∈ {0.00, 0.99} with a step

of ∆λ = 0.01. As a result, for each type of the EMA we get 100 different shapes. Since we

have three different types of the EMA, the total number of generated shapes amounts to 300.

As a result, we obtain 300 different trading strategies; each strategy is specified by a particular

shape of the moving average weighting scheme. Figure 2 illustrates the shapes of each type

of weighting schemes for two arbitrary values of λ. Both convex and concave EMA weighting

schemes underweight the most old price changes. Yet, whereas in the convex EMA the weight

of the price lag i is a convex exponential function with respect to i (see equation (38)), in the

concave EMA the weight of the price lag i is a concave exponential function with respect to i

24
(see equation (33)). It is worth repeating (recall the discussion in Section 3.6) that by varying

the value of λ from 0 to 1, the weighting scheme of the concave EMA varies from the equal

weighting scheme to the linear weighting scheme; the weighting scheme of the convex EMA

varies from the very extreme overweighting (where only the most recent price change has a

non-zero weight) to the linear weighting scheme.

The choice of the most robust moving average weighting scheme is made using the following

method. We fix the size of the averaging window and simulate all trading strategies over the

total sample. Subsequently, we measure and record the performance of every moving average

weighting scheme over each block of data. In each block of data, we then rank the performances

of all alternative moving average weighting schemes. In particular, the weighting scheme with

the best performance in a block of data is assigned rank 1 (highest), the one with the next best

performance is assigned rank 2, and then down to rank 300 (lowest). After that, we change

the size of the averaging window, k, and repeat the procedure all over again. In the end, each

moving average weighting scheme receives n × k = 30 × 15 = 450 ranks; each of these ranks is

associated with the weighting scheme’s performance for some specific block of data and some

specific size of the averaging window. Finally we compute the median rank for each moving

average weighting scheme. We assume that the most robust moving average weighting scheme

has the highest median rank. That is, the most robust moving average weighting scheme is

that one that has the highest median performance rank across different historical sub-periods

and different sizes of the averaging window. Note that since we use the median rank instead

of the average rank, and since we use ranks instead of performances, we avoid the outliers

issue (when an extraordinary good performance in some specific historical period influences

the overall performance).

4.3 Empirical Results

Table 1 reports the top 10 most robust moving average weighting schemes in our study. 7 out

of 10 top most robust weighting schemes belong to the family of the convex EMA (produced

by ∆EMA trading rule) where the decay factor λ ∈ [0.85, 0.91] with a step of 0.01. The most

robust weighting scheme is the convex EMA with λ = 0.87. The other 3 out of 10 top most

robust weighting schemes belong to the family of the concave EMA (produced by P-REMA

trading rule) where the decay factor λ ∈ {0.99, 0.73, 0.79}. It is worth noting that the use

25
 Rank Weighting scheme Decay, λ
1 CV-EMA 0.87
2 CV-EMA 0.88
3 CV-EMA 0.89
4 CV-EMA 0.90
5 CC-EMA 0.99
6 CC-EMA 0.73
7 CV-EMA 0.86
8 CV-EMA 0.91
9 CC-EMA 0.79
10 CV-EMA 0.85

Table 1: Top 10 most robust moving average weighting schemes out of total 300 tested. CV-
EMA denotes the convex EMA weighting scheme produced by ∆EMA trading rule. CC-
EMA denotes the concave EMA weighting scheme produced by P-REMA trading rule.

of the concave EMA weighting scheme for price changes with λ = 0.99 is virtually identical

to the use of the most popular among practitioners P-SMA trading rule. Thus, the P-SMA

rule employs a robust moving average which belongs to the top 5 most robust moving average

weighting schemes in our study.

The most robust weighting scheme in our study is also “robust” with respect to the perfor-

mance measure used, the segmentation of the total historical sample into blocks of data, and

the amount of transaction costs. Specifically, we used the Sortino ratio instead of the Sharpe

ratio and obtained the same results. We also tried different segmentations of blocks of data:

used 5- and 10-year non-overlapping blocks, used 5-year blocks with 2- and 3-year overlap. We

varied the amount of one-way proportional transaction costs in the range 0.0-0.5%. In each

case we arrived to the same most robust moving average weighting scheme.

In order to demonstrate the advantages of the robust moving average, we compare its

performance with that of 4 benchmarks. The first benchmark is the passive buy-and-hold

strategy. The other 3 benchmarks are the MOM rule (obtained by the P-REMA rule with

λ = 0.00), the P-SMA rule (proxied by the P-REMA rule with λ = 0.99), and the DCM

(given by two convex EMA with λ = 0.90). Table 2 reports the annualized Sharpe ratios of

the passive market and active trading strategies versus the size of the moving average window.

The active strategies are simulated over the period from January 1860 to December 2014. The

size of the averaging window is varied from 4 months to 18 months.

