Tuesday, January 24, 2012

Using The 200-Day Moving Average

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The 200-Day Moving Average
Plotting the 200-day moving average involves computing the average price for the previous 200 days,  then for another 200 days starting one day later, and so forth for the specified duration.  The reason for using moving averages is to smooth out some of the day to day volatility.  The longer the current price is above the 200-day moving average, the higher the average, resulting in the line on the chart curving higher.  Of course, the inverse is true when the price remains below the average.

Technical Analysis
Any student of technical analysis soon learns of the 200-day moving average.  When the price is above the 200-day moving average, that is taken as a positive sign.  When the shorter 50-day moving average crosses the 200-day moving average from below, that is also seen as positive.   Since there are 5 market days in a week, the 200-day moving average is also the 40-week moving average.  Today, not many people would probably assign much importance to a period of 40, but in the Bible, it was always seen as a significant period of time, whether days, weeks, months, or years.

Transition Point
The Basic Timing Model I propose on this blog uses the XIU Exchange Traded Fund (ETF of the largest 60 stocks on the TSX) and the 200-day/40-week moving average as the transition point from a good market to a poor one, or from a poor market to a good one.  It can also serve as a level of resistance when the price is below, and a level of support when the price is above.  The direction the price is headed will often reverse right at the 200-day moving average.  Whether this is self-fulfilling, or not, is irrelevant.

Such is the case with the price of the XIU ETF on the TSX.  The price has been steadily rising since before the end of last year, crossed yesterday, only to go lower today.  For people without the benefit of any knowledge of technical analysis, yesterday's price crossing the 200-day moving average would be taken as a buy for equities traded on the TSX.  Myself, I prefer to play the probabilities afforded me through technical analysis.  The above chart shows us the trend is growing rather tired.  Longer term, and perhaps even in the shorter term, the price would appear headed above the 200-day moving average, but the probability is the price will go lower than it is currently before continuing the uptrend.  I always look for the possibility of buying lower and selling higher.

Net Return
It may make little difference in the long run, but careful analysis could prevent us from bouncing in and out of the stock market as the price struggles in an effort to cross the 200-day moving average.  Regardless, buying  as the price crossed yesterday (after selling when it crossed going lower last summer), would result, according to my calculations, in an almost 6 percent gain relative to those who rode the market all the way down, and back, again, since the moving average has dropped that much during that time.  If/when the price rises above the 200-day moving average, it may signal a more favourable market, but given the headwinds the stock markets are facing, I am still quick to take profits when I can.

Questions?  Comments?


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