What breach of 200 DMA really means for the Nifty

Riken Mehta

The Wall Street wisdom of ‘Sell in May and Go Away’ so far holds true for the Dalal Street. Nifty breached its 200 DMA on Friday, giving yet another signal of bearishness in the market.

But why is breach of 200 DMA so critical for the market? Let’s find out

The 200 Day Moving Average is a long-term moving average which helps in tracking the overall health of an underlying asset. A stock trading above its 200 Day Moving Average is considered to be in a long-term uptrend and vice-versa. 

In a bull market, the 200 DMA time and again acts as a major support level. Whereas in a bear market, the 200 DMA often works as a major resistance level. However, a decisive break above 200 DMA can lead to sharp rally in prices.

Whenever an index or a stock trades near its 200 DMA, it draws support in a bull market and faces resistance in a bear market. Currently, the 200 DMA of the Nifty is around 5,112 with the benchmark closing below it for 3 consecutive sessions. (See the chart below)

It is important to keep an eye on whether an index closes above/below its 200 DMA on a regular basis before making any trading decision.

After all, it is a long-term trend indicator, so wait for some days for the confirmation of trend reversal. Only price correction need not confirm a reversal. One has to also view the slope of price correction along with time taken by Nifty for the correction.

So a mere breach of 200 DMA up/down does not signal trend reversal and one should not enter a trade (long/short) all guns blazing.

Lets understand better with an example. Nifty Time frame: May 2005 to May 2012

Points A, B and C: Nifty finds support around 200 DMA giving an opportunity each time to enter in a long trade.

Point D (May 2008): As you can see Nifty breached below its 200 DMA in January 2008. A relief or short covering rally found resistance at point D (200 DMA). This was a chance for long term investors to exit and traders to go short on the market.

Point E (May 2009): Again, Nifty inched above its 200 DMA before the outcome of election results. If you would have gone long at Point E then you could have ride long positions until point G.

Points H, I: Nifty finds resistance at point H in a downtrend and support at point I in an uptrend.

Point J: Nifty at current position. So it’s important to see whether Nifty finds support around 200 DMA or keeps falling and remains below it for a brief period of time.

More on Moving Averages

As the second word implies, it is an average of a certain body of data. For example, if a 200 day moving average (DMA) of closing prices is desired, the prices for the last 200 days are added up and the total is divided by 200. The term moving is used because only the last 200 days closing prices are used for calculations.

The moving average is a smoothing device. By averaging the price data a smoother line is produced making it much easier to view the underlying trend. Remember, moving average is a lagging indicator. What it means is that 20 Day Moving Average would hug the price action more closely than 200 Day Moving Average.

Depending on your time frame, a shorter, medium or longer term average can be used. A 20 day moving average would be more useful for short term trend while 200 DMA will prove effective for the longer term.

Types of Moving Average

Simple Moving Average

Simple Moving Average is widely used by most of the technical analysts. However, over the years this moving average has been criticized for assigning equal weight ages to all days. In a 20 day average, the last day receives the same weight age as the first day. This was taken care by Exponential Moving Average

Exponential Moving Average

Exponential Moving Average assigns a greater weight to the more recent data which is why it is called a weighted moving average. We will not brief the calculation. Technical software’s and charts makes it easy for you. All you have to do is select the number of days you want in the moving average: 20, 90, 200 etc.

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