Moving Averages as a Forecasting Indicator

There is reason for caution when analysts tell you that moving averages forecast price movement

Many analysts still claim that moving averages can be used to forecast the subsequent day's movement. I'm not sure why this is considered true as none of the tests I have ever done suggest that they are anything less than poor at the role. In fact, almost certainly they would lose money when used in this fashion.

Let me go through a test to highlight the numbers and the risk of loss.

The first test is a simple trading strategy. If the moving average closes higher then the strategy will buy at the next day's opening price and exit at close. In fact, just to try and discover the best parameter for Dollar-Yen I optimized the period used on a daily chart over 5 years from 2002 to 2006 and fount the very best period was a 7 day exponential moving average. The results can be summarized as follows:

Year Profit (in points)
2002: 1,299
2003: (664)
2004: 1,775
2005: (224)
2006: (840)

Total: 2,568

Maximum drawdown: 1,343 points (maximum loss from the equity high point)
% of winning trades: 50.89%
Average Profit: 50 points
Average Loss: 48 points
Ratio of profit/loss: 1 : 1.04

Let's just look at the numbers. First of all the net total over 5 years represents about 500 points a year. If we use a conservative 5x leverage it will represent an approximate 22.5% return a year on average. Not too shabby.

Now let's look at the maximum drawdown, a massive 1,343 points which using the same leverage would have lost you 61% of your capital and would have severely restricted your ability to trade at the same leverage, not even to mention whether you would have just plain given up.

Let's look at something more damning. By necessity chart prices are constructed using the bid price only and thus you should always look at allowing for the 3 point spread. Let me add in a 3 point slippage. The figures now look like this:

Year Profit (in points)
2002: 537
2003: (1,435)
2004: 992
2005: (553)
2006: (840)

Total: (1,299)

Maximum drawdown: 2,181 points (maximum loss from the equity high point)
% of winning trades: 48.25%
Average Profit: 50 points
Average Loss: 48 points
Ratio of profit/loss: 1 : 1.03

Clearly in reality we would have probably made a loss just because of the bid/offer spread! What is more, the maximum drawdown of 2,181 points would have implied a loss of 99% of our capital!

I think that clearly shows that moving averages simply do not forecast the next day's movements. However, in addition to the above the results shown are from using the optimized period. In reality we wouldn't know the optimum period until after the fact and would have to hope that the period chosen would continue to make the same level of profits. I have met many traders who think this is a reasonable assumption.

Well, to dispel any such ideas let me show you the graph of the profit/loss across the range of optimization periods which I organized from 3 to 30:

Out of 28 periods used only 9 actually produced profit. The 7 period average made the most at 2,568 points (before allowing for the spread) while the next best profit was the 6 period average which only made 1,620 points. When allowing for the spread no period of moving average made any profit at all.

I hope this puts to rest the claim that moving averages can be used to forecast price.