200 Day Moving Average: How it Works?

A 200-day Moving Average (MA) is simply the average closing price of a stock over the last 200 days. Moving averages vary in their duration depending on the purpose they are used for by stock traders. Moving averages are trend indicators of price behaviour over some time. This average is used to study price behaviour over the long term.

200-day Moving Average Chart

The purple line in the graph above represents the moving average over 200 days of the BSE Sensex. The line shows that prices after steadily rising though by very incremental margins, eventually flattened between March and May 2020, reflecting the impact of global triggers like the COVID-19 pandemic and resultant fears of job losses, weak cash flows and global economies spiralling into recession.

Example

Consider a stock that has consistently traded above its 200-day moving average. For instance, if Company XYZ’s stock has been trading at an average price of $50 over the past 200 days, and its current price is $55, this indicates strong performance. Traders may view this as a sign of robust fundamentals and continued upward momentum, reinforcing their decision to buy or hold the stock. Conversely, if the stock price falls below this moving average, it could signal potential weakness and a possible trend reversal.

Importance of 200 Day Moving Average

A long term moving average helps find the technically more robust stocks, gauge the market trends in the long run and set stop losses.

To Find Fundamentally Strong Securities

Traders use the trend indicator to filter out the 200-day moving average stocks. That is stocks that are fundamentally healthy from the ones that are not. If a stock has performed well above the moving average over this period, chances are it has strong fundamentals which have kept the prices buoyant. Also, the number of companies performing above their moving average of 200 days indicates a market’s financial health and trader sentiment.

Used as Support and Resistance

MA trend line can also give the traders key price levels that have not been breached yet. Prices would usually deflect before breaching the moving average unless there is a strong trigger. So the moving average doubles up as a reliable support and resistance level. For example, when the 200-day moving average trend line is moving upwards, traders will go long when prices deflect off the trend line that doubles up as the level of support. Here the trader would hope that prices have bottomed out and now prices are likely to rise, given the upward trend. But when the trend line rises upward too sharply, traders may take that as a cue for a trend reversal in the near term.  Similarly, when there is a sharp downward trend, it may signal a bottoming-out of prices too.

Setting Up Stop-Loss

For traders who are into trading zone strategies, picking a moving average for setting up a stop loss is an important decision. Picking too short a duration of a moving average can lead to loss of opportunity for the traders as the stop loss may be triggered before prices can potentially rise or fall further. Short term moving averages are used to examine if prices are losing steam as they monitor short term price movements.

Conclusion

A 200-day moving average is one of the more popular indicators of price movements and is reliable to study price behaviour in the long run. They indicate if the markets have had a bull run or have continued to be bullish in the long term.

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