We analyzed the importance of many ways to analyze the markets technically. Moving averages as I had mentioned earlier forms a key and intrinsic part of this analysis analogy. But amongst moving averages too, you have many types, simple, exponential, 50-day, 100-day and the like. So how would you decide what’s the best parameter to gauge the market movement and get a clear perspective on the movement and multitude of trends seen in the markets? I would say the time period is crucial. If you are looking at a fairly long-term perspective, say a 1-year view, perhaps the 200-day moving average is one of the best tools to gauge price trends.
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What Is a 200-day Moving Average?
In simple terms, the 200-day moving average is the average closing price of a currency pair over the past 200 days. One of the most popular tools to assess price trends, this indicator is commonly used by hedge funds, traders and investment banks. More than technical reasons, oftentimes this tool is used for fundamental analysis and that perhaps explains the widespread use of this tool not just by chartists, but many fundamental experts too. Considered the stalwart among charts, it often is a more realistic representation of the 1-year performance of a currency pair compared to several other methods.
As was seen during the economic mayhem in 2008, the EUR-USD pair lost over 21% or close to 3500 pips in 3.5 months. When the Fed finally announced the TARP or the Troubled Asset Relieve Program in October, 2008, the prices rallied on hopes of recovery. The EUR-USD climbed close to 20% from its recent lows. The upmove in prices continued till it reached its 200-day moving average, gaining over 2400 pips. This acted as the resistance zone. Traders who were aware of this, were cautious as this value approached and those who did not anticipate had their trades wrong. The euro could not breach this resistance zone and retraced some ground.
How To Calculate & Interpret 200-day Moving Average?
The approach for calculating the 200-day moving average is quite straightforward. You add up the closing price of all the 200 days under consideration and then divide it by 200. Therefore, one would perhaps conclude that the higher the average moves; the higher the markets would be and the vice versa, the lower the markets go, the stronger the bearish trend would be. However, the reality is a bit different. Very high readings on the chart signal an impending reversal in the market. These high prices symbolize euphoria among traders. Generally at this stage new buyers are few and far between and eventually the prices start slipping. Similarly, very low readings indicate than the downtrend is going to end soon. In short the shorter moving average you have, the faster the chance of seeing a change in sentiment in the markets.
The Key Role Of 200-Day Moving Average
So what is the special feature of this particular measure of market sentiment vis a vis several others? Well, perhaps the biggest and the most important one is that it is by far a measure of the overall health of the market as well as the health of the particular entity you might be trading in. Also, the percentage of entities that are trading above the 200-day moving average decide the health of the overall market and even global economy.
Not just that, many traders also use this measure to determine the entry and exit point of the market and the specific currency pair that they might want to trade in.
Recognizing Resistance & Support Zones
Another major benefit of the 200-day Moving Average is it makes identification of support and resistance levels very simple. Traders can easily decide to put stop loss below these levels and then take a call on the long-term direction based on the market movement.
If let’s assume, for a specific trade, the price reflects off this crucial levels; it is a safe call for the trader to take a long position with stop loss below this point. Or supposing the prices do not move higher than this level, one can look at cutting losses at this point. Essentially it helps the trader take a call on the long-term direction and gauge the market sentiment more precisely.
Role as Trend Filter
I had mentioned earlier too; the 200-day Moving Average is like a one stop shop addressing most of trader concerns. It is a sure gauge of the trend in the market. For example, the EUR-USD has crossed this crucial level only once in 2012. In 2011, there were just 6 breaches on three instances. This clearly tells you that this is not a signal that you will want to ignore. If the 200-day Moving Average is signaling a buy or a sell, it is best to pay heed to.
Some Handy Trading Strategies Using The 200-Day Moving Average
Now then let’s talk business, how well can we use this tool in maximizing our returns from the market? Traders can use these levels to build several strategies given the wide list of possibilities and the broad spectrum of trend it helps in identifying.
A trader can use the 200 DMA and fashion a trade to suit his or her convenience. As it is commonly noticed, prices may continue to move up for a considerable amount of time after breaching this crucial mark. Traders can use this as the cue; go along with a stop loss at this precise level to limit loss prospects in case of a reversal.
Another approach could be when the price of the currency pair you might be trading in slips below this psychological important level, you can choose to go short with the stop again at this very point.
In certain cases, traders may look at introducing the 200-day moving average parameter in their existing strategy and see how best they can capitalize from this in terms of identifying a trend and then executing the previous strategy they decided on. For example, let’s assume you trade with RSI. You can easily incorporate the 200 DMA by only entering the trade at levels that are sync with the 200 Day Moving Average. As a result if prices cross this mark, you take entries in your RSI at least 30 points above it and vice versa.
Thus in a nut shell while different traders use different kinds of strategies, the general inclination is trading with the trend, in tandem with the overall market direction. It is this very fact that the 200-day Moving Average helps in establishing.
Wherever in the world you might be, if you are a serious trader it is hard to ignore the breach of such a crucial level. Needless to mention then globally traders take this development as a sign of buying or selling a specific currency pair hence signaling the onset of a new trend. Most cases what this can ensure is if you are abiding by the 200-day Moving Average your potential loss prospects, or the probability of preserving profit is intact in 9 out of 10 trades. Whether you are a day trader, a mini trader, major hedge fund or a big investment bank, the 200-day moving average would help you reap equal benefit.