Market Timing using the 200 day moving average

Market timing gets a bad rap in the retail investing space.  Individual investors like you and I are often told that market timing does not work and it is impossible to predict when the market is going to reach a top and when it will reach a bottom.  Regardless of the tools available, be it charts, indicators, put/call ratios, advance/decline lines or market pundits declaring they know what is going to happen next. The ability to time the exact top or bottom is very hard if not impossible.

However, when professional investors use market timing they are not using it for exact buy and sell points.  Instead they use it to help them get an idea of the general trend of the market which helps determine what actions to take.  When huge hedge fund managers like Paul Tudor Jones uses market timing. Then there must be something to it that makes them use it to manage billions of dollars.

To help normal investors take advantage of the benefits of market timing. Let’s look at what market timing is really used for and one method of using market timing in your own portfolio.

The True Purpose of Market Timing

True market timing is not designed to make an investor a lot more money.  It is not about making more money using some fancy mechanism to determine if the market is going up or down.

Instead, the main purpose of market timing is to protect your investment capital during times when the market is down a lot and has the potential to go down even more.

A stock market can only go in three directions: up, down, and sideways.  As an investor, the best time to be in the market is when it is either going up or sideways.  When it is going up, we are obviously making money.  If the market is going sideways we are not making money, however we are not losing money either.  These are fine times to be invested in the market.

However, when the market is going down most stocks will get dragged down with it.  That is when we want to be out of the market and protecting our capital from evaporating.  Market timing is a tool that can be used to determine when to get out of the market during these difficult times.

There are a number of different mechanisms investors can use to time the market.  Some of them are more complex than others, however they all have the same purpose; to protect your hard earned capital when the market is doing nothing by going down.

One of the most popular market timing tools is the 200-day moving average.  Let’s look at how that works and how you can use it in your portfolio.

How to Implement Market Timing in Your Portfolio

Since market timing is a tool to protect capital as opposed to make more money. One of the easiest ways to market timing is by using the 200 day moving average.

As a refresher, the 200 day moving average is a price line on a chart that displays what the average price a stock has been at over the last 200 trading days.  Simply put, if a stock market is trading higher than its 200 day moving average the market is in an uptrend.  If the market is trading below the 200 day moving average the market is in a downtrend.  It is during these downtrend times that we need to be extra cautious as investors as it is very easy to lose money when the whole market is going down.

Therefore, a simple but effective market timing tool is to be long stocks when the market is above the 200 day moving average.  When the market eventually drops below the 200 day moving average that is an idea time to sell stocks and wait it out.  You can eventually get back in when the price starts to trade above the moving average line again. Knowing that, you are protecting from losing any more money while the market is trending lower.

As an example of when this method worked, you can look at how Paul Tudor Jones used the 200 day moving average as a guide to get out before the 1987 market crash – one of the worst market crashes of all time

Summary

As discussed, market timing is not a tool that is used by investors to make money.  Instead, market timing is used to protect capital.  Put another way, it protects you from losing all your money during a down trending market.

One of the most effective, but simplest methods to market time is using the 200 day moving average.  The rules are simple, buy and hold stocks when the market is above the 200 day moving average and sell them when it is below that line.  The outcome is that you protect your downside and preserve your investment capital.

 


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