Last Updated on September 5, 2021 by Oddmund Groette
Moving averages are frequently used as an indicator in the financial markets. Who hasn’t heard about the “Death Cross”, “support at the moving averages”, “the trend is positive because the price is above the averages”, etc.? Among the moving averages, the 200-day is probably the most used and referred to.
This article looks at the 200-day moving average and how it works, why it works, and additionally why it sometimes doesn’t work. As with most things in life, the 200-day moving average comes with both pros and cons. Its main advantages are simplicity, it makes you ride the trend, and it makes you play defensive. However, without a recession and falling prices, you are unlikely to beat buy and hold because of the many whipsaws. The 200-day moving average is no silver bullet.
Let’s start with a short primer about what a moving average is:
What is a moving average?
Hopefully, most readers of this website have some basic mathematical knowledge and understand intuitively what a moving average is. Anyway, we start by describing what a moving average is:
A moving average is the sum of the x last closes divided by the same x. For example, a ten-day moving average summarizes the closing prices over the last ten days and divides the sum by ten. On the next day, the process is repeated by including the most recent close and dropping the eleventh most recent close.
There are different ways to calculate a moving average: simple, exponential, and linear (for example). We have previously covered the basics of moving averages in this article:
- Are moving averages good or useless? (Quantified strategies)
The moving averages are all about trend-following
The main idea with a moving average is to capture trends in the market. A moving average is an extremely simple tool to determine the trend: if the close is above the 200-day moving average, the trend is up. If the close is below, the trend is down.
- A simple trend-following system/strategy on the S&P 500 (By Meb Faber and Paul Tudor Jones)
- Trend following strategies and systems explained (including strategies)
Why a 200-day moving average, why not 183?
There is no particular reason to use a 200-day moving average than, for example, 183 days except that it’s a round number. You risk curve fitting if you optimize to another number of days. Furthermore, 200 days is a long average and thus captures the long-term trend.
However, there might be a reasonable explanation for why you could, for example, go for a 182-day moving average, or 213 for that matter: To avoid crowding.
If you are afraid of many traders and investors getting the same signal on the same day, you can use another moving average that is reasonably close to the 200-day average.
Why the 200-day moving average works: It’s all about playing defense
My metric for everything I look at is the 200-day moving average of closing prices. I’ve seen too many things go to zero, stocks and commodities. The whole trick in investing is: “How do I keep from losing everything?” If you use the 200-day moving average rule, then you get out. You play defense, and you get out.
The quote above is from Paul Tudor Jones when he was interviewed by Micheal Covel, the author of Trend Following.
The main reason why the 200-day moving average works is that it keeps you out of a bear market. Look at what happened in the S&P 500 in 2007-09:
The moving average took you out in late 2007 at 113 except for a false signal in May 2008. You reentered in May 2009 at 73 and kept you in for a long time when the quantitative easing made the markets move higher.
And not to mention in the oil price action in 2020:
The average took you out at 65 in January 2020 and you reentered in October and November 2020 at around 40. Perhaps many traders believe this doesn’t amount to much, but how would you react to see your position go to almost zero during the Covid-mess?
The 200-day moving average works when you have recessions because it takes you out before a bear market hits. It saves you money and you can start compounding again at higher levels when the dust settles.
When the 200-day moving average is not working
The GFC in 2008/09 is a perfect example of explaining how such a moving average is useful.
However, when there is no significant bear market, the moving average might fail to work properly. The reason is simple: the main reason why the 200-day moving average works is that it keeps you out of bear markets. Obviously, if it’s no bear market, you will underperform compared to buy and hold.
As long as the central bankers interrupt the business cycles with more money printing, quantitative easing, and protecting business failures the moving averages will underperform.
To better illustrate when a moving average works and not we look at the long-term returns of the S&P 500:
The 200-day moving average on the S&P 500
Let’s test this simple strategy:
- Buy when the close of the S&P 500 crosses above the 200-day average,
- Sell when it closes below the average.
It can’t get any simpler than that. Here is the return (log chart) of investing 100 000 in 1960 and reinvesting and compounding until July 2021:
- 187 trades since 1960.
- CAGR is 6.7%, buy and hold is 7.1% (reinvested dividends not considered).
- 2.5% average gain per trade.
- Max. drawdown is 28%, buy and hold drawdown is 56%.
