The 200 DMA Pivot

During a bull market, breaks below the 200-DMA tend to represent good buying opportunities. During a bear market, breaks above the 200-DMA tend to represent good selling opportunities. The challenge, of course, is to be able to weigh all the evidence and arrive at a high-confidence conclusion as to whether the previous major trend is still in force because every break of the 200-DMA will be a false signal…until the last one.

Market makers track the percentage of stocks above/below their respective 200DMA. If this number is greater than 85% or 90% then many traders look for a reversal in the market. On the other side, when this indicator plunges below 20%, people hope for an upswing. Ergo, most traders may end up avoiding stocks that are trading below their 200DMA. Whether the line is the cause of trend reversal or not is not my point – i haven’t read enough to make that point. All I am saying is that if enough people behave in step, it can cause a stampede. Who cares who cast the first stone in the pond and caused the ripple? As long as enough subsequent ripples/waves follow that first in synchronous phases, you can have the makings of a great wave. Then there is the “golden cross” which is the point at which the 50DMA and the 200DMA cross each other. A close (and sustenance) of the 50DMA above the 200DMA is supposed to indicate the commencement of a bull journey (and vice-versa). When used in conjunction with the 50DMA, the 200DMA line provides some trending views: if a stock that has price trading above its 50DMA and if the 50DMA is above its 200DMA then the stock movement is bullish and the trend should continue. A natural logical extension of the above rule is to consider the 200DMA as support and resistance levels. This is what appears to be the case with the NIFTY currently. Will the 5400 level get taken out? If the index closes and stays conclusively above 5400 then maybe this will become the new support line. The index could hover around that level, being range-bound and wait for the 50DMA to catch up and cross-over the 200DMA giving a clear signal of an intermediate up-move. Alternatively, with Trichet (President, European Central Bank) warning all that the Europe’s sovereign debt woes are far from over, it could well be possible that the 200DMA level does not get breached by the NIFTY and the index falls down. I have no hunch and in moments of apparent inflection points such as what i am thinking next week to be, it’s best for retail rats like us to sit the action out and see what happens.

Here’s a trading strategy:

Monitor your portfolio. On stocks that you pick (whatever be the method), get out of them if their price falls below their respective 200DMAs. Stay in cash and re-enter when the price goes above the 200DMA.

I have a feeling that, if this tactic be consistently applied over a long time period, it would yield superior returns to a “random walk” style of investing even after taking transaction costs and taxes into account. This scheme may not work in markets like Europe, US or Japan, but this would be very applicable to economies that are in the middle of their S-curve of economic growth (China, Thailand, India…)

Deepak Shenoy has given some direction here on how to live under the 200DMA line.

And finally, a very important trading lesson picked up from State of the Market:

One should never buy stocks on HOPE when they trade below 200 dma and one should never sell stock on fear when they trade above 200 dma because no HIGH is too High and no Low is too Low.