What is the 200-Day Moving Average?
The 200-day moving average is arguably the most widely cited Technical Analysis indicator among financial media journalists, investment analysts, and portfolio managers alike. Roughly equivalent to ten months of trading, this measure of long-term trend has found uses in everything from trading to risk management. However, it’s just a tool like anything else at the end of the day. Its uses are limited by the skill and experience of its user rather than its own merit.
Some will posit that this indicator is an outdated relic of the past, harking from the days when charts were drawn by hand and numbers rounded to provide quicker calculation, while others elevate the indicator in isolation as the holy grail of all trading systems.
The purpose of this blog is to provide insight into the 200-day moving average primarily as a risk management tool and explore the historical context of the behavior of the S&P 500 when it closes both above and below its own 200-day moving average. However, we note that this post is timely given the current proximity of the index to its 200-day moving average currently.
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The Importance of Trend in the 200-Day Moving Average Strategy
Before we dive into the historical results and testing, it’s important to lay out a few concepts that are important to the interpretation of results—namely, trend and trend identification.
What is the trend? Merriam-Webster provides the simplest definition: a prevailing tendency or inclination. Over timeframes, both long and short, we know that asset classes tend to trend, and this effect tends to be most magnified over long timeframes.
However, even on long timeframes, price trends tend to be messy and erratic, often oscillating around a point of central tendency. This is where the 200-day moving average’s usefulness comes into view. By giving equal weighting to every trading day in the previous 200-days, this metric provides a level of smoothing that allows the user to better determine both the direction and relative position of price in relation to the long-term trend.
The Disadvantages of Using Moving Averages
While the aforementioned are certainly all advantages, there is one major disadvantage with any moving average: lag. Despite the seemingly endless ingenuity of market technicians over the years, moving averages tend to be slow to change. This is their biggest benefit when the price is rising erratically, but also their most glaring disadvantage when the trend inevitably changes.
As we have mentioned in prior notes, no one indicator should stand on its own without incorporating additional metrics into the user’s desired system.
History of the 200-Day Moving Average
Now that we have explored the concept of trend, another question needs to be answered: how do we stay on the right side of the trend? The simplest answer is often to use the 200-day moving average as a filter; we are in when the market price is above the average, and we are out when the market price is below the average.
For a simple illustration, let’s review the historical behavior of the S&P 500 when these conditions are present.
When the S&P 500 is above its 200-day moving average, median gains have tended to return 2.77% with a 70.10%-win rate over the following trading quarter on a sample size of 12,814 since 1950. When the S&P 500 is below its 200-day moving average, median gains have tended to return 1.83% with a 56.97%-win rate over the following quarter of trading on a sample size of 5,172 since 1952.
While it is noteworthy that median gains have historically been positive in the instances where the index closed below its 200-day moving average, median gains have been lower than closing above the average, in addition to a significantly lower win rate, only slightly better than the flip of a coin.
An additional metric worth drawing attention to is returns at the 20th percentile; -1.95% when closing above the average vs. -5.64% when closing below the average. Again, just because returns have historically been positive does not mean that risk has stayed the same. In fact, if investors used this system in isolation (which they should not), history suggests that there is a significantly higher likelihood of a deeper decline when the index spends time below the moving average.
*As of the close of trading 4/12/22. Data via Optuma.
In fact, we would argue that the positive returns while the index is below the moving average are a function of the market’s tendency to move higher over time. Perhaps a more scientific exploration of detrended data would give us different results.
Digging further into the data, we find a similar dynamic for S&P 500 sector ETF performance when the index closes above and below its own 200-day moving average.
When the S&P 500 closed above its 200-day moving average, median sector ETF performance was a gain of 2.54%, with a 65.23%-win rate over the following trading quarter on a sample size of 40,393 since 1999. When the S&P 500 closed below its 200-day moving average, median sector performance was a gain of 2.46%, with a 58.55%-win rate over the following quarter of trading on a sample size of 15,005 since 1999.
Again, a very similar dynamic is noted in that while median gains for the sector ETF group were both positive, we see lower win rates in the sector ETFs along with significantly deeper declines at the 20th percentile. These data again suggest a heightened level of risk when the S&P 500 is trading below its 200-day moving average.
The 200-day moving average has been a useful measure of the long-term trend for as long as investors, analysts, and money managers have been putting pencil to chart paper. Beloved by Market Technicians and Fundamental investors alike, it has stood both the test of time and market lore as one of the most popular indicators on several charting platforms. From a risk management standpoint, this indicator has historically lent itself to being a useful tool that investors can add to their toolbox in the pursuit of controlling exposure to market environments that have been characterized by a higher-than-normal probability of loss. Is the 200-day moving average perfect? Of course not. There are nearly unlimited methods for calculating a moving average as well as tuning the lookback periods for different time frames and investor preferences. In addition to this, the 200-day moving average should always be a part of an existing system, not the whole system. While this indicator might not be the holy grail of trading systems, it is nonetheless noteworthy that it has historically stood the test of time as a reasonable tool for risk mitigation.
Disclosure: This information is prepared for general information only and should not be considered as individual investment advice nor as a solicitation to buy or offer to sell any securities. This material does not constitute any representation as to the suitability or appropriateness of any investment advisory program or security. Please visit our FULL DISCLOSURE page.