One of the first types of systems that many people experiment with are simple moving average crossover systems. While there is a wide range of different parameters that quantitative traders can use to build these types of systems, the basic idea behind them is fairly straightforward. This is what makes simple moving average crossover systems so appealing.
One of the biggest problems with these types of systems is the amount of whipsaws that can be generated when a market is trading within a certain range. Jeff from System Trader Success recently posted a few different ways that simple moving average crossover systems could be enhanced in order to eliminate some of those whipsaws.
Jeff began his post by describing the baseline crossover system he would be using:
Our baseline system will consist of two simple moving averages (SMA) executed on a daily chart of the Euro futures.
I’m picking the Euro because it has demonstrated solid trending characteristics as opposed to the stock index markets which tend to be mean reverting.
If you will recall, signals are generated when a faster moving average (trigger SMA or trigger line) crosses a slower moving average (slow SMA or slow line).
Jeff sets his slow moving average to 50 and his fast moving average to 3 and backtests the simple system from May 2001 through the end of September 2013. The results indicate a profitable system that struggles with whipsaws at times.
The first method that he suggests to improve this is a delayed entry. He suggests waiting ten bars after the signal and then entering on the eleventh as long as the fast moving average does not cross back below the slow moving average. This forces the system to confirm its signal before taking a position:
The idea behind this method is if a new bull market is about to start, price should not fall back below the slow SMA.
In short, it’s another way to measure the amount of conviction for the next market phase. However, we will keep the exit the same
The results of this method reduce the overall profitability of the system, but also eliminate almost all of the whipsaws. The resulting equity curve is much smoother.
The next improvement Jeff suggests is another way to require confirmation of an entry signal:
For example, picture another band above the slow SMA that is 1 ATR above the slow SMA.
In order to open a new long position we require the trigger line to penetrate that ATR band above the slow line.
Now picture another band that is one ATR below the SMA.
This band represents our short trigger when we open a short position. We hope to eliminate some whipsaws by delaying our entry and forcing the market to show us some strength.
This method results in an equity curve that is somewhere in between the original and the first enhancement. This method allows the system to keep most of its returns, while reducing the volatility slightly.
Another method Jeff suggests is implementing a delay with a time decay feature:
Often you will notice a string of whipsaws on a moving average crossover system right after a great winning trade was closed. The market apparently is now morphing to a range bound market and will likely do this for sometime.
However, as the days or weeks wear on the likelihood of a breakout probably increases. Thus maybe we can reduce the delay amount as time goes by. After the close of a successful trade we begin looking for the next cross with our default X bar delay.
One final suggestion Jeff makes to enhance a simple moving average crossover system is probably the most obvious idea:
Maybe only taking long trades during a bull market or taking short trades during a bear market would improve results. This would be an interesting and simple test to perform.
None of these ideas on their own warrant the trading of real capital. However, they do a great job of encouraging traders to think about different ways to enhance their systems. The most successful systems are often very simple strategies that contain just a few key enhancements.