Technical Analysis – Moving Averages
My favorite part of this job is learning about different investing techniques. I’m always reading about new strategies some hedge fund manager is using to generate huge returns. I’ve met with individual investors focusing on fundamental analysis. Sometimes, I get to debate the merits of a strategy with people who use it.
One of the biggest debates these days is fundamental vs. technical analysis.
Clearly investors who follow an exclusive strategy can be passionate. Locking two of them in a room is the closest you’ll come to ancient Roman Gladiator battles.
Every investor has their own technique for interpreting market and fundamental data. Everyone’s looking for an edge that will make them millionaires. Sometimes it’s the simplest strategies that yield the biggest results. I’ll give you an example in a minute… but first my thoughts on fundamental vs. technical analysis.
I’ve got to admit, I ride right down the middle of the road on this one.
Some investors like Warren Buffett believe only in fundamental analysis. Others focus exclusively on technical indicators. Here’s the thing… I’ve seen both methods work. That’s why I like to use both of them in my own research.
I’ve already talked a great deal about fundamental analysis in other articles. Today I want to touch on some of the technical indicators investors use.
The big question on every investor’s mind is when do I get into and (more importantly) out of a trade? It’s a simple question with thousands of potential answers. One answer is by using technical analysis, and specifically moving averages. It’s a simple strategy that almost anyone can use.
Moving averages have gained notoriety as a simple method for determining entry and exit points. The reason is moving averages give off reliable trading signals and they’re easy to use.
First, what’s a moving average?
A moving average takes a specific time period and averages the closing prices. For example, a five day moving average takes the prior five days of trading and averages the closing price. The next day they add the new closing price and drop off the oldest. Ok, it sounds a bit complicated I know. Here’s the key, moving averages smooth out price action, giving us a better look at what markets are doing.
Some of the popular moving averages are 5-day, 9-day, 20-day, 45-day, 50-day, and 200-day. You can also create moving averages on a weekly or monthly basis.
Because we can modify the moving average, we can look at short term or long term trends very easily. Take a look at the charting software that your broker uses. They probably have a number of moving averages already programmed in. So it’s easy to use no matter your trading style.
As I mentioned, moving averages give off a number of signals.
First and foremost, they easily show the direction a market is moving. Second, when they change direction, many investors use that as a signal. Third and finally when one short term moving average crosses over another long term moving average (called a moving average crossover), it’s another signal of change.
When you look at moving averages you want to identify points of change. These signals show when a market might be changing direction, and indicate now’s the time to take action.
All throughout 2007 the 200-day moving average was heading higher, and the 50-day moving average (the blue line) went along for the ride.
Then in early 2008 we noticed a signal. We had a moving average crossover to the downside. The 50-day moving average clearly drops through the 200-day. The shorter term moving average is more sensitive to price movement. Because of that, the movement lower shows the trend might be changing.
Many investors would look at this signal as a time to exit.
But these signals aren’t always perfect.
So the more cautious investors wait for another signal, a confirmation. The second signal showed up a few weeks later. As you can see in April the 200-day moving average went from an upslope to a downslope. A clear indicator the trend had changed.
GE’s stock was trading well above $30 when these technical signals screamed “SELL”. Today GE’s trading for less than $10. If you owned GE, following these signals could have saved you thousands or tens of thousands of dollars.
Aggressive traders might have even gone short and really cleaned up.
Here’s the great thing. This doesn’t apply just to selling. We’ll know to get back into GE when we see a 50- and 200-day crossover to the upside and the 200-day moving average starts to trend higher.
Category: Technical Analysis
