Last update: July 2021

One of the core tenets of technical analysis is that prices trend. The aim of many trading approaches, then, is to identify trends and ride them. Unfortunately, prices are often helter-skelter. They messily move up, down, and all around which can make it challenging to identify trend direction.

This is where moving averages can help. These indicators are designed to smooth out the erratic price action and thus reflect the essence of the trend.

You can track moving averages across any time frame, but the 200-day is undoubtedly one of the most popular. And since the S&P 500 just recently vaulted back above the 200-day, I wanted to take a fresh look at how it can be helpful as a trading signal.

• When a stock crosses above the 200-day, it flashes a buy signal.
• When a stock crosses below the 200-day, it flashes a sell signal.

Moving averages are trend-following indicators which means they prove most effective during trending markets. That means if you believe markets exhibit trending behavior (they do!) then systems designed around moving averages should prove effective.

Check out the accompanying chart that I recently stumbled across at StockCharts.com:

It shows the S&P 500 and its 200-day over the past 25 years. Over that time the market has crossed above the average some 90 times, creating as many buy signals. Per the system, you would have purchased the S&P 500 and stayed long until we crossed back below the 200-day.

As you can see there were only 20 winning trades out of 90 (a win rate of 22%). Crappy system, right?

WRONG!

Remember, the win rate is only one part of the equation. The other part is how much money you capture during those winning trades versus the losers. And that’s where trend following-based systems excel. They keep you on the right side of trends. And if those trends keep on trending, then you will capture the occasional big wins.

Even though you suffered 70 losers out of 90, the average loss was small enough to still generate a profit over time.

Takeaway: Being bullish when SPY > 200 MA = Smart idea

You may wonder why we’re not looking at how the bearish crossovers performed. Why not look at shorting the market when it breaks the 200-day? The answer lies in understanding that asset prices tend to rise, not fall, over time. Historically it’s proven much better to look for excuses to buy than sell.

Said another way, since uptrends have staying power they offer bigger profits than downtrends.

Drawdown Reduction

The hardest part of buying and holding the stock market is the excessive volatility. When you face the ravages of a bear market unprotected, your beloved portfolio can suffer 30%, 40%, or even 50% drawdowns.

What if you simply exited when the S&P 500 broke below the 200-day moving average? Wouldn’t that reduce the amount of pain you experience when the bottom falls out?

Yes.

Here’s one of the best charts I’ve seen illustrating that very benefit. It comes courtesy of Michael Batnick at the Irrelevant Investor:

The red area chart shows the magnitude of drawdowns that a buy-and-hold investor would have experienced over the past 22 years. In contrast, the black graph shows your performance if you would have shifted your investment from stocks to bonds when the market broke the 200-day.

Color me impressed.

By jumping ship when the S&P 500 breaks below the 200-day moving average, your losses were reduced significantly from around 55% to 20%. The primary drawback to such a gambit is the whipsaw. There are many times which the market breaks the 200-day, only to reverse course back in the bullish direction. It would have taken excellent discipline to stick with the system after a string of false alarms.

But, let’s be honest, it takes discipline to stick with any set of rules.

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