Moving averages (MA’s) are among the most popular tools available to portfolio managers, analysts, investors and traders but are they being used in the most effective way? We have stressed the importance of MA’s many times and this article will teach you how, and why, we use them.
The simple moving average (SMA) is the most common type of MA used. This method uses a fixed number of data points as the data series moves forward. For example, a 200-day SMA will average the most recent 200-days worth of data (usually closing prices). With each new day, a new data point is added and the oldest data point is removed. In other words, the 200-day SMA displays the arithmetic mean of the most recent 200-days of closing prices.
It is important to determine the right length MA for your intended purpose. We use the 200-day SMA as a trend filter for stocks and indices. A stock or index trading above the 200-day SMA is considered to be in an uptrend, while a stock or index trading below the 200-day SMA is considered to be in a downtrend. Our research shows that using the 200-day SMA in this manner improves the test results.
We have also published research that uses the 5-day SMA or 10-day SMA to take profits/exit trades. We use these shorter MA’s because our research shows them to be among the better exit strategies available.
Why the 200-day MA is so important
Here’s a look at how the S&P 500 and the NASDAQ 100 has performed in relation to the 200-day MA. The test period covers from 1/1/89 to 6/30/06. The tables below shows the average percentage gain/loss for SPX and NDX during our test period over a 1-day, 2-day, and 1-week (5-days) period.
S&P 500 (SPX)
Historically, the SPX outperforms when it is trading above the 200-day MA, 2-days and 1-week later.
Historically, the SPX underperforms when it is trading below the 200-day MA, 1-day, 2-days and 1-week later.
NASDAQ 100 (NDX)
- Historically, the NDX outperforms when it is trading above the 200-day MA, 1-day, 2-days and 1-week later.
- Historically, the NDX underperforms when it is trading below the 200-day MA, 1-day, 2-days and 1-week later.
This research can be extended to cover stocks too. We looked at over seven million trades from 1/1/95 to 6/30/06*. The table below shows the average percentage gain/loss for all stocks during our test period over a 1-day, 2-day, and 1-week (5-days) period.
- Historically, stocks slightly outperform the benchmark when trading above the 200-day MA, 2-days and 1-week later.
- Historically, stocks underperform the benchmark when trading below the 200-day MA, 1-week later.
How to use this information
When you go to the new TradingMarkets Stock Indicators page you’ll see that all of the indicators (bullish and bearish) use the 200-day MA. The bullish stocks are all trading above the 200-day MA, while the bearish ones are all trading below the 200-day MA. The lists are filtered this way because our research shows an even greater edge can be obtained.
Please send me any questions or comments you may have regarding this article.
David Penn is Editor-in-Chief of TradingMarkets.com.
Larry Connors is CEO and Founder of TradingMarkets.com, and Connors Research.
*Our research looked at 7,050,517 trades from Jan 1, 1995 to June 30, 2006. We applied a price and liquidity filter that required all stocks be priced above $5 and have a 100-day moving average of volume greater than 250,000 shares.