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
robhanna@comcast.net

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.