Introduction to simple moving average signal generation
One method to generate a signal is react on cross overs between the index and its simple moving average (index cross over). If the index (or stock price) cross its moving average line from top downwards, this is seen as a signal to sell. If the index crosses the average from down upwards this is seen as a buy signal.
Now where does the name ‘simple’ moving average come from? Because the average is calculated in a simple way by just using the arithmetic average of all values, as opposed to other movering average calculation methos e.g. the exponential one. With the simple moving average you just add all days of your timewindows N and then divide this sum through N to get the simple average.
In figure 1 you see the DAX index and its simple moving average calculated with a 150 day time window. Now what would have happened if we just bought the index at the begin of the chart time and hold until the end? Well at the beginning it stands at ca. 5000 points, at the end it has 4100 Points, while its lowest point was at 2500 points. So with Buy & Hold you have earned a -18%.
Now if we would have used the index cross over to trade in this chart, you have left the investment at about 5000 points, and reinvested at about 2900 Points, so at the end you stand there with a nice win of about +41%.
Really looks simple huh? Of course it is if you choose a good example. :) What wasnt considere that there are many small cross overs which occurred. These have to be seen as false signals, you are signaled to trade although the real trend of the index has not changed, caused by little spikes in the price index crossing the moving average. This is problematic because every trade causes costs through order fees and taxes.
Figure 2 shows a chart where Buy and Hold did a better job then the trade system with the moving average of 150 days. With Buy & Hold the get the whole rise from 2600 at the start to 4200 points at the end, so +60%. With the moving average you invest later at ca. 2900 points and then sell and buy back a few times because the average gets crossed several times, so you end up with a worse result.