Connors Research Trading Strategy Series  Trading Stocks and  Options with  Moving Averages ‐  A Quantified  Approach  By  Connors Research, LLC  Laurence Connors   Matt Radtke    www.forex-warez.com | skype: andreybbrv | [email protected] P a g e | 2    Copyright © 2013, Connors Research, LLC. ALL RIGHTS RESERVED. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the publisher and the author. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with the understanding that the author and the publisher are not engaged in rendering legal, accounting, or other professional service. Authorization to photocopy items for internal or personal use, or in the internal or personal use of specific clients, is granted by Connors Research, LLC, provided that the U.S. $7.00 per page fee is paid directly to Connors Research, LLC, 1-973-494-7333. ISBN 978-0-9886931-7-3 Printed in the United States of America. This document cannot be reproduced without the expressed written permission of Connors Research, LLC. Copyright © 2013, Connors Research, LLC. All Rights Reserved.   www.forex-warez.com | skype: andreybbrv | [email protected] P a g e | 3    Disclaimer By distributing this publication, Connors Research, LLC, Laurence A. Connors and Matt Radtke (collectively referred to as “Company") are neither providing investment advisory services nor acting as registered investment advisors or broker-dealers; they also do not purport to tell or suggest which securities or currencies customers should buy or sell for themselves. The analysts and employees or affiliates of Company may hold positions in the stocks, currencies or industries discussed here. You understand and acknowledge that there is a very high degree of risk involved in trading securities and/or currencies. The Company, the authors, the publisher, and all affiliates of Company assume no responsibility or liability for your trading and investment results. Factual statements on the Company's website, or in its publications, are made as of the date stated and are subject to change without notice. It should not be assumed that the methods, techniques, or indicators presented in these products will be profitable or that they will not result in losses. Past results of any individual trader or trading system published by Company are not indicative of future returns by that trader or system, and are not indicative of future returns which be realized by you. In addition, the indicators, strategies, columns, articles and all other features of Company's products (collectively, the "Information") are provided for informational and educational purposes only and should not be construed as investment advice. Examples presented on Company's website are for educational purposes only. Such set-ups are not solicitations of any order to buy or sell. Accordingly, you should not rely solely on the Information in making any investment. Rather, you should use the Information only as a starting point for doing additional independent research in order to allow you to form your own opinion regarding investments. You should always check with your licensed financial advisor and tax advisor to determine the suitability of any investment. HYPOTHETICAL OR SIMULATED PERFORMANCE RESULTS HAVE CERTAIN INHERENT LIMITATIONS. UNLIKE AN ACTUAL PERFORMANCE RECORD, SIMULATED RESULTS DO NOT REPRESENT ACTUAL TRADING AND MAY NOT BE IMPACTED BY BROKERAGE AND OTHER SLIPPAGE FEES. ALSO, SINCE THE TRADES HAVE NOT ACTUALLY BEEN EXECUTED, THE RESULTS MAY HAVE UNDER- OR OVER-COMPENSATED FOR THE IMPACT, IF ANY, OF CERTAIN MARKET FACTORS, SUCH AS LACK OF LIQUIDITY. SIMULATED TRADING PROGRAMS IN GENERAL ARE ALSO SUBJECT TO THE FACT THAT THEYARE DESIGNEDWITH THE BENEFIT OF HINDSIGHT. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN. Connors Research 10 Exchange Place Suite 1800 Jersey City, NJ 07302     This document cannot be reproduced without the expressed written permission of Connors Research, LLC. Copyright © 2013, Connors Research, LLC. All Rights Reserved.   www.forex-warez.com | skype: andreybbrv | [email protected] P a g e | 4    Table of Contents   Section 1 Introduction ............................................................................. 5   Section 2 Strategy Rules ........................................................................... 8   Section 3 Test Results ............................................................................ 15   Section 4 Selecting Strategy Parameters ............................................... 21   Section 5 Using Options ......................................................................... 25   Section 6 Additional Thoughts ............................................................... 29   Appendix:  The ConnorsRSI Indicator and Historical Volatility .............. 31     This document cannot be reproduced without the expressed written permission of Connors Research, LLC. Copyright © 2013, Connors Research, LLC. All Rights Reserved.   www.forex-warez.com | skype: andreybbrv | [email protected] P a g e | 5    Section 1  Introduction        This document cannot be reproduced without the expressed written permission of Connors Research, LLC. Copyright © 2013, Connors Research, LLC. All Rights Reserved.   