200 Day Moving Average (or 200DMA) is a popular ‘weapon’ found in every technical analyst’s or a trader’s toolbox. And surprisingly, it is one of the very few technical analysis tools that are easily understood by those who don’t respect technical analysis, i.e. even a fundamental analyst understands the importance of 200DMA
200DMA & 3 Year Returns
How To Calculate 200DMA
200DMA is calculated by taking arithmetic mean of all values in consideration (Stock prices, index levels) in last 200 trading sessions (40 weeks). 200DMA is generally used to assess long term trends. Another tool regularly used by traders to assess short term trends is 50DMA. Generally, a stock trading above its 200-day moving average is said to be in an uptrend and is being accumulated; one below it is in a downtrend and is being sold. (Learn how to calculate CAGR)
200DMA is calculated by taking arithmetic mean of all values in consideration (Stock prices, index levels) in last 200 trading sessions (40 weeks). 200DMA is generally used to assess long term trends. Another tool regularly used by traders to assess short term trends is 50DMA. Generally, a stock trading above its 200-day moving average is said to be in an uptrend and is being accumulated; one below it is in a downtrend and is being sold. (Learn how to calculate CAGR)
200DMA & 3 Year Returns
To find out whether there is a correlation between Investing based on 200DMA and returns obtained over a period of 3 years, I analysed Nifty’s data of last 20 years.
A comparison between 3 year CAGR and index’s distance from its 200DMA was made.
A comparison between 3 year CAGR and index’s distance from its 200DMA was made.
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| Correlation | Investing based on 200DMA & 3 Year Returns (CAGR) |
The red portion indicates index’s level (+/-) from its 200DMA. For example, in region marked P, index was trading at level which was 20% lower than its 200DMA. The green portion indicates returns over a 3 year period on CAGR basis.
A few observations from above graph are –
- Regions marked A, B, C, D & E had Nifty trading at level 20% (+) above its 200DMA. And as green graph shows, returns obtained in all 5 regions have been negative. As of now, discussion on region F is being left out intentionally.
Possible Reason: Chances of your investments earning a negative return are more if you invest at times when index is trading at a premium of 20% or more to its 200DMA.
- In regions marked P, Q, R, S and T, Nifty has been trading at level 20% (-) below its 200DMA. And as green graph shows, returns obtained in all 5 regions have been positive.
Possible Reason: Chances of your investments earning a positive return are more if you invest at times when index is trading at a discount of 20% or more to its 200DMA.
- It is assumed here that investor is investing in index as a whole using an index fund or something similar. Similar graph drawn for individual stocks may show different results depending on sector’s business cycles.
- Region F (i.e. Year 2000-2004) is an outlier in this analysis as during this period, India was in long term secular bull market and as evident from graph, relation between 3Y-CAGR and distance of index from its 200DMA is not evident. Returns continue to be positive even though distance from 200DMA oscillates between positive and negative.
This small but interesting analysis shows that though 200DMA is generally used by traders, it can be a handy tool in hands of a long term investor as well. On broad levels, it actually helps investors understand the general direction of overall markets.
It is therefore advisable that one should always have a look at a stock’s 200DMA before investing in it.
You can read a similar analysis where 5 year returns were investigated for having a correlation with investments based on moving averages.
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