Most investors buy or sell on good or bad news, but technical indicators are the things professionals use when share trading. Here are five to watch for.
As always, content on Star Investing is not an investment recommendation.
1. Moving Average
In its simplest form, a ‘moving average’ is the average of all recent closing prices (adding them and and dividing by the number of time periods).
This form is a Simple Moving Average (SMA) although there is another form called the Exponential Moving Average (EMA) that gives more weight to recent data. It does so by calculating only the higher closing price and calculating an average from those and assuming it applies equally across the period.
The formula is:
(Closing price – previous EMA) * (c/n+1) + previous EMA where c is the number of closing prices you want to give weight to and n is the total number of periods.
The Moving Average is a metric used both in its own right and to calculate other signals. Various time frames can be used although a 200 day period is the most popular, particularly in regard to major indices.
For example, on Thursday 8 February, the ASX 200 was on track for its best week in two and a half years, up over 4 percent.
But it crossed its 200 day moving average and arguably this was a reason why the index fell 0.34 percent the day after.
Professional traders took notice and responded accordingly.
2. Relative Strength Index
The Relative Strength Index (RSI) measures buying and selling momentum.
If a stock has an RSI of under 30, it may be oversold and traders may think it is about to rebound. Conversely, if a stock’s RSI is over 70 it may be overbought and traders may think a sell-off is about to occur.
An RSI of 0 indicates only selling activity whereas an RSI of 100 indicates only buying momentum – although this rarely occurs outside tightly held stocks. While there is a precise, comprehensive formula, these days it is all calculated on computers.
Essentially the formula compares all the stock’s gains in the period to the magnitude of losses and computes a number between 0 and 100.
The weakness is that traders are relying on past performance to indicate future performance and this is not always reliable.
3. Moving Average Convergence Divergence
– This metric similarly measures whether a stock is overbought or sold. But unlike the RSI, it takes into account moving averages.
It simply involves subtracting one period’s Exponential Moving Average (MDA) with another. These periods can be whichever the trader wants but usually it’s a 26-day EMA subtracted from a 12-day EMA.
From this result a chart is plotted and nine day EMA of this line is plotted. When the MACD crosses above this line, traders may buy the stock but when it falls below the signal line, they will sell or short the stock.
For instance Qantas’ (ASX: QAN) stock fell 5 percent on January 29 and the signal line crossed below the MACD line despite no news out of the Red Roo.
Seemingly, this occurred because competitor Air New Zealand (ASX: AIZ) cut its earnings due to a reduced tourism outlook. Yet perhaps investors should have waited to hear whether or not they would affect Qantas before selling.
4. Bollinger Bands
Bollinger Bands measure stock volatility, based on the standard deviation from a SMA.
Every chart for the index or stock being measured will contain three lines, or bands.
- The middle will be the SMA
- The upper will be the SMA plus the standard deviation from the SMA over that period
- The lower band will be the SMA minus the standard deviation
Theoretically, nearly 90 percent of trading should occur within the lower and upper bands. Any price movement outside the bands should indicate prices are relatively high or relatively low.
The example below depicts Virgin Australia’s (ASX: VAH) shares.
They have largely remained in the bands, any movement outside has been temporary.
Big companies such as Virgin are traded in large quantities on a daily basis in response to trends such as these, in addition to company news and analysis.
One movement outside was the release of their half yearly reports in mid-February which led to a 5 percent jump in its share price and a breaching of the upper band. Yet major institutions such as JP Morgan remained bearish about the stock and argued it was overbought.
While its client note did not mention Bollinger Bands, it is likely this would be one metric used to justify their overall conclusion.
5. Analyst recommendations
On the basis of all of these, analysts make recommendations about the stock. Sometimes they will use the above metrics to indicate a stock’s direction is about to make a sharp turn.
While the recommendation isn’t a technical marker per se, they do take into account all the technical data to arrive at their conclusions.
Single Analyst recommendations can shift stocks more than any of these, especially because unlike all the others on this list they are easy to understand.
If you follow the U.S. markets, almost every day you’ll hear one stock or two ‘fell after being downgraded by Goldman Sachs/JP Morgan’.
Yes, Investors take these firms so seriously they are willing to bet their money on the basis of what these firms think. This can even occur on the basis of predictions rather than reality, most pertinently with earnings.
Ultimately, what matters to most investors is gaining a return on their investment and good news or bad news is the main trigger for share trading.
But these signals are ways of predicting whether or not your thoughts about stocks being overbought, oversold or are on the brink of a turnaround are justified.