Our first observation is that the trading rule with the (most) robust moving average showed

26
 Window, Weighting scheme
months Market Robust MOM P-SMA DCM
4 0.38 0.47 0.50 0.44 0.44
5 0.38 0.55 0.57 0.51 0.48
6 0.38 0.48 0.49 0.50 0.52
7 0.38 0.55 0.53 0.52 0.49
8 0.38 0.54 0.50 0.52 0.48
9 0.38 0.55 0.50 0.54 0.49
10 0.38 0.53 0.55 0.54 0.48
11 0.38 0.54 0.49 0.56 0.50
12 0.38 0.53 0.48 0.53 0.51
13 0.38 0.53 0.45 0.53 0.52
14 0.38 0.51 0.43 0.54 0.50
15 0.38 0.50 0.44 0.54 0.49
16 0.38 0.53 0.41 0.54 0.50
17 0.38 0.52 0.38 0.52 0.49
18 0.38 0.55 0.38 0.50 0.48
Median 0.38 0.53 0.49 0.53 0.49
Mean 0.38 0.53 0.47 0.52 0.49

Table 2: Annualized Sharpe ratios of the passive market and active trading strategies versus
the size of the moving average window. Market denotes the passive market strategy. Robust
denotes the convex EMA weighting scheme with λ = 0.87. MOM denotes the momentum
rule. P-SMA denotes the price-minus-simple-moving-average rule. DCM denotes the double-
crossover method where the moving averages in both the short and long window are computed
using the convex EMA with λ = 0.9. The active strategies are simulated over the period from
January 1860 to December 2014. For each size of the averaging window, bold text indicates
the weighting scheme with the best performance.

the best performance only for 4 out of 15 alternative sizes of the averaging window. The P-

SMA rule scored the best for 6 out of 15 sizes of the averaging window. However, the robust

moving average generates the best median and mean performances.13

Our second observation is that the MOM rule generates a good performance only when

the size of the averaging window is relatively short. Specifically, when k ∈ [4, 5] the MOM

rule generates the best performance; when k ∈ [6, 10] the performance of the MOM rule is

rather good. However, when the size of the averaging window increases beyond 10 months, the

performance of the MOM rule starts to deteriorate. In contrast, the performance of the robust

moving average and the P-SMA rule remains stable when the size of the averaging window

increases. All this suggests that indeed, as many traders argue, the most recent stock prices
13
In Table 2, due to rounding the value of a Sharpe ratio to a number with 2 digits after the decimal delimiter,
sometimes we do not see the difference in performances. Yet the bold text indicates the trading rule with the
best performance.

27
 Weighting scheme 0.15 Weighting scheme

Robust Robust
0.3
P−SMA P−SMA

0.10
Weight

Weight
0.2

0.05
0.1

0.0 0.00

0 1 2 3 0 1 2 3 4 5 6 7 8 9 10 11
Lag Lag

Panel A: Averaging window of 4 months Panel B: Averaging window of 12 months

Figure 3: The shape of the robust moving average weighting scheme versus the shape of the
weighting scheme in the P-SMA trading rule. Panel A illustrates the shapes when the size of
the averaging window amounts to k = 4 months. Panel B illustrates the shapes when the size
of the averaging window amounts to k = 12 months. Lag denotes the weight of the lag ∆Pt−i ,
where Lag0 denotes the most recent price change ∆Pt−1 .

(or price changes) contain more relevant information on the future direction of the stock price

than earlier stock prices. We conjecture that there are probably substantial time-variations in

the optimal size of the moving averaging window and the optimal weighting scheme. It is quite

probable that the MOM rule allows a trader to generate the best performance when the trader

knows the optimal size of the averaging window. But because there is a big uncertainly about

the optimal window size, underweighting the most old prices makes the moving average to be

robust. That is, underweighting the most old prices allows the weighting scheme to generate

sustainable performance even if the size of the averaging window is way above the optimal

size. In principle, either in the robust moving average or in the P-SMA rule we can extend the

size of averaging window beyond 18 months without any noticeable performance deterioration,

because the weights of the old prices diminish quite fast and approach zero as the size of the

averaging window increases.

It is worth emphasizing that the shape of the robust moving average weighting scheme

differs from the shape of the weighting scheme in the P-SMA trading rule mainly when the

size of the averaging window is short. Figure 3 illustrates the shape of the robust moving

average weighting scheme versus the shape of the weighting scheme in the P-SMA trading

rule for two different sizes of the averaging window: 4 and 12 months. When the size of the

averaging window is 12 months, there are only marginal differences between the two weighting

schemes. In contrast, when the size of the averaging window is 4 months, the shape of the

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robust weighting scheme is somewhere in between the shapes of the weighting schemes in the

MOM and P-SMA rules. That is, when the size of the averaging window is rather short, the

robust weighting scheme underweights older price changes to a lesser degree as compared with

that in the P-SMA rule.

To further demonstrate the advantages of the robust moving average, Table 3 reports

the rank of the robust moving average weighting scheme together with the ranks of the 3

active benchmark strategies for each 10-year period out of 30 overlapping periods. The active

benchmark strategies are the same as above: the MOM rule, the P-SMA rule, and the DCM.

We remind the reader that in our study there are totally 300 alternative weighting schemes.

