One of the most popular indicators in the world is the 200 Day Simple Moving Average.
This indicator can be found on the charts of many investment banks, hedge funds, and market makers as a key point of analysis for a multitude of reasons.
The indicator’s usage has become so widespread that it will often be looked at in Fundamental analysis; for the premise that so many traders may be watching the indicator that corresponding reactions may be seen when price encounters this stalwart of the chart.
For example, during the Financial Crisis the EURUSD currency pair lost over 3500 pips in value (21.58%) in only 3 ½ months. The Troubled Asset Relieve Program (TARP) was announced on October 14, 2008; followed shortly thereafter by the first round of bond purchases by the Treasury department.
This gave the world hope. The market rallied massively.
EURUSD moved up nearly 2400 pips (19.35%) off its lows, rallying all the way until price ran into the 200 Day Simple Moving Average. The chart below will illustrate further:
http://media.dailyfx.com/illustratio..._Picture_5.pngCreated with Marketscope/Trading Station IIThis brings us to the first usage of the 200 Day Moving Average; as support and/or resistance.
Support and Resistance
Few technical attributes can be as important to a trader as support and resistance. And while there are numerous ways of finding potential levels, few are as interesting as the 200 Day Moving Average for the very reason we mentioned at the beginning of this article: The potential for a self-fulfilling prophecy to take place as traders around the world react by selling when price resists at the 200 Day Moving Average, or buying when price is supported by the 200 Day MA.
http://media.dailyfx.com/illustratio..._Picture_4.pngCreated with Marketscope/Trading Station IITraders can look to place stops below these levels when looking to trade in the direction of the longer-term trend. In the example above, upon noticing that price had reflected off of the 200 Day Moving Average, traders could look to go long with a stop below the 200 Day MA.
So, if price does not move higher, the trader can look to close the trade before the loss grows to an undesirable level. The picture below will illustrate this premise in more detail:
http://media.dailyfx.com/illustratio..._Picture_3.pngCreated with Marketscope/Trading Station IIOne of the primary desires of such a strategy is the thought that the trader might be able to get in the trade in the direction of the longer term trend.
After all, if price is moving down to the 200 Day Moving Average, then price is moving lower after having previously traded above that level; indicating that the trend was previously to the upside. This brings us to another popular usage of the 200 Day MA: As a tool to determine trends.
The 200 Day Moving Average as a Trend Filter
Price has crossed the 200 Day Moving Average only once in 2012 on EURUSD (when looking at a closed bar for confirmation of the crossover).
Price made only six such crosses in 2011, over 3 different instances; many of which were followed by an extended run in the pair in that direction. The picture below will show in more detail:
http://media.dailyfx.com/illustratio..._Picture_2.pngCreated with Marketscope/Trading Station IIEach instance of crossover activity was followed by a corresponding extended movement, with sizes of those moves indicated in the chart below:
http://media.dailyfx.com/illustratio..._Picture_1.pngCreated with Marketscope/Trading Station IIStrategies to Trade with the 200 Day MA
Traders can build entire strategies around the 200 Day MA. As was seen above, price may run for an extended period of time after crossing the 200 Day MA. So, when price moves above the 200 Day MA, traders can look to go long with a protective stop at the Moving Average. That way, if price does reverse then the trader can contain the loss to a palatable level. Alternatively, when price moves below the 200 Day Moving Average, traders can look to go short with a stop at the Moving Average.
Alternatively, traders can integrate the 200 Day Moving Average into their pre-existing strategies or setups as a trend filter.
Let’s say for instance a trader wanted to trade with RSI. Well, they can do so by filtering trades to only take entries that agree with the 200 Day Moving Average. So, if price is above the 200 Day MA, the trader is only taking entries when RSI crosses up and over 30; or if price is below the 200 Day MA the trader is only taking short entries on RSI crosses down and under 70.
A Note on Risk Management
While traders may look to employ a multitude of different strategies, the general desire to trade in the direction of the trend brings special relevance to the 200 Day Moving Average.
When price crosses the 200 Day Moving Average, many traders around the world may be taking notice and if price trades below support or above resistance – that can be taken as a sign that the previous trend is over and a new trend may be developing. This is one of the areas that traders can look to avoid The Number One Mistake that FX Traders Make
by mitigating the potential loss when the trend reverses.
Written By James B. Stanley, Trading Instructor
