“You don’t need to go to business school; you’ve only got to remember two things. The first is, you always want to be with whatever the predomianat trend is.” – Paul Tudor Jones, Market Wizard
Trend following has been around for ages and it is still one of the most efficient ways to tackle the markets. The fact is that the devil, as always, is in the details. In this article we’ll try to decipher why one market wizard, Paul Tudor Jones, uses the 200 Day moving average as his trend filter despite the well known fact that moving averages are not a holy grail.
The 200 Day Moving Average Kill Switch
“My metric for everything I look at is the 200-day moving average of closing prices” – Paul Tudor Jones
Source: Yahoo Finance
What made Paul Tudor Jones famous was the fact that his fund survived the 1987 crash and the only publicly known reason for that was the 200 Day moving average rule. In his own words “At the very top of the crash, I was flat.”
Readers know that I’m no fan of having charts full of indicators. My experience with indicators was frustrating at best, because they simply work until they don’t. But what if we don’t use indicators as the main decision-making tool? What if they are there to serve another purpose?
Long-Term Fundamental Estimate
Let’s take off our FX hat for a moment and put on our stock trader hat. When we analyze stocks to insert into our Spoonfed Investor portfolio, we don’t start by looking at the charts. We start with a filter based on certain fundamental qualities we like to see in stocks.
While it’s difficult to ascertain the precise fundamentals of a currency, it is almost paramount to understand the fundamentals of a company whose stock you wish to possess. Let’s take Google for example.
Source: Yahoo Finance
Google has been in an uptrend ever since 2009, with only periods of consolidation but never periods of outright falling prices. This is mirrored by Google’s fair value estimates and earnings per share (remember that at the core, stock investors care about the company’s profitability and earnings – all else is secondary). The purple line in the chart above is the 12 month moving average which is a very close proxy to the 200 day moving average.
Data source: Skaffold Stock Research
The day to day fluctuations in stock prices do not depend on the company’s fundamentals. Only earnings announcements, regulatory changes or breaking news about the company are meaningful. So why do stock traders and investors alike hang their hats on a stock’s fundamental outlook, rather than the technical picture? Because in the long run, good companies survive. Good companies withstand economic cycles.
When I started digging into fundamentals however, I found something “obvious”: the markets discount the current fundamental outlook for the business perfectly.
BHP Billiton’s fair value estimate vs. stock price – Skaffold Stock Research
Google’s example was easy: things have been going better each year. BHP has had a different story: their fundamentals have been more volatile. As you can see, the stock price rises and falls with the fair value estimate. We could overlay the company’s revenue, net income or EPS and the result would be the same: the current outlook is discounted in the current market price.
My studies lead me to believe that the 12 month / 52 week / 200 day moving average is a good proxy for the current long-term fundamental assessment for the asset in question.
BHP Billiton stock price – Yahoo Finance
How to Use the 200 Day Moving Average
This brings us back to our day to day focus on FX. It is practically impossible to calculate the current long-term fundamental estimate (or fair value) of a currency. So let’s not even try. Instead, let’s use the method described above, and have faith in Paul Tudor Jones’ idea: if price is above the 200 Day SMA and the SMA is sloping upwards, there is probably a strong fundamental reason to look for buying opportunities. Vice versa, if price is below the 200 Day SMA and the SMA is sloping downwards, there is probably a strong fundamental reason to look for selling opportunities.
EurUsd with the 200 Day SMA
Over to You
So avoid using the moving average as a buy/sell indicator. Instead, use it as a bias indicator: depending on it’s slope and the position of price at any given moment in time, you can logically believe there are fundamental reasons for price rise or fall because the average is a good proxy for long-term fundamentals.
Does this mean you can blindly buy or sell the currency? I wouldn’t.
Currencies are different than stocks in more ways than one. The biggest difference is that stocks reflect an underlying company that has a going concern. Basically, companies will fight in order to survive. Currencies have no real going concern. They are simply a vote of confidence on the underlying economy, and in this sense much more prone to emotional swings.
In short, use the 200 day moving average like Paul Tudor Jones as a long term bias filter (and now we have evidence of just why this may make sense) but overlay your own timing rules in order to leg in & out of that longer term trend.
About the Author
Justin is a Forex trader and Coach. He is co-owner of www.fxrenew.com, a provider of Forex signals from ex-bank and hedge fund traders (get a free trial), or get FREE access to the Advanced Forex Course for Smart Traders. If you like his writing you can subscribe to the newsletter for free.