As a result, the rank of a weighting scheme can be any integer number from 1 to 300. To

compute the ranks in this table, we use the size of the averaging window of 10 months. It

is worth noting that with this window size the best overall performance, among 4 competing

moving averages (see Table 2), is generated by the MOM rule; the second best by the P-SMA

rule; the robust moving average scores 3rd; the DCM has the worst performance. However,

the robust weighting scheme has the highest median rank and the second highest mean rank.

Even though the MOM rule generates the best performance over the total historical sample,

its median rank over all sub-periods, and especially the mean rank, is noticeable below those

of the robust moving average. Specifically, the mean rank of the MOM rule is higher than its

median rank. This tells us that the distribution of the performances of the MOM rule over sub-

periods is right-skewed. Apparently, the superior performance of the MOM rule tends to be

generated mainly over a few historical sub-periods. In contrast, for the robust moving average

the mean rank is virtually identical to the median rank. This tells us that the distribution of

the performances of the robust moving average over sub-periods is symmetrical. Finally, we

observe that out of 4 competing rules, the P-SMA rule most often outperforms the other rules

in sub-periods. Specifically, it is the best performing rule in 11 out of 30 sub-periods. Besides,

the P-SMA rule has the highest mean rank. Yet, the robust moving average has the highest

median rank over all sub-periods.

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 Weighting scheme
Period Robust MOM P-SMA DCM
1860 - 1869 206 164 76 30
1865 - 1874 169 5 290 285
1870 - 1879 137 5 228 271
1875 - 1884 112 102 114 143
1880 - 1889 51 109 127 103
1885 - 1894 113 108 172 36
1890 - 1899 198 62 216 152
1895 - 1904 133 164 77 278
1900 - 1909 91 218 129 100
1905 - 1914 125 108 253 114
1910 - 1919 160 221 156 209
1915 - 1924 3 124 25 193
1920 - 1929 2 107 63 229
1925 - 1934 93 27 130 255
1930 - 1939 116 26 109 246
1935 - 1944 273 199 62 127
1940 - 1949 286 171 150 296
1945 - 1954 61 126 5 143
1950 - 1959 19 181 1 101
1955 - 1964 58 249 7 210
1960 - 1969 124 212 119 268
1965 - 1974 108 88 46 168
1970 - 1979 92 206 38 12
1975 - 1984 158 256 41 3
1980 - 1989 79 189 42 145
1985 - 1994 2 64 152 127
1990 - 1999 90 14 186 97
1995 - 2004 112 63 116 125
2000 - 2009 14 111 18 154
2005 - 2014 103 237 63 121
Median 110 117.5 111.5 144
Mean 109.6 130.5 107.0 158.0

Table 3: Ranks of the four alternative trading rules over 10-year historical periods with 5-year
overlap. The total number of tested rules amounts to 300. As a result, the rank of a trading
rule can take any integer number from 1 to 300. The trading rules are ranked according to
their performance; the best performing rule is assigned the 1st rank, the worst performing
rule is assigned the 300th rank. In all trading rules the size of averaging window amounts to
k = 10 months. Robust denotes the convex EMA weighting scheme with λ = 0.87. MOM
denotes the Momentum rule. P-SMA denotes the Price-Minus-Simple-Moving-Average rule.
DCM denotes the Double-Crossover method where the moving averages in both the short and
long window are computed using the convex EMA with λ = 0.9. For each sub-period, bold
text indicates the weighting scheme with the highest rank (i.e., best performance) among the
4 alternative weighting schemes.

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5 Conclusions

In this paper we presented the methodology to study the computation of trading indicators in

many market timing rules based on moving averages of prices and analyzed the commonalities

and differences between the rules. Our analysis revealed that the computation of every technical

trading indicator considered in this paper can equivalently be interpreted as the computation

of the weighted average of price changes over the averaging window. Despite a great variety

of trading indicators that are computed seemingly differently at the first sight, we found that

the only real difference between the diverse trading indicators lies in the weighting scheme

used to compute the moving average of price changes. The most popular trading indicators

employ either equal-weighting of price changes, overweighting the most recent price changes, or

a hump-shaped weighting scheme with underweighting both the most recent and most distant

price changes. The trading indicators basically vary only by the degree of over- and under-

weighting the most recent price changes.

As a practical application of our analysis, in this paper we also proposed and implemented

the novel method of selecting the moving average weighting scheme to use for the purpose of

timing the market. The criterion of selection was to choose the most robust moving average.

Robustness of a moving average was defined as its insensitivity to outliers and its ability to

generate sustainable performance under all possible market scenarios regardless of the size of

the averaging window. We performed the search over 300 different shapes of the weighting

scheme using 15 feasible sizes of the averaging window and many alternative segmentations of

the historical stock price data. Our results suggest that the convex exponential moving average

with the decay factor of 0.87 (for monthly data) represents the most robust weighting scheme.

We also found that the popular Price-Minus-Simple-Moving-Average trading rule belongs to

the top 5 most robust moving averages in our study.

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