Here’s another post with some basic information that anyone investing should know about. If you’ve read any of my “Intro to Investing” posts before, you’ll have noticed that I give warning when there’s a fair amount of, well, let’s just call it “dry” reading ahead. Fair warning, this post shall be no different! But I do promise that I’ll try to keep it short enough so that you’ll be through with it before you’re tempted to poke your eyes out with a dull pencil.
What is Technical Analysis
In a nutshell, Technical Analysis is the complex mathematical study of a stocks past price and performance to predict a trend or provide a signal to sell or buy. It is quite often associated with trading activities. I’m no longer an active trader, but I’ve found that technical analysis has a place in the traditional long term investor’s toolbox as well. The same technical analysis techniques that I used when researching stocks I traded work as well in conventional long term investing.
Many long term investors are insensitive to a stocks price when buying into a position. I imagine that they are very price sensitive when selling though. I really believe that an investor should be just as price sensitive going into a position as when they are exiting it. Technical analysis of stocks can be a useful tool to identify good exit points when you are ready to get out of a position. You can also get fair warning of when it’s a bad idea to get out of a stock position using the same metrics,
When I’m interested in adding a position to my portfolio, I’ll usually rely on technical analysis indicators to identify a good entry point. I don’t want to buy into a position when it’s potentially at a peak, or worse when there’s a decisive downward trend. When I want to get out of a position, I’ll either use a trailing stop, or I’ll keep a close eye on the technical metrics to if not quite identify a peak, at least get close to it.
So without much further ado, let me roll right into it!
SMA – Simple Moving Average
I’m including and making te Simple Moving Average first simply because in the past, it’s been mentioned a lot as a good indicator. I completely disagree. I don’t like the SMA as a technical analysis tool, at its best it might give you a basic trend in terms of what direction a stock is moving. The graph here shows two lines, a 200 day moving average and a 10 day moving average. These are the two I paid attention to in the past. The simple moving average is calculated by taking the closing price of an issue for a time period and deriving the average. It’s trailing, so a 200 day moving average shows the last 200 days, a 10 day moving average shows the last 10.
The perceived value of the SMA is when a price crosses over or under the SMA line. For a long term average, the price of the stock relative to the average gives you a technical indicator of whether the stock is bearish or bullish. For a short term technical indicator, you would be looking at cross-overs that would give you a sell or a buy signal.
In case I wasn’t clear earlier I DON”T LIKE SMA’s. I don’t use them. I wanted to include them in this technical analysis tutorial because it is widely recognized and recommended by the “experts”
RSI – Relative Strength Indicator
Similar to SMA, RSI is a technical analysis indicator of momentum (upward or downward trending). The formula to calculate RSI is RSI=100-100/(1+RS). RS is equal to Average Gain/Average Loss. RSI ranges between 1 and 100. A normal range is considered anything between 70 and 30. I view RSI as a decent indicator as to a stocks trend (bearish or bullish) and to know when it is overbought (near the 70% line) or oversold (near the 30% line).
I don’t use RSI to look for trade signals. I do use RSI to get a feel as to whether a stock is bearish or bullish. This is important to me. If I’m looking to get out of a position and a stock is bearish then I’ll be less likely to sell the position until that particular stock rallies and goes into bullish territory. Likewise, if I’m looking to buy and the stock is bullish, I’ll probably wait it out until it goes out of favor and starts getting oversold.
Here’s where the fun begins. The Bollinger Band is a technical analysis tool that I wouldn’t be without. It consists of three lines, the center line is an exponential moving average, similar to the SMA except that more weight is given to the latest data. Above and below the EMA are two lines (Or bands). These bands are calculated from the standard deviations of the EMA of that stock.
These metrics are user definable. My preferences are for a 20 day EMA with 2 standard deviations for the bands (as depicted below). Conventional analysis of Bollinger bands dictates that when a stock is above or below the EMA and touching either of the bands that the stock is overbought (top band) or oversold (bottom band) and that is a trade signal to either buy or sell.
