This technical-analysis-based assignment was written by Stockpickr member Ira Krakow.
technicians ignore the stock's
fundamentals, concentrating instead on the tug of war between the
bulls and the
bears, as shown in the chart's price movement (see "
Technical Stock-Picking: How to Trade Off of a Chart"). If the bulls are winning, the price moves up. If the bears are in control, the price goes down.
Rev Shark: It's in the Charts
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In this assignment, you will learn how to use the most common technical tool: the
A Look at Microsoft's Chart
Let's look at
one-year line chart for 2007:
Microsoft zigged and zagged during the year, trading in about an 11-point range, between $26 and $37. Clearly there were many times when you could have reaped a short term
you could have figured out how to buy one price and sell a higher one.
For example, if you bought Microsoft on Oct. 22 at the
open (for $30.12) and sold on Nov. 2 at the open (for $37.22), you would have captured the biggest price move in the shortest time period, a 22% gain -- 7 out of the 11 points -- in less than two weeks. The strategy here: time your trades to capture the biggest percentage move in the shortest period of time. But how?
Overlaying the 200-Day Moving Average Line
Plotting a moving average line over the stock price chart will show the price trend in a smooth line, with fewer zigs and zags. The higher the number of days, the more long term the trend. Here's the same one-year chart for Microsoft, with its 200-day moving average line -- a commonly used long term time period -- plotted as a green line over the daily price chart. (To see a moving average line on a Yahoo! Finance stock chart, click "Technical Indicators: Simple Moving Average: Line 1 Period:
As you see, there are times when Microsoft traded above the moving average line and times when Microsoft traded below it.
Institutional investors often follow the 200-day moving average (or the "200DMA"). This indicator represents about 10 months of activity. When a stock's price is above its 200DMA, the stock is considered expensive relative to its price over that period. Conversely, when its price is below its 200DMA, the stock is seen as cheap relative to its 10-month trading activity.
One way to trade is to buy when the stock switches from trading
its moving average and sell when it switches from trading above its moving average to when it is below its moving average.
Using that methodology for the 200-day moving average, we would have spotted a buy signal in late September and we would have ridden the stock up to its major move in November.
The 50-Day Moving Average: Fewer Days, More Trading Signals
If you want to trade over a shorter time frame, reduce the number of days in the moving average to get more buy and sell signals. Another commonly used time frame is 50 days. Here's Microsoft one-year chart with its 50-day moving average line:
In this scenario, you would have made a few trades based on 50DMA-based buy/sell signals in February, April, June, July and September:
- If you had a position in Microsoft at the beginning of the year, there was a sell signal in February, when the price moved below the 50DMA line.
- Buy in early April when Microsoft crossed from below to above its 50DMA line.
- Sell in early June, capturing a 2-point gain.
- There was also a quick buy and sell signal in July with a small loss.
- The next buy signal would have been in late September at around $29, similar to the 200DMA line, and we would still be holding it for the same gain.
The takeaway: The fewer the number of time periods, the more buy and sell signals. Use your favorite charting software/Web site to plot moving average lines with different time periods.
Your Moving Average Assignment
Technical Stock-Picking: How to Trade Off of a Chart," you can see how to pick "
rocket stocks" based on chart reading, without the help of moving average statistics. This time, look for stocks ready to rocket because they were trading below their 50-day moving average line and now trade above it.
Stockpickr , create a portfolio called "Rocket Stocks By 50 Day Moving Average Analysis:
Your Stockpickr Username." (To create a portfolio on Stockpickr, you'll need to first log in. If you're currently not a Stockpickr member, you can register at
Research the Stockpickr portfolio database to find five companies that have recently crossed from
their 50-day moving average to
it. Using your favorite charting software, such as Yahoo! Finance Charts, plot the stock price and its 50-day moving average.
Since some institutional "
elephants" base their buy decision on the 50-day moving average, and this is considered a bullish bellwether, you may find reports in the financial press on this.
Remember, you're playing technician, not really worrying about the fundamentals. The idea is that if more money is being bet that the price will go up than that it will go down, the price will react to this. Check out
volume as well -- a move on heavier than average volume makes the buying signal even stronger.
Document your reasoning in the "Reason?" box. Enter the high, low, close and volume for that day as well.
After the close of the next trading day, enter the high, low, close, and volume in the "Reason?" box. Is the high price on high volume trend continuing or is it time to sell?
Repeat Step 3 for the next four trading days, developing a weekly history of the stock's price and volume performance.
At the end of the week, compare your results with last week. Do you feel more confident because you have moving averages to support your decisions?
Professionals from long term investors to
day traders use moving average lines on their charts. Long term investors use the 200-day moving average and 50-day moving average lines to find optimal buy and sell points. Day traders plot moving average trends in increments as small as one minute, looking for price blips on an intraday chart.
As you gain experience in chart reading, you're not simply staring at a wavy line but instead, you're basing your buy or sell decision on solid patterns.
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