Price Momentum: A Simple Moving Average Risk Management Process
Price behavior alone can tell us a lot about supply and demand. When there are more buyers than sellers, prices move higher. When selling overpowers buying demand, the price declines.
Imbalances build up—when confidence in the market is gained, investors tend to allocate greater percentages of their investable net worth to stocks. Further, margin is used that allows the more aggressive investor to buy even more stock.
But when the trend changes, margin calls can kick in that result in forced selling and more margin calls. A spiral of selling can occur—such as what happened in the 2000 tech bubble collapse and the 2007 great financial crisis.
We can think it won’t happen again, but it will. Yet, while we can measure the degree of risk, the timing is nearly impossible to predict.
So let’s take a look at several ideas that can help you stay in sync with the primary trend. I do believe you can let the cyclical trend, as they say, “be your friend.”
The chart that follows looks at the S&P 500 Index 50-day moving average price line and compares it with its longer 200-day moving average price line.
Here the trend is identified to be higher when the shorter-term moving average price trend (black line) is higher than the longer-term 200-day moving average price trend (dotted red line). The concept is easy to understand, and you can see the performance results highlighted in yellow.
The Benefits Of Stop-Losses
As I said, overcoming a 50 percent decline requires a 100 percent subsequent return. It also takes years to recover from such losses. Long-term thinking can be emotionally impossible if such a decline happens near retirement. Logic and discipline are tossed aside. It may be equally emotional for the younger investor as well.
Take a look at the chart again. Note how the 50-day over 200-day moving average cross helped one avoid the 2008 market meltdown and also allowed participation in the recovery. That’s the general idea with risk management. There are hundreds of academic studies on price momentum tested many ways and in multiple markets over hundreds of years.