Trade Gold Using Moving Average Crossovers

Introduction to moving average crossovers

Moving averages are the most widely used indicators in technical analysis, and help smoothing out short-term fluctuations (or volatility) in order to highlight a longer-term trend. Traders classically use the past daily (or intraday) prices to compute their time series, applying different variations of moving averages. In this article, we are going to look at a basic momentum strategy looking at a simple moving average (SMA) crossovers as our signal to buy or sell the underlying asset, gold. In this strategy, traders build a trading signal based on moving average crossovers, by taking a long position if the shorter (faster) moving average is above the longer (slower) moving average, and a short position if the shorter moving average is below the longer moving average (see more here).

For instance, the famous terms ’Golden Cross’ and ’Death Cross’ result from crossovers of the 50 SMA and the 200 SMA. ’Death Cross’ is when the 50 SMA crosses the 200 SMA to the downside, signalling a potential long-term bear market on gold (figure 1).

Figure 1

Source Eikon Reuters

Which parameters should we use to build a SMA crossover strategy?

Even though the 50 and 200 SMAs are probably the most popular moving averages that investors tend to watch carefully, we first have to check if there have been different combinations in the past that have generated ‘enhanced’ returns. Therefore, using daily prices on gold, we look at different combinations of SMA crossovers, with the short SMA ranging from 2 to 50 and the long SMA ranging from 5 to 200. We then compute the Sharpe ratio of each of the combination, which we define as the ratio of the annualized returns over the annualized volatility of the entire sample:

As there are many different combinations, we decide to use a heatmap to detect if there are some ‘hot’ and ‘cold’ areas. How to read a heatmap is pretty straightforward:

  • The red areas are ‘hot’ areas, which implies that the SMA combinations have been working well in the past few years.
  • The green area are the ‘cold’ areas, which are the combination to avoid if you want to build a systematic strategy on gold using SMA crossovers.

In our first backtest, we look at the daily price of gold since 2016; results are shown in Heatmap 1A and 1B. It is important to know that the parameter of the short SMA cannot be bigger than the parameter of the long SMA (blue shaded area).

The ‘Death Cross’ strategy stands at the bottom right of the entire heatmap (Heatmap 1B) and has generated a Sharpe ratio of 0.75 over the past four years, which is less than the ‘long-only’ strategy (long GLD) with a Sharpe ratio of 0.87. The combination that has generated the highest performance is the (35,37) SMA crossovers, with a Sharpe ratio of 1.36.

Figure 2 (left frame) shows the equity curve of the long-only (GLD) versus the traditional ‘Death Cross’ and the (35,37) SMA crossovers. The (35,37) SMA crossover strategy shows that investors would have captured the late declining by going short GLD in the past few months. Figure 2 (right frame) shows the changes in signal for the two strategies; while the Death Cross strategy is very slow and has changed signals only 5 times in the past 5 years (currently sending a buying signal as 50D SMA is trading above the 200D SMA), the (35,37) has a higher frequency and has been sending a sell signal since mid-September to the exception of a few days. As we look at daily prices, we assume that the transaction costs are negligible for a commodity such as gold.

Heatmap 1. Sharpe ratios of SMA crossovers strategy using daily prices of gold since 2016

Heatmap 1A (Long SMA from 5 to 105)

Source: Eikon Reuters, RR calculations

Heatmap 1B (Long SMA from 105 to 200)

Source: Eikon Reuters. RR calculations

Figure 2

Source: Eikon Reuters, RR calculations

In our second backtest, we look at the daily price of gold since 2010 in order to capture the bearish momentum in gold prices that occurred in the first half of the last decade; results are shown in Heatmap 2A and 1B. First, we can notice that the Sharpe ratio are significantly lower, which is not surprising as gold consolidated sharply after reaching its previous high of in September 2011. The ‘Death Cross’ strategy has generated a Sharpe ratio of 0.29, which is again much lower than the ‘long-only’ strategy with a Sharpe ratio of 0.37.

The winner combination this is the (27,53) SMA crossover generating a Sharpe ratio of 0.64.

