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Daily Traders Edge

What The 200 Day Moving Average Does & Does Not Tell You

May 16
10:02 2018

Trend-following is a strategy that got a lot of attention following the financial crisis. It’s something my views have evolved on over the years. There are a lot of misconceptions out there about what the typical trend-following signals actually mean. There’s much more nuance involved than simply looking at the moving average of the price of a stock or index. If you would like to use this type of strategy you have to be very thoughtful about implementation and understand the limitations involved. This piece I wrote for Bloomberg looks at the 200-day moving average, a favorite tool for many trend-followers.  

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On April 2, the S&P 500 Index closed below its 200-day moving average for the first time in almost two years, and has been bouncing around that level ever since.

Traders and investors pay close attention to this key technical level as a market timing signal to get out of stocks before the onset of a large downturn. As the legendary hedge fund manager Paul Tudor Jones said:

The whole trick to investing is: ‘How do I keep from losing everything?’ If you use the 200-day moving average rule, then you get out. You play defense, and you get out.

Investors need to be careful about blindly following any indicator that gets them out of the market. There is no guarantee that markets are headed for a crash just because this trend was broken. There are no market timing signals that work every single time, so there’s no telling if the current correction will morph into an all-out bear market.

The 200-day benchmark works much better as an indicator of the type of market environment we are in than as a perfect timing signal. Here are the stats for the S&P 500 going back to 1928, when it was above and below the 200-day moving average:

Over the past 90 years or so, stocks have spent about two-thirds of the time above the 200-day mark and one-third of the time below. The volatility of all trading days in this time was 18.6 percent, so up-trending markets above the moving average showed higher average returns and lower than average volatility than markets below the moving average.

Continue Reading at A Wealth of Common Sense

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