www.forex-warez.com | skype: andreybbrv | [email protected] P a g e | 6    Indicators are not always what they appear to be. Moving averages are widely used as a trend‐following  tool. In many of the trading strategies that we have developed over the years, the 200‐day moving  average (MA) is used to identify the direction of the trend. We have found that taking buy signals only  when the price is above the 200‐day MA can improve profitability in many systems.  Recently, we completed research that shows moving averages can also be used as part of a strategy to  find short‐term, mean reversion trading opportunities. This may be surprising to some traders because it  might seem odd to use a trend‐following indicator like MAs in a short‐term, mean reversion strategy.   While MAs are used in this strategy, the MA is not being applied in its traditional way. As we highlighted  in the 2004 book How Markets Really Work, it is important to develop unique insights into the behavior  of prices.  In How Markets Really Work, we tested common knowledge and discovered it was not always best to  follow widely accepted market truths. We found that it was best to buy short‐term weakness, for  example, and research showed that selective buying when market breadth was poor was more  profitable than buying when market breadth indicators were uniformly positive. We also discovered that  changes in volume were irrelevant to making buy and sell decisions despite the widespread belief  among traders that volume is needed to confirm an uptrend.  We have continued that type of research and we always look at data rather than widely accepted truths.  In doing so, we found that moving averages (MAs) can be used as short‐term timing tools.  Traditionally, MAs are usually used as trend‐following tools. Buy signals are given when prices close  above the MA and sell signals result from closes below the MA. While they can be used profitably in this  way, there are also a number of problems associated with MAs.   When a market is range‐bound, which is most of the time, traders experience a number of whipsaw  trades while waiting for the next trend to emerge. Whipsaw trades are entries that are quickly reversed.  Commissions and other trading costs can be substantial when prices whip back and forth around the  moving average and those costs decrease profits.  Signals based on MAs will also always be late. This is by design since MAs trail the market. However,  these delays can lead to missing large price moves. The price of SPDR S&P 500 ETF (NYSE: SPY) increased  more than 30% after bottoming in March 2009, for example, before long‐term MAs gave buy signals.   Systems based on MAs generally have low win rates and a majority of the system profits come from only  a few of the trades. Most trades end in only small gains or losses that result from whipsaws.   These problems make MAs difficult to trade. In back‐testing over long periods, they seem to be  profitable but in real‐time, the delayed signals and large number of losing trades lead many traders to  abandon the system.  We viewed the problems of MAs as an opportunity to develop a trading system based on mean  reversion.   This document cannot be reproduced without the expressed written permission of Connors Research, LLC. Copyright © 2013, Connors Research, LLC. All Rights Reserved.   www.forex-warez.com | skype: andreybbrv | [email protected] P a g e | 7    Whipsaws are caused by the binary nature of the MA system. It is always either in or out of the market,  or is always long or short, based on the interaction of the MA with prices. We can reduce this problem  by defining rules that only take high probability trades. Many markets are untradeable the majority of  the time and rules can be designed to recognize when the market is at an extreme and trade only under  the right conditions.    Another weakness of MA systems is that they give back large amounts of profits after the trend reverses  before they exit or they require delays that miss large profits before entering trades. This is caused by  the fact that prices move significantly away from the MA when markets are trending. Some traders  address this problem by closing trades when prices deviate too far from an MA, which leads to another  problem because strong trends will be missed and the profitability of the system will be reduced. We  address the problem of by using two MAs which minimizes the delays at turning points.  All of the strategy rules are fully detailed in the next section. This is a powerful new way to use MAs that  can deliver profits in any market.  We hope you enjoy this next installment of the Connors Research Trading Strategy Guidebook Series. If  you would like to see more topics from our Strategy Research Series please click here.        This document cannot be reproduced without the expressed written permission of Connors Research, LLC. Copyright © 2013, Connors Research, LLC. All Rights Reserved.   