Trading Stocks and Options with Moving Averages - A Quantified Approach

40 Pages·2013·1.06 MB·English

by  Larry Connors

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]