The importance of the 200 day moving average for the Dow Jones Industrial Average

Using the 200 day moving average in trading

A simple 200 day moving average can be great for spotting big trends in stocks. Yet many people don’t use it and consider it to be a newbie-tool. But what makes the 200-day average so great is precisely that. Its simplicity and ease of use.

A simple 200 day moving average can be very efficient for figuring out the direction of the primary, or big, trend. Awareness of the primary trend puts you in a position in which you can figure out a buy point. You can then trade with the trend, for its remaining duration. Whether that is up or down.

Paralysis by analysis

I have used countless of indicators and methods over the years. But an old saying on Wall Street is that overanalysis leads to paralysis and indecision. And in the past I could sometimes find myself using ten different indicators all at once, in the same chart. But although it might seem sophisticated to use ten different indicators, I assure you that it’s not. Trust me. I’ve been there. And it just made my head spin. Ridiculous and pathetic are better words for it. But a simple 200 day moving average on the other hand is quite simple.

What is a moving average?

A daily moving average is exactly what it sounds like. It is a simple average of price that is moving. And that is the beauty of it. In this article I will use the 200 day simple moving average as an example, since it is widely used. The 200 simple moving average is the median price line of the last 200 trading days for a particular investment. That could be a stock, index, commodity, currency, a painting or anything else that trades on a market.

And it does not have to be 200 days. It can be any other number of days that are used. Or a completely different timeframe. For example the hourly chart might give you a 10-hour moving average. The most used moving averages are the 100-day, 50-day and the ten day moving averages. But the most famous for spotting primary long term trends, is the 200 day moving average. And that is why I will use it as an example for this article.

How does it work?

It smooths out price on the chart, for the investment you follow. If the 200 SMA is going up it means price is in an uptrend. And not until it starts to turn down again is a change in trend confirmed. Further since 200 days is quite a long timeframe it takes time for these trends to change direction. And that makes it quite a reliable indicator. At least for gauging the long term trend used by swingtraders like myself.

The picture below shows the 200 day moving average for the Dow Jones Industrial average. It forms a major support level when price is above it. And a major resistance level when price is below it. When it is rising, like it is right now, it shows that the market is in a long term uptrend, or Bull market.

The importance of the 200 day moving average for the Dow Jones Industrial Average
Many traders view the 200 day simple moving average as an an important indicator. Especially to gauge the long term trend for the Dow Jones industrial average. If you want to read more about Dow theory and where the Dow Jones is headed in 2019, you can do it here. – Chart provided by TradingView

The picture shows how price got extended on the downside from its moving average in the bear market of 2009. This made it snap back to the average because it got too far away from it. When price deviates too much from the line it is likely to snap back to it in time. And these mean reversions are tradable as well.

How to use the 200 day simple moving average?

If the last 200 tradingdays have been updays, it is likely that price will keep on going higher into the future. And when you have established that price is going higher you can start to look for buy points in that uptrend. Those buy points could be close to, or below, the average. Or above it in a downtrend. You want to buy on pullbacks to maximize the upside potential. But another strategy, which might be safer, is to buy into new highs. For example if the long term moving average is pointing up and you see price moving into new highs. Like in the picture above towards the end.

There are several ways to trade moving averages. Some traders trade the extreme standard deviations from the moving average. Because the probability is high that price will snap back to it. As it did in 2009. Or even longer to the other side. But those are not trendtrades, which is what I use moving averages for.

How I trade moving averages

I think price itself is the best indicator for where it is going. So I don’t trade moving averages all on their own. I use them alongside other indicators, fundamentals and above all else price. But I try to not overcomplicate things. And I use moving averages to gauge and confirm the primary trend. And then to find good entry points in that existing trend.

The reason why I believe a simple moving average can be so useful is that it simplifies the way we look at an uptrend. In this picture we can see that Berkshire Hathaway, which I have written an extensive fundamental analysis about here, is in a long term uptrend:

There are three obvious uptrends in this daily Chart of Berkshire Hathaway. One from 2009 to 2011, the second from 2012 to 2015 and the third from 2016 which is to be continued. – Chart provided by TradingView

Why is this a long term uptrend? Because the 200 weekly simple moving average is moving up over the long run. Simple as that. Good entry points might be when the trend snaps below it or comes close to the average. Or to look for breakouts into new highs, inside the existing trend. And good points for profit taking might be when price deviates a lot from the average on the upside. And when it starts to point down you need to start worrying. When that happens other indicators and tools should be used for gauging if the trend will continue or not.

The 200 day moving average can sometimes act as important support in an uptrend. But this differ between stocks. For Facebook it has acted as support twice in 2019:

Facebook stock
The 200 day moving average acting as support twice for Facebook – Chart from TradingView

Now, caution is adviced when trading these support areas. And some stocks trades right through them without stopping. Because moving averages are basically just lines. Sometimes they are important. Sometimes not. It depends on the personality of the individual stock.

Crossovers

The second, and more uncommon, way I use moving averages is to look for crossovers to confirm trends. An example is Stillfront‘s chart, in the picture below, where the 50-day crossed the 200-day moving average. Thereby confirming the upside momentum. Although I would never use crossovers all on their own. I use many other tools, for example fundamentals, and most of all price, in all of my analysis.

Using the 200 day moving average for crosvovers
Simple moving average crossover verifying momentu in Stillfront’s chart. – Chart provided by TradingView

These crossovers, of the 50-day and 200-day, are also called Golden cross and Death cross. The Golden cross is when an uptrend begins, and the cross happens to the upside. The 50-day then crosses the 200 day from the downside and breaks above it. The Death cross is the opposite. It is when a bear trend begins, and the crossover happens to the downside in a breakdown.

A warning

Even a simple tool, like the 200-day moving average, should be taken with a grain of salt. The 200 day moving average is not a Holy grail. Moving averages are just lines. It can get overcomplicated by the human brain. So don’t use it all on its own. Instead use it along other helpful tools. For example price action, trendlines, volume and fundamental analysis. And don’t overcomplicate things. Use what is useful but discard the rest.

Conclusion

Making things difficult is often a bad idea in investing. People have a tendency to overcomplicate things. Further this makes us seek out one difficult strategy after another. But often the simpler methods, like a moving average, are the best. A quote from William Golding sums it up well, “The greatest ideas are the simplest.”

Disclaimer: All information found on this site, ideas, opinions, predictions, commentaries are for informational, entertainment or educational purposes only and should not be construed as personal investment advice. While the information provided is believed to be accurate, it may include errors or inaccuracies. I will not and cannot be held accountable for any actions you take as a result of what you read in here. Use the information at your own risk. I am not your investment advisor. Consult a licensed financial advisor before making any investment decisions.

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