The importance of the 200-day simple moving average as a trend indicator is well-known and indisputable. Even those who do not use technical analysis pay attention to this average. But why 200 days and not 250, for example? The latter should better describe a yearly trend than the former, which only corresponds to 40 weeks. Is there an explanation for the choice of 200 days in the average?
Note on the above chart that the 250-day simple moving average (brown line) also indicates the trend as well as the 200-day simple moving average (blue line) with the notable exception that price found support this week at the former but moved below the support of the latter. Thus, according to the 200-day simple moving average GLD is possibly starting a down trend but according to the 250-day simple moving average GLD is still on an uptrend. Kind of confusing? Yes and no depending on how seriously one takes these things.
Most rules of technical analysis have no clear explanation or justification for their use and as a result neither does the choice of the 200-day simple moving average as an important trend indicator. It is evident that a 201-day simple moving average should indicate the same thing as a 200-day simple moving average, so the latter was probably chosen because it involved a nice round number. But why 200 days and not 250 days? Possibly, this had something to do with the ease of calculating the average in the old days when traders did that manually.
Before offering a possible explanation as to why this average is considered so important, let us first take a closer look at the GLD chart and at what happened earlier this week:
The blue line is the 200-day simple moving average and the two little arrows were used to indicate the two occasions during this week when prices tested this average. The first test was on Tuesday. The value of the moving average by Tuesday’ close (based on closing prices) was $157.44. The GLD high on the same day was $157.43, just a penny shy of the average.
Then on the next day, last Wednesday, the value of the 200-day moving average increased to $157.53 and the GLD high on that day was also $157.53. Amazing, isn’t it?
No, it is not. It is just a self-fulfilling prophecy. In the 1980s financial media (FNN now CNBC) and analysts reinforced the importance of the 200-day simple moving average by constantly referring to it. Actually, they raised it to the status of an indisputable principle. But some of us, who were actually doing quantitative work for developing trading systems, could not find any special significance of this average no matter how hard we tried. Actually, its use would often result in trading strategies with very high drawdown levels. Despite that, the use of this average in the past 20-25 years has increased its importance to the point that it has become a self-fulfilling prophecy, causing the effects seen on the GLD chart during the earlier part of this week.
Does it matter whether the 200-day simple moving average is a self-fulfilling prophecy instead of some kind of a natural rule? Yes, it does because the outcomes of self-fulfilling prophecies can be manipulated much easier than those of natural rules, especially during periods of insufficient liquidity. Although I pay attention to this average, I am very careful with it. Actually, when prices come close to it I view that as a period of increasing risk than anything else and I adjust position size accordingly.
Charting program: Amibroker
No relevant positions at this time.
Disclaimer:The author is not a financial advisor and does not recommend the purchase of any security or advise on the suitability of any trade or investment in any timeframe. ETF, stock, futures, forex and options trading and investing involves substantial financial risks and can result in total loss of capital. If investment or other professional advice is required, a licensed professional should be consulted.