I, being the stubborn old mule that I am, use these bands somewhat differently. I look for prices crossing the bands as an alert to potentially buy or sell. Look at the chart below. You’ll see that having the stock “touch” the lines isn’t the best indicator in the world. In this particular chart, the lines seem to constantly touch the lower band during a price decline. If I see a stock price cross a band outside of the zone between the two bands, and then cross it again into the zone between the bands, I take that as a very strong signal to buy or sell.
In other words, one the price crosses a band a trigger is set. If it crosses it again into the the “band” then the trigger is pulled. A signal to buy or sell has been created.
Say that a few times out loud! I like this indicator, let me re-phrase that, I LOVE this indicator! The Slow Stochastic is actually a variation of a Stochastic Oscillator. (Maybe that’s way I love this one, oscillators abound in electronics which is my working background). A Stochastic Oscillator is a momentum indicator. There are two variants of the Stochastic Oscillator. There is a fast and a slow stochastic.
The fast is the original technical analysis tool developed by George Lane in the late 50’s. The slow is a variant of the Fast with smoothing introduced into it. There are two lines in a stochastic Oscillator, %K and %D. The %K line in a Fast Stochastic is somewhat erratic. Here are the formulas used to derive both:
%K = (Current Close-Lowest Low) / (Highest High – Lowest Low) *100 the look back period for this is usually 14 days.
%D = 3 day period moving average (SMA) of %K
Slow Stochastic introduces a 3 day SMA to %K to smooth it, %D is a 3 day SMA of the new %K
In the chart below, %k is represented by the orange line and %K by the Green line. %D is widely accepted as being the most accurate indicator in terms of generating signals.
As usual, I buck conventional wisdom and use my own interpretation of %K and %D. I look for these indicators to cross outside of the 80% and 20% boundaries, once they are out there, I look for a crossover of the two lines. If either %K or %D are outside of the zone defined by 80% and 20%, and a cross over occurs, a signal is generated where the two lines cross. It might be easier to look at the chart below where I’ve indicated where the signals are.
Putting It All Together
As you may have guessed by now, the two key metrics I look at when I’m using technical analysis are the Bollinger bands and the Slow Stochastic. When the conditions for both of these metrics are giving a sell or a buy signal, I would then move to get in or out of a position. Are these technical analysis metrics 100% reliable? ABSOLUTELY NOT! It’s easy to look at a historical chart and identify those perfect opportunities. But when conditions are “live, and you don’t have a view into the future, things are a little stickier. I’ve traded on technical analysis metrics before and gotten burnt, and I have the scars to prove it!
Are Stock Technical Analysis indicators useful? Yes, in my opinion they are. They can help you identify good entry and exit points as well as trends. If a stock you are evaluating is in the process of taking a sleigh ride down to the bottom of the hill, you probably don’t want to buy into it until it’s close to its bottom. Likewise, you may not want to sell a position if it looks like it’s in the midst of a nice run.
Ok, the torture is over, you can put down that dull pencil and save your eyeball for another day. In all seriousness though, I hope that this is informative and helps you in your investment decisions. Use your good judgment when investing and more importantly, do your homework. Check the fundamentals on a potential stock to see if they fit into your investment model. Remember, I am not an investment professional, the information presented here is based on my opinion and experience and is provided for informational and educational purposes only. There, I feel better now that I said that !
- Investing in Stocks and Fundamental Analysis – An Introduction
- Investing in Stocks and The Stop Loss
- The Perils of Being an Emotional Investor
Do you use technical analysis in your investing activities?
Image courtesy of Nick Benjaminsz
Latest posts by John Schmoll (see all)
- 5 Crazy Ways Frugality Can Go Too Far - July 27, 2016
- 3 Easy Ways to Start Building an Emergency Fund - July 20, 2016
- 5 Simple Ways to Save Money When Buying a New Home - July 13, 2016