How 200 DMA Makes A Difference

By TradingMarkets Research

Up 10% or more in the past few days may be a great way to start the week, but moves like that can be great ways to start a reversal, as well.

We examined millions and millions of simulated stock trades between 1995 and 2007 with the goal of better understanding short term stock behavior. Is it better to buy breakouts or pullbacks? Is it better to buy a stock that has rallied over the past few days or a stock that has fallen for the past several sessions? Which is truly more bullish: stocks that are making higher highs or stocks that are making lower lows?

What we found out may surprise you. Most importantly, we found out that context is key. Stocks trading above the 200-day moving average tend to act very differently from stocks that are trading below the 200-day moving average. In fact, just about everything that can be said about stocks should be filtered through this one primary lens: is the stock in question above or below the 200-day moving average?

We believe that this is always the first and more important question every short term stock trader should ask him or herself. This is because the answer to that question is what lets us know whether or not a breakout is a good thing or a bad thing, whether or not higher highs are truly meaningful and bullish for a stock, and whether a big rally is prelude to a significant advance or potentially just a set-up for a fall.

Consider the five stocks in today’s report. All five stocks have had significant price increases over the past five days, increases to the tune of 10% or more. While this could easily be seen as a very bullish development, the problem with these advances is that they have occurred as the stocks have traded below the 200-day moving average.

While some stocks that rally big while under the 200-day moving average will ultimate rally above that level, our research indicates that the edge over time for the short term trader is in betting that these stocks will not remain strong and, instead, will under perform the average stock over the next one-day, two-day and one-week time frames.

Although we conducted research on a staggering number of simulated stock trades in order to reach these conclusions, these conclusions to have more than a whiff of common sense to them. For one, stocks that are trading below their 200-day moving averages have full true patrons. There are value investors trying to scoop up bargains, and a few traders looking to strike it big with lottery bets on stocks that have declined in price, but the rallies that stocks below their 200-day moving averages tend to produce on average are weak and unreliable ones indeed. As such, they are best avoided or when the circumstances are opportune-sold short.

A second point is that many of these stocks are held by longer term investors who, having held on to these stocks all the way down, are more than eager to sell them after the slightest advance. An investor who sees his or her stock fall from $45 to $15 will break land speed records to sell if that $15 stock bounces a few dollars, taking just a little bit of the sting out of the losing trade.

Short term traders want to position themselves on the right side of such situations. By selling stocks that make this bounce, traders can take advantage of the selling that often swiftly appears just as these stocks appear to be finally making progress to the upside.