Ed Seykota's Moving Average System: A Practical Guide.

The Simplicity of the Moving Average

The moving average is one of the oldest and most widely used technical indicators, and for good reason. It is simple, robust, and effective. Ed Seykota, a master of trend following, recognized the power of this humble tool and made it a cornerstone of his trading system. He understood that the moving average is not a magic bullet, but a way to objectively define the trend. By using a combination of fast and slow moving averages, he could identify when a new trend was beginning and when an existing trend was coming to an end.

The Crossover: A Signal to Act

The most common way to use moving averages is the crossover system. This involves plotting two moving averages on a chart: a fast moving average (e.g., 5-day EMA) and a slow moving average (e.g., 20-day EMA). When the fast moving average crosses above the slow moving average, it is a bullish signal, suggesting that a new uptrend may be starting. When the fast moving average crosses below the slow moving average, it is a bearish signal, suggesting that a new downtrend may be starting. Seykota used these crossovers as his primary entry and exit signals.

Choosing the Right Parameters

There is no single "best" set of parameters for a moving average crossover system. The optimal parameters will depend on the market being traded and the trader's time horizon. A shorter-term trader might use a 5-day and 20-day EMA, while a longer-term trader might use a 50-day and 200-day simple moving average (SMA). The key is to find a combination that works for you and to stick with it. Seykota himself was not dogmatic about the specific parameters he used. He understood that the edge comes not from the parameters themselves, but from the disciplined application of the system.

A Word of Caution: The Whipsaw

One of the biggest challenges of trading a moving average crossover system is the "whipsaw." This occurs when the moving averages cross back and forth multiple times in a short period, generating a series of losing trades. Whipsaws are most common in range-bound markets, where there is no clear trend. This is the price that a trend follower pays for being able to catch the big trends. There is no way to avoid whipsaws completely, but they can be mitigated by using other indicators to confirm the trend, or by simply accepting them as a cost of doing business.