If you have been involved in any financial markets, whether actively trading or simply investing, you have likely heard of the infamous 200 day moving average.
This moving average is simply a line on a chart that plots the average price over 200 trading days. To calculate it, you just take the average of a security’s closing price for the past two days. In other words, you add all the numbers up and divide it by 200 to get your moving average.
Why It’s Useful
The 200 day moving average provides both traders and investors a clear picture on the overall trend within a market.
Markets that are trading above their 200 day moving average (MA) are said to be trending higher while markets trading below their 200 day MA are said to be trending lower.
Although there are various ways one can potentially use the 200 day MA, one of the most common methods is to go long stocks above their 200-day MA and go short stocks below their 200 day MA.
Here is an example:
Stock ABC is trading at $40 per share. The stock’s 200-day MA is at $38 per share. Since the stock price is above the 200 day MA, an investor may potentially look for a long entry on a smaller timeframe.
On the other hand, if stock ABC is trading at $40 per share and the 200 day MA is at $42 per share, then the investor may potentially look for a short position on a smaller timeframe.
The 200 day Moving Average is Good, but Not Perfect
Think about it: it does look like that the higher the 200 day moving average is, the more bullish the market is (and the more bearish the lower it is). In contrast, the opposite is actually true. Really high readings could be a sign that the market may soon reverse. This is when traders are too optimistic and there aren’t many new buyers. When it’s low, you should technically see changes in the market.
Given the large time frame involved, this moving average may be most useful to longer-term investors. While it may potentially help keep one on the right side of the prevailing trend, used alone it will likely yield poor results.