A moving average always lags the price action. In this figure, look at the prices and moving average in the left-hand ellipse. From the peak close, it takes the price six days to cross below the moving average — and ten days for the value of the moving average to be lower than the day before. By the time the moving average puts in a lower value than the day before, it’s Day 10 and the price has fallen from $82.49 to $75.38, or by 8.6 percent.
But despite giving up 8.6 percent from the highest close while you wait for the moving average to catch up with prices, to trade this stock by using this indicator during this period would have been profitable.The black arrows on the chart in the preceding figure mark the buy/sell entry and exit points, using the moving average level rule. You buy and sell at the open the day after the moving average meets the rule.
This table shows the profit you make by applying the rule. Your gain is $43.07 on an initial capital stake of $71.05, or 61 percent, compared to 14 percent if you buy on the first date and account for the gain on the last date (called mark-to-market).
This is a classic example of the technical trader mindset; you have an indicator-based trading rule, in this case the price crossing the moving average. You make buy/sell decisions on that rule without regard for the fundamentals of the security. You keep track of the gains and losses associated with the trading rule (and some day may want to alter the indicator parameters). That’s technical analysis in a nutshell — indicators built on bars, trading rules based on indicators, following the trading rules strictly, and keeping track of the results.
| Hypothetical Profit from the Moving Average Level Rule | ||||
| No. of Days | Action | Price | Level Rule Profit | Buy-and-Hold |
| 22 days | Buy | $71.05 | $71.05 | |
| Sell | $78.24 | $7.19 | ||
| 42 days | Sell | $78.24 | ||
| Buy | $61.54 | $16.70 | ||
| 29 days | Buy | $61.54 | ||
| Mark-to-market | $80.72 | $19.18 | $80.72 | |
| Total | $43.07 (61%) | $9.67 (14%) | ||
Be on the lookout for trading system vendor performance track records that rely on mark-to-market gains for wonderful end-of-period gains. Mark-to-market gains are only paper gains and can vanish in a puff of smoke. To evaluate a technique, look at its performance on closed trades.