“You always want to be with the
predominant trend. My metric for everything that I look at is the 200-day
moving average.” – Paul Tudor Jones
Being able
to determine the market’s primary trend will put the odds in your favor to
properly position your portfolio for future events. There are many ways to
accurately identify a trend, however using the 200-day moving average* is one
of the simplest yet most effective strategies. In fact, most Trend Following
firms employ trading strategies that take an entry and, possibly, an exit based
on a specified percentage close above or below the 200-day moving average,
respectively. Moreover, the 200-day moving average can be an effective trading
signal for all markets since Trend Followers are typically registered as Commodity
Trading Advisors (CTA’s) that have exposure to equities, fixed income, currencies,
as well as commodities.
Additionally,
the 200-day moving average has been an effective signal throughout many market
cycles. One study examined the S&P 500 (represented as SPY) in relation to
its 200-day moving average from 1993 through 2014 and produced the following
results:
SPY Average Total
Monthly Return when:
SPY is above 200-day moving average: +1.22%
SPY is below 200-day moving average: -0.15%
Additionally,
when the monthly return series was above the 200-day moving average it exhibited
less volatility, as defined by standard deviation. Specifically, when SPY was
above its 200-day moving average its price displayed standard deviation of
3.44% and when below that value increased to 5.89%. The implication from this
observation is that SPY will exhibit greater monthly price swings below its
200-day moving average than when it is above.
Both its effectiveness
in multiple markets and the tested results throughout market history should
implore traders to add the 200-Day Moving Average Rule to their tool chest for
market analysis, if it is not there already. As Paul Tudor Jones says, “The
whole trick in 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.” In essence, the 200-day moving average signal can be effective in
detecting the long-term trend as well as preserving your capital.
Current and
Historical Observations:
Over the
past ten years, it can be seen how the 200-day moving average of the S&P
500 (SPX) has provided a reliable indication of trend direction. For example,
in late 2007 SPX began to vacillate around this moving average implying a range
bound market for the near term and possible change of direction going forward.
As it turns out, since the beginning of 2008 SPX only had one close above the 200-day
moving average before entering into the Financial Crisis. The 200-day moving
average cannot predict future events, however it can help traders and investors
identify the market’s current direction and mitigate risk. Looking ahead, in
2009 SPX closed above its 200-day moving average and continued its uptrend from
its 2009 lows until breaking the 200-day moving average in 2010. After a few
months of consolidation the uptrend resumed before SPX closed below this level
in 2011. Then, at the beginning of 2012 the price closed above the 200-day
moving average again which resulted in a long, sustained uptrend that lasted
until the Ebola panic of 2014 and more recently mid-2015. It should be noted
that in each instance of a pre-defined close above the 200-day moving average,
SPX was able to generate a profit before exhibiting a specified close below
this line prompting a trader to exit the position. Additionally, the equity curve
would have experienced less drawdown than the general market. As can be seen
currently, SPX is displaying some indecision around its 200-day moving average
and is clearly trendless. However, price will either continue downward, for which
the 200-day moving average rule has already positioned traders defensively, or close
above the line and signal a possible new uptrend. Only time will tell. For now,
while price remains undecided with a slight downward bias, it is best to heed
the advice from Paul Tudor Jones and “play defense.”
*The 200-day
moving average referenced in this post is categorized as a Simple Moving
Average where the value is calculated by adding up the closing values of an
instrument for the past 200 days and then dividing the sum by the number of
observations (e.g. 200). While simple moving averages are useful and commonly
used, there are some limitations. For example, as the moving average range of
calculations is constantly shifting, the oldest data point is subject to the
drop-off effect on a forward-looking basis. That is, the previously oldest data
point is no longer considered and is replaced by the value of the most recent
day’s closing price. This can cause some skew in the trend of the moving
average when an old outlier event is no longer included or a new outlier event
is weighted into the average. Some alternatives to simple moving averages
include exponential moving averages, centered moving averages, and
double-smoothed moving averages. Typically, exponential moving averages are
used as an alternative to simple moving averages, while the latter two moving
averages are employed when conducting cycle analysis.
As always,
please feel free to contact me with any questions.
JD
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