One Chart Explains It All

The graph below is very simple. It shows the daily moves in the S&P 500 Index (SPX) versus its 10-day moving average. 

It is quite obvious that SPX has been riding the 10-day average throughout the year thus far. In fact, it has only spent a small fraction of the year below that average. Just this week we were reminded of the powerful attraction this moving average holds. The sharp selloff that we saw after Wednesday’s Federal Reserve meeting only brought us back to the 10-day average. The minor selling that followed – despite the normally powerful chart pattern of an outside reversal (aka bearish engulfing candle) – hewed close to the average. 

Trend following and mean reversion are very simple strategies to implement whether you are trading manually or algorithmically. I have no doubt that there are automated strategies that have been rewarded for staying net long and buying whenever SPX touches its 10-day moving average.

It would be very easy to suggest simply following along. But there are risks to blindly following mean reversion strategies. First, there is no necessity that a stock or index will revert to a mean. Mean reversion is a tendency, not a requirement, and external events can provide an unwelcome jolt. One only needs to look back to late last year to see what happens when trends change. Further, it’s not always clear to which average one might revert. SPX has been in lockstep with its 10-day moving average. There is nothing that prevents it from suddenly reverting to, say, the 30-day moving average.

We are in the midst of one of the simplest trends to follow in recent memory. A significant amount of seemingly easy money has been made with the mantra “the trend is your friend”. But traders should never forget that while a trend can be a very rewarding friend, it can also be a fickle one.

(Click on image to enlarge)