Trading with Technical Analysis

June 3, 2016 |

In my last several articles, I discussed ways to limit losses, safely trade options, and find a great stock. Today I want to discuss another element of trading: technical analysis. After you decide you like a stock’s fundamentals, you can use technicals to optimize your entry point. Even just a simple technical analysis can be incredibly powerful for your trading. Here are a few of the technicals I use before entering a position with any stock.

Moving Averages

I believe moving averages are one of the most valuable indicators in technical analysis. The moving average is a simple technical analysis tool that smooths out price data by creating a continually-updated average price. In my opinion, a chart without moving averages is like baking a cookie without butter or eggs. Those simple lines above or below current price tell many tales, and their uses in market interpretation are unparalleled.

There are a few different moving averages to choose from however the two that I like to use are the simple moving average (SMA) and the exponential moving average (EMA). The only difference between these two types of moving averages is the sensitivity of each one shows to changes in the data used in its calculation. More specifically, the EMA gives a higher weighting to recent prices while the SMA assigns equal weighting to all values.

Moving averages provide a trader with a simple yet effective way for knowing what side of the market you should be trading because they smooth out some of the noise to show a clear trend. If the stock is currently trading below a moving average then you might consider either holding off on a long position or entering a short position; conversely, if the stock is trending higher then you should enter long. This helps you take advantage of positive momentum and avoid negative momentum.

When I am looking at a stock to trade, I will first make sure the stock is a good candidate from a fundamental standpoint and not too volatile (generally I like the beta of the stock to be less than 1).

Let’s take an example. Oftentimes, I look at the Buffetology Inspired list of stocks found within Stock Rover, shown below.

buffetology screener

In this example, I am interested in possibly trading stock ticker: CCF (Chase Corporation), a company in the diversified industrials industry.

Prior to making any trade, I would like to see this stock trading above the monthly 20EMA, which is roughly equivalent to a 400-day EMA, which can be charted in Stock Rover (you can edit the moving average periods from the Technicals menu). On a side note, when a stock is below its monthly 20EMA, under no circumstances will I take a long position.

400 ema

You can see from the chart above that the stock is trading well above the 400-day EMA, and has been since the starred point. Therefore this stock looks like a good stock to trade based on my first criteria. In fact, just by looking at this alone, you were signaled to enter a buy (long position) in late 2012 at a price roughly around $15.46/share and still be in the position at $58.59 for a gain of $43.13 per share.

Although I like looking at the long-range chart first to remove a lot of the noise and get a broad context, it is not my only stop before entering a trade. I next like to look at the daily chart of the stock and place a 50-day SMA and a 100-day SMA. My rule is to buy only when the 50SMA is above the 100SMA, ideally just after the 50SMA has crossed over the 100SMA.

50sma and 100sma

As you can see by the stars in the image above, there are three crossovers on which to buy this stock according to my rule. Again, per the monthly chart, this stock has been in a buyable zone since late 2012. Now, my last criteria prior to purchasing this stock is to try to pinpoint the timing so I suffer the least amount of drawdown possible. This is when I use Bollinger Bands.

Bollinger Bands

Bollinger Bands are a versatile tool combining moving averages and standard deviations. There are three components to the Bollinger Band indicator:

  1. Moving Average: By default, a 20-period simple moving average is used.
  2. Upper Band: The upper band is usually 2 standard deviations (calculated from 20-periods of closing data) above the moving average.
  3. Lower Band: The lower band is usually 2 standard deviations below the moving average.

You’ll notice in the image below that a price chart tends to bounce off its lower and upper bands, meaning a good time to buy is while the stock is close to its lower band, and a good time to sell (if you’re looking to sell) is as the stock is hitting its upper band. I look to only buy my stocks when they are below the 20SMA on a daily chart (the middle line in red below). This helps me reduce risk and provide a decent entry. Alternatively, I could sell put options to enter in my long trade at a lower cost basis (discussed here). Once I enter the trade, I will then begin my money management rules (discussed here).

bollinger bands

Summary

There are a number of technicals you can apply to optimize your trading. I like to use moving averages and Bollinger Bands because they are simple to use and effective. To sum this article up, the steps I take prior to entering any trades are as follows:

  1. Select a good stock that is not too volatile and has sound fundamentals. (Look at all the great screeners within Stock Rover!)
  2. Look at a monthly chart and place a 20EMA, or place a 400-day EMA on a daily chart. Only trade long positions when the stock is above this long-range EMA.
  3. Place a 50SMA and a 100SMA on the daily chart. Only make a trade when the 50SMA is above the 100SMA.
  4. Lastly, use Bollinger Bands to enter a trade. Make sure the stock is below the 20 SMA on the Bollinger Band.

Again, only trade when all four of the rules are met. Once they are met, you should be on your way to trading more profitably while you reduce your risk!

As always, happy trading!





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