www.forex-warez.com | skype: andreybbrv | [email protected] P a g e | 8      Section 2 Strategy Rules  This document cannot be reproduced without the expressed written permission of Connors Research, LLC. Copyright © 2013, Connors Research, LLC. All Rights Reserved.   www.forex-warez.com | skype: andreybbrv | [email protected] P a g e | 9    Moving averages are generally used to follow the trends. Some traders will use MAs to help identify  overbought or oversold markets. This approach usually involves identifying when the price has moved  too far from the MA.  To determine when prices are too far from an MA, channels, based on  percentages or standard deviations, are often added to the MA. Channels fail to identify strength and  are invariably wrong during the market’s largest advances or declines.  The Quantified Moving Average Strategy uses two moving averages to reduce the probability of being  wrong at major market turns. Both moving averages will move along with prices and the relationship  between the two averages will highlight oversold market extremes.   This strategy executes trades using a simple three‐step process consisting of Setup, Entry and Exit. The  rules for each of these steps are detailed below.  A Quantified Moving Average Strategy Setup occurs when all of the following conditions are true:  1. The stock’s price must be above $5.  2. The stock’s average daily volume over the past 21 trading days (approximately one month)  must be at least 250,000 shares.   3. The historical volatility over the past 100 days, or HV(100), must be greater than 30. (See the  Appendix for a definition of historical volatility).  4. Today’s close must be above the 200‐day moving average, or MA(200).  5. The fast MA is at least Y% below the slow MA where Y = 2.5, 5.0, 7.5, or 10.0%. The  following MA scenarios will be tested:  Scenario Fast MA Slow MA 1 MA(C,5) MA(C,10) 2 MA(C,5) MA(C,20) 3 MA(C,5) MA(C,50) 4 MA(C,10) MA(C,20) 5 MA(C,10) MA(C,50)   If the previous day was a Setup, then we Enter a trade by:  6. Submitting a limit order to buy the stock at a price X% below yesterday’s close,   where X is 2, 4, 6, 8 or 10%.  After we’ve entered the trade, we Exit using one of the following methods, selected in advance:  7a. The closing price of the stock is higher than the previous day’s close. We typically refer to  this exit as the First Up Close.  7b.  The stock closes with a ConnorsRSI value greater than 50.  7c. The stock closes with a ConnorsRSI value greater than 70.  7d. The closing price of the stock is greater than the 3‐day moving average, or MA(3).  7e. The closing price of the stock is greater than the 5‐day moving average, or MA(5).  This document cannot be reproduced without the expressed written permission of Connors Research, LLC. Copyright © 2013, Connors Research, LLC. All Rights Reserved.   www.forex-warez.com | skype: andreybbrv | [email protected] P a g e | 10        Let’s look at each rule in a little more depth, and explain why it’s included in the strategy.   Rules 1 & 2 assure that we’re in highly liquid stocks which can be readily bought and sold with tight  bid/ask spreads that reduce trading costs.  Rule 3 assures that the stock has enough volatility to allow for large moves.  Rule 4 identifies the direction of the long‐term trend. By requiring the close to be above the 200‐day  MA, we are finding stocks that are oversold but remain in a long‐term uptrend.  Rule 5 identifies short‐term oversold extremes.  Rule 6 allows us to enter the trade at an optimal price. The Setup rules identify an oversold stock and  the entry rule waits for it to become even more oversold on an intraday basis.   Rule 7 provides a well‐defined exit method. Few strategies have quantified, structured, and disciplined  exit rules. Rule 7 gives you the exact parameters to exit the trade, backed by over 12.75 years of  historical test results. As with all other strategy parameters, we select in advance the type of exit that  we will use, and apply that rule consistently in our trading.  Rules 7b and 7c use ConnorsRSI to define the exit. In the past, many of our strategies used a 2‐day RSI,  or RSI(2) to identify overbought and oversold conditions. Our recent research has shown ConnorsRSI to  be a more effective indicator. If you’re not familiar with ConnorsRSI, details can be found in the  Appendix.  In our testing we closed all trades at the close of trading on the day that the Exit signal occurred. If this is  not an option for you, our research has generally shown that similar results are achieved if you exit your  positions at or near the open the next morning.  Now let’s see how a typical trade looks on a chart.   For the example below, we’ll use a strategy variation that requires the 5‐day MA to be more than 10%  below the 20‐day MA on the Setup day. The limit order will be placed 6% below the Setup day’s closing  price. We will exit when the ConnorsRSI is greater than 70, the exit method defined by Rule 7c.  This document cannot be reproduced without the expressed written permission of Connors Research, LLC. Copyright © 2013, Connors Research, LLC. All Rights Reserved.   www.forex-warez.com | skype: andreybbrv | [email protected]