In other words, the 200-day moving average has almost managed to keep track of the S&P 500 while having substantially lower drawdowns. The downside is that you might face tax bills because of the non-deferred capital gains.
We believe low drawdowns are underappreciated:
- Why is max drawdown important in trading? What is a good drawdown percentage?
- How to deal with drawdowns (How to prepare and minimize drawdowns)
The S&P 500 since the GFC in 2007/08:
However, as we indicated above, the strategy most likely underperforms in the absence of a long recession and falling prices.
Let’s test the 200-day moving average from the bottom in March 2009 until July 2021 (buy when the close is above, sell when it closes below the average):
The reason is simple: There are no major recessions. As long as the markets keep going up, the 200-day moving average strategy will get a lot of whipsaws and never keep track of buy and hold.
A perfect example is what happened in 2010:
During the summer of 2010, you would face 7 trades of which only one showed a gain. However, the losses were offset because the last trade entered on the 29th of October kept you in until July 2011 with a nice gain.
The RSI (and other indicators) and the 200-day moving average:
The beauty of backtesting is that you can test a lot of ideas in literally just seconds. Let’s first test how we can utilize the 200-day moving average in a strategy.
The core strategy is as follows:
- Enter at the close when the S&P 500 closes below a five-day RSI of 30.
- Sell at the close when the same five-day RSI crosses above 50.
This strategy returns this equity curve in SPY from 1993 until July 2021:
- The number of trades is 262 and the average gain per trade is 0.9%.
- The win ratio is 77%.
- CAGR is 8.3%, buy and hold is 10.4%.
- Max drawdown is 27%.
What happens if we add a 200-day moving average criterion? The strategy is the same but the close needs to be above the 200-day moving average to generate a signal.
The equity curve gets slightly better:
When we add the trend filter, the strategy yields these numbers:
- The number of trades is 173 and the average gain per trade is 1.02%.
- The win ratio is 81%.
- CAGR is 6.3%, buy and hold is 10.4%.
- Max drawdown is 14%.
As you can see, the total return is lower because of fewer trades and less time spent in the market, but the upside is that you get a lower drawdown.
If we trade the strategy only when the close is below the 200-day average we get this equity curve:
- The number of trades is 98 and the average gain per trade is 0.81%.
- The win ratio is 66%.
- CAGR is 2.7%, buy and hold is 10.4%.
- Max drawdown is 26%.
Volatility above and under the 200 day moving average
The price behavior in most markets is different depending on a bull or bear market. During a bull market volatility tends to go down, while in a bear market volatility picks up.
If we look at the statistics of the S&P 500 the difference is huge: The daily percentage difference between high and low (compared to the closing price) has been like this from 1993 until the summer of 2021:
- Above the 200-day moving average: 1.05%
- Below the 200-day moving average: 2.1%
Clearly, the price action is completely different depending on the price being above or below the long-term moving average.
It might not be like this in all markets because we only looked at the stock market, however, we suspect this is a pattern that is not random.
Time spent above the 200-day moving average
Markets that have a long-term upward bias, like stocks and the price of gold, spend most of the time above the 200-day moving average.
For example, the S&P 500 has spent 70 percent of the time above since 1960 and 85% of the time since 2010. Again, the remarkable bull market since the GFC is, historically, a somewhat outlier, but who knows, this might be the new norm if the central bankers keep on printing money.
The 200-day moving average and whipsaws
The moving average would have done a great job in keeping you out of the markets in 2000-03 and 2007/09. However, it comes at a price:
There are plenty of whipsaws and false signals along the way. Since 1960 it has crossed above the average 187 times.
But astonishingly, only 28% of the trades turn out to be winners!
Are you able to trade a system with such a low win ratio? We would guess many would give up after a few losses in a row.
The strategy has a max of 9 consecutive losers. Are you able to pull the trigger on the tenth trade? The one that eventually turned out to be a big winner?
Only you can answer that, but our guess is that many couldn’t and would have abandoned the strategy earlier.
Conclusions about the 200-day moving average:
This article has highlighted some facts about the 200-day moving average. It’s not the sexiest tool a trader and investor can use, but it’s still reasonably effective in filtering out noise.
Moreover, as a trader, you might not be interested in beating a buy and hold strategy but simply use the strategy as a tool among many other strategies.
Disclaimer: We are not financial advisors. Please do your own due diligence and investment research or consult a financial professional. All articles are our opinions – they are not suggestions to buy or sell any securities.