Market Phase - Going Beyond The Death Cross

[jswanson 10]

There are many ways to use indicators to help determine when the market is within a bull or bear mode. A common method that works well on trending markets over the long term has been the so-called death cross and golden cross (Death/Golden Cross) indicator. Below are the rules used by the Death/Golden Cross to divide a market into a bullish or bearish mode.

 

Bull Market = 50-Period SMA > 200-Period SMA

Bear Market = 50-Period SMA < 200-Period SMA

 

In short, the Golden Cross has been a great signal for long term market strength while the Death Cross often signals market weakness. Simply using the Death Cross as a signal to close all long positions within your retirement and brokerage accounts has historically saved your account from painful drawdowns. But can we improve upon this idea?

Within this article I’m going to build upon the Death/Golden Cross concept. I recently became inspired to write this article after reading “Defining The Bull And The Bear” by Chuck Dukas. Chuck developed a simple and interesting method to take the Death/Golden Cross to the next level. I’m going to reconstruct his concept using EasyLanguage programming code and backtest it to see how effective it is.

 

Within Chuck’s article, he uses a 200-period simple moving average (SMA) and 50-period SMA as the two primary indicators. These are the same indicators used by the Death/Golden Cross. However, where the Death/Golden Cross uses the crossing of these averages to generate their respective bull and bear signals, Chuck goes further by breaking up both the bear and bull markets into six different Phases.

 

1. Recovery Phase
   
2. Accumulation Phase
   
3. Bull Phase
   
4. Warning Phase
   
5. Distribution Phase
   
6. Bear Phase
   

 

These phases take into account the relative positions of both the daily closing price and the two moving averages. This finer granularity can be used as a guide to deploy your money in the markets.

 

Recovery Phase

50-Period SMA < 200-Period SMA

Close < 200-Period SMA

Close > 50-Period SMA

 

Accumulation Phase

50-Period SMA < 200-Period SMA

Close > 200-Period SMA

Close > 50-Period SMA

 

Bull Phase

50-Period SMA > 200-Period SMA

Close > 200-Period SMA

Close > 50-Period SMA

 

Warning Phase

50-Period SMA > 200-Period SMA

Close > 200-Period SMA

Close < 50-Period SMA

 

Distribution Phase

50-Period SMA > 200-Period SMA

Close < 200-Period SMA

Close < 50-Period SMA

 

Bear Phase

50-Period SMA < 200-Period SMA

Close < 200-Period SMA

Close < 50-Period SMA

 

The original article goes into much more explanation behind each phase but let’s stick with the basics which are very quantifiable. These simple rules can now be programmed into an automated trading system and tested. This system will be called the Market Phase System. For our examples I’m going to be buying the S&P 500 ETF (SPY) and deduct $30 per round trip for slippage and commissions. The system will be going long only and will scale into a position based upon the following rules:

 

Buy 100 shares when we advance from Recovery Phase into Accumulation Phase.

Buy 100 shares when we advance from Accumulation Phase to Bull Phase.

 

At most we will hold 200 shares of SPY and we will exit our entire position when we enter Bear Phase. The exit rule is basically the same as the Death/Golden Cross. Also the entry rules are similar. The only difference is with the Market Phase System we are scaling into our 200 share position while the Death/Golden Cross purchases all 200 shares when the signal occurs. In short, the Market Phase System allows us to scale into our position during the Accumulation Phase instead of waiting until we transition into a Bull Phase. So, how do these two systems compare?

 

 

Since the inception of SPY it has been difficult to beat following the Death/Golden Cross signals. The Market Phase System holds its own. It produces twice as many trades, but remember that’s also due to the fact it scales into the 200 share position. Please note, TradeStation reports each entry as an individual trade. That’s why we have over twice as many trades. But the system does hold up well.

 

One tweak I would like to make to the Market Phase System is to substitute the closing price with a price proxy. As we know, the daily closing price of SPY can be rather choppy resulting in whipsaws. Let’s try to reduce some of these false signals and see if we can improve the system’s performance. For our price proxy let’s take the exponential average of the last five days. But don’t use the closing price of SPY. Let’s take an average of the daily high, daily low and the closing price. With this method we are taking into account the size (range) of the daily bar. Here is the formula.

 

PriceProxy = Exponential Average ( (High+Low+Close)/3, 5 )

 

We will use the value of PriceProxy instead of the daily closing price in all our calculations. This is done to smooth out the short-term price noise. Below are the results.

 

 

Does the scale-in technique of the Market Phase System perform better than our Death/Golden Cross system? It does! By entering 1/2 of our position during the Accumulation Phase we are getting on board the trend sooner and seem to be generating slight more net profit. Notice there are twice as many trades with the Market Phase System. Again, this is due to the fact we are scaling into the position.

 

Both systems produce similar trading signals, but we get in earlier with the Market Phase System. Both the Market Phase System and the Death/Golden Cross system are long term trend following systems. They do OK on SPY because it’s such a broad based index. However, they don’t fair so well on major stock index ETFs such as NASDAQ, DIA or IWM. They also perform poorly when trading individual stocks. So, what else can we use these systems on? Commodity ETFs appear to be the best bet since they tend to have smoother trending characteristics which trend following systems can take advantage of. Note, many times a lot of cash is left on the table as we wait for the Bear Phase to close our long positions.

 

Trading this type of system, which is typical for a long-term trend following system, one must have a lot of psychological strength to sit and watch profits evaporate while waiting for your exit signal. This is mentally difficult to do! This also makes me wonder if scaling out of the trades may work better to capture more profit.

 

In closing, both of these systems are not tradable systems as they stand. For example, they do not utilize protective stops, take into account position sizing and money management. However, it appears they could provide a basis for a complete system with some modification.

 

Download

 

You can find the EasyLanguage code for the Market Phase Strategy here.

[mikewinfrey 10]

Thanks for writing the article. If I interpret your explanation correctly, using a price proxy means the entry price is behind the close of the trigger bar and the market must retrace to that price in order for an entry to occur. That also means some entries may be missed if that retrace does not occur. Am I reading you correctly?

 

By the way, I appreciate the definition of the different phases.

 

Thanks,

Mike Winfrey

[Marubozu 10]

I think this is a great post, well done for sharing. I agree with the content outlined and using moving average to gauge how a stock is doing and what phase it may be in, is good practice.

[jswanson 10]

Thanks for writing the article. If I interpret your explanation correctly, using a price proxy means the entry price is behind the close of the trigger bar and the market must retrace to that price in order for an entry to occur. That also means some entries may be missed if that retrace does not occur. Am I reading you correctly?

 

By the way, I appreciate the definition of the different phases.

 

Thanks,

Mike Winfrey

 

Mike,

 

A price proxy is a substitution for the closing price of the instrument. Often the closing price of the bar is used in the calculation of indicators, but in this case a proxy is used. That proxy is nothing more than a smoothed exponential moving average.

 

When using a price proxy, don't even look at the closing bar. Instead use the value generated by your price proxy as the "close" price and base your trading decisions on this value. No retraces are required. Below is an example.

 

 

In this example we have a simple moving average crossover system. However, there are two things going on. First, we want to go long when price closes above the upper band.

 

Second, we are not using price! Notice there are several bars that close above the upper band but no position is opened. Instead we trigger our buy signal based on a price proxy.

 

The price proxy is the yellow line. When the yellow line crosses above the upper band, we go long on the open of the next bar.

 

This is a technique that reduces whipsaw.

 

Hope this helps.