Trading the 200-Day Moving Average

A simple yet effective trading rule is to stay on the right side of the 200-day moving average.  If you always own a stock when it is above this key indicator and sell it when it drops below, you will be on the right side of all big moves.

As is often the case with simple rules, the execution may present some challenges.  For an example, let's check recent trading in Apple Computer, Inc.  (AAPL).

I am using the popular 200-day exponential moving average and looking at the last two months so that we can highlight the key period.  You can see that the stock closed just above the key level on Friday, June 17th.  The stock collapsed on no news on the following Monday, as those adhering to this indicator chose to sell.  Many other traders, understanding what was going on, stepped back from the trade.  By late morning even CNBC mentioned what was going on.

How did this work?

If your rule is to buy and sell on a closing basis, you sold at 315 and bought back at 325.  My guess is that many did much worse.  Those panicking on the sell date might have sold as low as 310.  Those who sold may have decided to defer the repurchase.  People hate to buy back a stock at a higher price, and they hate to chase.  Those not acting right away may still be waiting to repurchase their shares, now trading in the 340's, nearly ten percent higher from the sale price.

Conclusion

It is important to have a disciplined system, especially including a rule for selling when something has not worked.  I prefer to sell on a fundamental basis.  When the company's business changes, when events change, or when my thesis has proven wrong, I accept the mistake and move on.  An advantage of this approach is that I do not have millions of others competing to sell at the same time.

The 200-day moving average rule is one way of improving over buy-and-hold investing, but not the best.  If you are going to follow this method, discipline is essential.  This is especially true in a volatile stock like AAPL and in volatile times like the past few weeks.

My guess is that many sellers of AAPL have yet to repurchase the stock.  When you validate a system through testing, you had better follow the rules in your actual trading.

While I have written this article in terms of AAPL, the same argument could be made for the QQQ's or the major market averages, all of which have been trading at this important technical level.

 [long Apple in personal and client accounts]

Comments

[Dan]

I have never used the 200 day MA. I know a lot of traders that have and have a lot of success with it. The market seems to know our every move so I am looking at the 200 day MA for longer term trades. anyone read The Naked Trader.

[eztrader.com]

The strategies are divided into groups that vertical differences, differences in Delta, credit spreads and credit spreads. Different strategies for different markets. For example, a horse or a strategy of vertical propagation strangling be used to your advantage in a market is bullish or bearish. Again, a ratio spread is a practical strategy for a market to go sideways.

[oldprof]

Proteus -- Thanks for the pointer. I'll have to take a look. We do a lot of systems testing of our own, but that is more specialized.

Helpful for all of us ----

Jeff

[Proteus]

I think one needs to be careful in assuming that any moving average system will beat a buy and hold. David Aronson, in his book Evidence-Based Technical Analysis, shows pretty compelling calculations that the historical outperformance of indicators like the 200 day MA is due to data mining. Now, maybe he´s wrong, but clearly any effectiveness of these MA systems is declining as more people use them. Using a MA system to avoid a large loss may be a good idea, but expecting market-beating performance is iffy.

The book is a pretty good read, and the math and ideas about validating indicators are not too complex if you have some statistics training.

[oldprof]

Keith -- I think the system probably works fine in the long run, but you have to accept the loss when the direction changes quickly. It is designed to keep you in (or out) for the big moves, so you must keep that in mind.

I also got some emails about Meb's approach, which avoids the exact 200-day rule followed by others.

Thanks for pointing this out.

Jeff

[oldprof]

Ian - That certainly would have worked better this time than those trading daily with the EMA. I think we can both imagine situations where it might not work as well.

Meanwhile, I agree that avoiding the most popular method seems wise!

Thanks for the suggestion.

Jeff

[Keith Piccirillo]

Babak at Traders Narrative has written about it and Meb Faber uses the 200 as part of his timing strategies as well.
If so many mechanized systems use it for long term decisions, what causes it to stop working? Major drawdowns are the effect of forced liquidations.
Short term, Ken Heebner seems to have traded AAPL poorly by selling a large position too early and then buying back in.

[Ian]

An even better rule: trade only once a month with the 200-day MA rule. In this case, you would have waited to see if AAPL closed the month below the 200-day and would not have sold at all.