The 200 day moving average (MA), is simply a line plotted based off the close price of the past 200 days added together, and divided by 200.
While actual price action may jump around on a day-to-day and week-to-week basis, the 200 day MA is a smooth line, which assists to differentiate normal volatile price movements that is acceptable and do not break a trend verses price movements that break a trend and mark a turning point.
In summary, the 200 day MA is often used to indicate a potential major trend change.
Often there is talk in the media of the 200 day MA being crossed, this is simply when the current price action crosses from above or below the MA. However, it is not the crossing which is important but the direction that the MA is pointing in.
There are basically three states that exist in a market:
- Ranging Market: This is when prices go up and down within a range and after a long period of time, of months or years, the price has essentially gone nowhere of significance. This is indicated by the 200 day MA flat lining, or pointing sideways with no incline or decline.
- Upward Trending Market: This is when prices move higher and higher, over months or years, making higher highs and higher lows. An indicator is the 200 day MA changing from pointing flat or down, to up.
- Downward Trending Market: This is when prices move lower and lower over months or year, making lower lows and lower highs. The 200 day MA will be pointing down.
Real World Application
Below is a chart of the US Standard & Poor 500 for almost 16 years since September 1992.
The white jagged line is the index, the red line is the 200 day Moving Average.
So where are we at now, and what does the 200 day MA indicator tell us?
The 200 day MA has been pointing down since 30 January 2008 (point 10 in the Chart) when the Index was at 1,355.
It is now at 888 (down 34 per cent).
The MA which was at 926 was crossed this month on 1 June 2009, closing at 942. It has since peaked at 956 on 11 June and retreated since.
The fall last night was over three per cent, closing at 893 crossing the moving average which was at 900.
According to this longer-term measure, the MA has not begun to point upwards despite rising from 666 on 6 March. This is an increase of 43.5 per cent in three months.
Despite this HUGE increase in prices, the steepness of the curve pointing down looks like it has only flattened out from about an 80 per cent slope to about a 70 per cent slope.
For those wondering if this is a good time to buy and that possibly the worst is over, the 200 day MA is not generating a buy signal.
According to this measure, at best, we are beginning to bottom, at worst, this is just a brief reversion to the mean type rise, a “dead cat bounce” before prices in fact turns lower.
If we adhere to the mantra “the trend is your friend”, the 200 day MA is still indicating a downward trend despite the huge gains we’ve enjoyed.
What am I expecting in the short term?
A pull back to lower levels is over due and indicators are pointing to a sell off in the wind, 830 and even 796 would be a benign and healthy retracement. This equates to a fall of between another seven to 12 per cent.
If these levels can hold, then potentially we have the commencement of the building of a base.
10 Historic Lessons From September 1992 (Almost 16 years)
- On 8 Feb 1995 MA begins to turn up after Range Trading for 12 months, S&P 500 was at 481.
- Mid to end of July 1996 MA crossed five times in two weeks. First crossing at 629, a gain of 31 per cent in 17 months.
- During the Asian Crisis for two months commencing 27 August 1998, the MA was crossed five times, first crossing at 1,042, a gain of 66 per cent in two years and a month. Or 117 per cent in three years and six months.
- Top of IT Bubble, on 23 September 1999 MA crossed at 1,280.
- It crosses 25 times in over a year to 18 October 2000 at 1,342 when the MA begins to turn down. Selling on MA turning down from when it turned up would have given you a run of 179 per cent over five years and nine months.
- Following September 11, 2001, the MA was crossed seven times in the three months between 4 January 2002 at 1,172, to 2 April 2002 at 1,136. At no point was the MA slope changed in this up tick in price action.
- The build up to the War on Terror matches the “W” type bottom on 21 March 2003 the downward sloping MA is crossed at 895 and crossed three times in the month until 17 April. It is not until about 30 May 2003 when the Index is at 963 that the MA is pointing up. A new uptrend commences from that day.
- This period is an example of how the MA can be crossed again and again, while keeping the Up Trend in tact. In the two years between 16 July 2004 when the Index was at 1,101 until 15 August 2006 when it was at 1,285, the MA was crossed 30 times. Despite so many crosses, the MA line continued to point up.
- This point on the 1st of August 2007 marks the next time the MA is again crossed. After crossing 30 times at point 8, this crossing as it turns out, is the beginning of the top formation peaking two months later on 9 October, at 1,565.
- From point 9, on 1 August 2007, to this point – 30 January 2008 (ie. six months later) the MA was crossed 20 times. The difference to the 30 crossings at point 8 is that price action failed to advance and by 30 January, the MA began to point down. The Index was at 1,355.