Why Every Trader Needs to Watch the 200-Day Moving Average

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.

Stocks

• 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.

This information, combined with our

days of the month study,
PowerRatings, and the other research we have recently published (view
archives) shows how to build successful trading strategies.

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.  For a free trial to the new TradingMarkets Stock Indicators,
click here.

Ashton Dorkins is
Editor-in-Chief of TradingMarkets.com.


editor@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.