Figure 3 shows the equity curve of the long-only (GLD) versus the traditional ‘Death Cross’ and the (27,53) SMA crossovers. We can notice again that the Death Cross strategy have barely changed signals in the past decade.

Heatmap 2. Sharpe ratios of SMA crossovers strategy using daily prices of gold since 2010

Heatmap 2A (Long SMA from 5 to 105)

Source: Eikon Reuters, RR calculations

Heatmap 2B (Long SMA from 105 to 200)

Figure 3

Source: Eikon Reuters, RR calculations

Closing thoughts

Even though a lot of investors tend to focus significantly on the Death Cross 50/200 signal when defining bullish or bearish trends coming from momentum strategies, we have seen that this strategy has performed poorly in either the past 5 years or since 2010. We know that past performance does not guarantee future returns, but it is important to add the most powerful ‘quantitative tool’ to your fundamental analysis. At the moment, fundamentals signals on the GLD are mixed; on one hand, the weak USD and the large amount of negative-yielding debt are pricing in stronger GLD, but rising yields in the US could weigh on the pressure metal in the short run. As we saw in the article, the best combinations are also sending bearish signals on GLD.

V-shape equity recovery: a killer for momentum crossover strategies

Even though the financial markets recently experienced a variety of interesting events, the most surprising one was the fast recovery in equities since they hit their low on March 23rd. Figure 1 shows that the SP500 has pulled back to its 50% Fibo retracement of its yearly high-low range, experiencing one of its fastest rally after plunging by 35%. In addition, we saw that one popular technical indicator, the 50D-200D simple moving average crossover, has been forming a ‘death cross’ in the past, which traditionally indicates a bearish signal to market.

Figure 1

SP500

Source: Eikon Reuters

There are many popular momentum strategies based on MA crossovers (both simple and exponential), but the death cross vs. golden cross is a very known one for all asset classes and is closely followed by many market participants. It is a simple systematic strategy, that sends a positive signal when the short-term moving average (50D) trades above the LT MA (200D), which is also called a ‘Golden Cross Formation’, and sends a bearish when the ST MA trades below the LT MA (‘Death Cross Formation’).

Looking at 25 years of daily data, we compute the performance of the Long/Short strategy on the SP500 and compare it to the performance of the SP500 index. Figure 2 shows that the 50/200 crossover strategy generally performs well in periods of slowly trending market (either bull or bear markets), but experiences severe drawdowns in periods of choppy markets. Figure 2 also compares the performance of the L/S strategy with the buy-and-hold one. For a similar volatility, the L/S strategy enhances our annual return by 1.4% to 8.5% for a Shape ratio of 0.44 (vs. 0.37). In addition, drawdowns are significantly reduced as investors are shorting the SP500 in periods of bear equity markets.

Figure 2

Crossover

Source: Eikon Reuters, RR calculations

Based on these results, it seems very tempting for buy-and-hold investors to change their strategy to the systematic one and therefore avoid severe losses in periods of selloff. However, we think that equities will experience frequent V-shape forms with central banks trying to prevent the stock market from falling by 50%+ in the future, which will be devastating for momentum strategies such as MA crossovers. In other words, it will be the death of the ‘Death Cross’ crossover strategy.

 

FX Technical Analysis

This page aims to provide the major technical indicators used in Finance, and especially in the Foreign Exchange market. In addition to define the several steps to compute each specific indicator, we describe a potential systematic (and tactical) strategy applied to currencies and also provide an Excel File (with VBA macros). Hence, readers are able to see how those technical indicators are built, and then can backtest a few strategies on exchange rates using their own parameters.

We chose to first start with the major indicators used by market participants: there are the Moving Average (Simple and Exponential), the Relative Strength Index (RSI), the Moving Average Convergence Divergence (MACD) and the Bollinger Bands.

