Need a big edge? Use the 200-day MA wisely
The market took another hit
today as the indices extended their recent selloffs. Friday’s attempted bounce
was a complete dud. The market remains extremely oversold, so hopefully the next
bounce attempt will be a bit stronger. The S&P has now closed below its
200-day
moving average three days in a row. No doubt you will be hearing lots of talk
about the 200-day moving average…which leads me to today’s topic.
How significant is the move in
the S&P 500 below its 200-day moving average?
To answer this let’s first
consider what the 200-day moving average signifies, and then look at some
statistics.
The 200-day moving average is
simply the average closing price of a market over the last 200-days. When the
market is in a long-term uptrend, you will generally be trading above this line.
When the market is in a long-term downtrend, you will generally be trading below
this line. While a crossing of the line doesn’t necessarily mean the market is
changing from uptrend to downtrend or vice-versa, it can be used as a useful
barometer.
Let’s look at a mechanical
entry technique to better understand the difference between trading in an
uptrend versus trading in a downtrend (above or below the line). Entering the
market on pullbacks is a well known and simple strategy that has proven
effective over time. The major indices all declined between 2%-3% last week, so
I decided to use the recent action as a benchmark. The rules are simple. Tests
were run over the last 15 years, through 9/30/05. Each trade purchased one unit
of the $SPX.X.
Test 1:
Buy the market under the
following 2 conditions:
1)
Today’s close is at least 2% lower
then the close 5 days ago.
2)
Today’s close is above the
200-day moving average.
Sell at the close 5 days later.
Test 2:
Buy the market under the
following 2 conditions:
1)
Today’s close is at least 2% lower
then the close 5 days ago.
2)
Today’s close is below the
200-day moving average.
Sell at the close 5 days later.
As you can see, these entries
and exits are not representative of the kind you should require in a system you
would actually want to execute. They are good enough to tell us something about
the market, though. Here are some of the results: (Commission, slippage and
dividends were not taken into account.)
Test 1 (pullbacks in an
uptrending market)
Total trades — 96
Pct Winners — 70%
Total Net Profit – 825.78 S&P
500 points
Profit Factor* – 2.67
Max Drawdown — 134.29 S&P 500
points
Test 2 (pullbacks in a
downtrending market)
Total trades — 83
Pct Winners — 53%
Total Net Profit — 165.32 S&P
500 points
Profit Factor* – 1.17
Max Drawdown — 281.62 S&P 500
points
*Profit factor = (Gross
Profits / Gross Losses * (-1))
As you can see, even with our
lame exit strategy, this system would have performed quite well when buying
pullbacks above the 200-day moving average. When trading below the 200-day
moving average, though, every statistic takes a significant hit. So what does
this tell us about how we should adjust our trading in a downtrending
environment? While money can still be made, it becomes much more difficult —
even when buying pullbacks in the hope of a short-term gain. Should the market
fail to regain the 200 MA, the downtrend will begin to assert itself. The fact
that the market is downtrending creates additional risk and that should be taken
into account when evaluating potential trades.
So, back to our original
question, “how significant is the move in the S&P 500 below its 200-day moving
average?†If it remains below it, our tests show a huge significance. Ignore it
at your own peril.
Best of luck with your trading,
Rob
Rob Hanna is the principal of a money
management firm located in Massachusetts. He has spent the last several years
developing and refining methods for trading in stocks across multiple time
frames. He selects stocks using both fundamental and technical criteria, and
then trades them using technical analysis techniques.