  1. Link to Momentum Indicators ===> TA_Momentum
  2. Link to Reversal Indicators ===> TA_Reversals
  3. Link to Excel File ===> TechnicalAnalysis_Indicators

Figure 1. Performance of a L/S Portfolio using EMA(5,20) on USD/AUD

Performance.PNG

Markets after Yellen…

There have been some interesting developments for the past few days in the middle of this low-volatile environment. Firstly, Fed Chair Yellen opened two days of testimony on Capitol Hill yesterday, delivering the central bank’s semi-annual report to Congress. With the QE-Taper to end in October (already priced in), the market was waiting for more details concerning the ‘future path’ of the Fed Funds target rate (currently at a historical low of 0-0.25%). Despite strong employment data with Non-Farm Payrolls printing above the 200K level for the fifth month in a row in June (288K) and the jobless rate that edged down by another 0.2% to 6.1% (2008 levels), Yellen clearly stated that the US economic recovery ‘is not yet complete’ with the housing market showing ‘little progress’ but still disappointing this year.

However, she surprised the market a bit when she told the Senate Banking Committee that rates could rise sooner than planned. These comments ‘kind-of’ played in favour of the US Dollar, with USD index trading 80.50 at the moment. Its main component, the Euro (57.6%), broke out of his tight 1.3575 – 1.3675 range and is now trading at 1.3540 (see chart below). The next support on the downside stands at 1.3520, the 38.2% Fibonacci retracement of 1.2750 (July 2013 low) and 1.3992 (May 2014 high).

EUR-16-Jul

(Source: Reuters)

The second interesting development was the higher-than-expected CPI figures in UK that gave a boost to Cable after its last two weeks of weakening momentum. Annual inflation came in at 1.9% YoY in June (vs expectations of a 1.6% print), while CPI MoM increased by 0.2% (vs -0.1% consensus). It reinforced the market’s view that the BoE will be the first major central bank to lift rates. Even though some analysts are expecting a first move from UK policymakers later this year, we personally think that Q1 2015 sounds more reasonable. If we have a look at short-sterling interest rate futures, the March 2015 contracts sold off to 98.91 from 98.97, which means that the implied yield from 103bp to 109bp. Earlier this morning, UK claimant counts fell by 36.3K in June, following a revised 32.8K drop registered in May. The jobless rate edged down to 6.5% as expected.

After it reached a high of 1.7191 yesterday afternoon, Cable remains poised for a break above 1.7200 and is now trading at 1.7125. The first support on the downside stands at 1.7100, followed by 1.7060. A more interesting pair would be EUR/GBP, which is now trading at a 22-month low at 0.7900 and is approaching its next support at 0.7880 (see chart below).

EURGBP-16-Jul

(Source: Reuters)

Another surprise came from New Zealand where inflation accelerated less than expected, easing pressure on the RBNZ to continue its monetary policy tightening cycle. As a reminder, the central bank has increased its overnight cash rate (OCR) three times to 3.25% since the beginning of the year, and the market is still expecting a 25bps rate hike at the next meeting on July 23rd. We felt that the Kiwi strength would probably weigh on NZ policymakers’ decision at the next meeting, therefore we were expecting a correction on NZD (see our last trade short NZD/JPY). It was also interesting to play a technical bear correction on NZD/USD when the pair was flirting with its 3-year high as you can see it on the chart below.

NZD-16Jul

(Source: Reuters)

Quick update on BoJ and the Yen: USDJPY continues to trade sideways after the BoJ decided to keep its monetary policy unchanged (as expected), maintaining its target of increasing the monetary base at a annual pace of JPY60-70tr per year. The central bank cut its 2014 growth prediction to 1.0% (down from 1.1% last meeting and from 1.5% last October), but the board (9 members) unanimously maintained its inflation projection of 1.9% in the next fiscal year. If we have a quick look at the chart below, USDJPY is still trading within its tight 101.00 – 103.00 range. It found support slightly above the 101.00 level last week and seems on its way to test its next resistance at 101.94 (200-day SMA).

JPY-16-Jul

(Source: Reuters)

To finish, another currency AUDUSD that we have been trying to play lately is AUDUSD. The RBA minutes didn’t surprise the market on Tuesday despite AU policymakers’ willingness to see a lower Aussie (the minutes stated ‘the exchange rate remained high by historical standards’). We still think it is interesting to go short AUDUSD if the pair trades above 0.9400, with a medium term target at 0.9200 and a stop loss above 0.9560.

AUD-16Jul

(Souce: Reuters)