Creating an Investment Worksheet - Part Four
We are continuing this week with the next instalment of the investment worksheet - Part 4. This week we look at some final technical measures (as was the case in the previous Parts, we are using Jason Kelly's book The Neatest Little Guide to Stock Market Investing as our guide. Full book cite-- Kelly, Jason. The Neatest Little Guide to Stock Market Investing. New York: Penguin Group, 2012. Print)
Let’s begin with the final metrics for our worksheet. As a preliminary note, these measures seem complicated but stick with it and focus on what you need to get out of the chart for your purposes, not particularly how the charts are made or operate (which arguably is complicated!). If you do that, you will have no trouble reading the charts.
Simple Moving Average (SMA): This measure shows you the stock price trend. Let’s use an example for further explanation – if you wanted the SMA over the past 20 days (50 days or 200 days are also used), you would add up the closing price of the stock over the past 20 days and divide by 20. You would keep doing this and stringing them together to get the SMA. The relationship of the price of the stock you are interested in with the SMA will show you what the trend of that stock price is doing. Is the price above the SMA line? If so, that is an upward trend. Is it below the SMA line? If so, that is a downward trend. Now what do you do with this information? Jason Kelly advises that you want to buy on the occasions where the stock price has dipped down below the line but then closes above the SMA the next bar. It is at that point you want to buy. Conversely, when the SMA is moving down, you will want to sell at the occasion when the stock price goes above the SMA but then closes below the SMA.
Here, in this example Buy chart courtesy of onlinetradingconcepts.com, first look at each time the red bar crosses the SMA line or touches it. Then look to see if the next bar over has closed above the SMA line. If it has, that is a buy signal:
Conversely, with the Sell example below, look to where the green bar crosses over or touches the SMA line and then look to the next bar over. If it has closed below the line, that is a signal to sell.
Moving Average Convergence/Divergence (MACD): This metric looks at exponential moving averages (EMA). This means it places more weight on recent prices rather than past prices. It refers to fast and slow periods of analysis with the fast being used for a short time period and slow for a longer one. The fast EMA responds more quickly than the slow EMA to changes in stock price so by comparing these two metrics, you can figure out which way the stock price is trending. The way it is calculated is somewhat technical and since we will be looking at these charts online already complete, it may be more useful to spend our time figuring out what they mean and how to use them.
There are three components to the MACD metric:
1. MACD: This is the 12 period EMA (fast) minus the 26 period EMA (slow).
2. MACD Signal Line: This is the trend of the difference between the fast and the slow time period (it is a 9 period EMA of the MACD); and
3. MACD Histogram: This is a bar chart that shows whether the MACD is above, below or the same as the MACD Signal Line.
Here is an example MACD chart from onlinetradingconcepts.com:
Once you have the chart in front of you, what do you do with this information? 1. Look for when the faster time period EMA line crosses over the slower time period EMA line so that the faster time period EMA line is now above the slower one. When this occurs, that is a buy signal. Conversely, if the faster EMA line is crossing so it ends up below the slower time period EMA, that is a sell signal. 2. Another way is to look when the MACD line crosses the MACD signal line. When this happens, you will notice the histogram bars flip to above or below the line depending on where it was before – when the bars flip above the line, that is a buy signal and when the flip below, that is a sell signal. 3. You can read the histogram. The bars move back and forth across the line signifying changes. When the bars are above the line but shrinking in height and getting closer to the main line, there is a slowdown in the stock price and a sell signal. When the bars are on the underside of the main line but shrinking up towards the main line, that is a buy signal.
Relative Strength Index (RSI): This chart looks at the current stock price of a company and measures it with its past performance to determine its relative strength position. An example one from onlinetradingconcepts.com is set out below. It is looking at the strength as compared to its own history and not that of other companies. Unlike perhaps the other two measures above, this one is much easier to understand! An RSI reading fluctuates between 0 and 100 with a reading over 70 meaning the stock is overbought (this may mean the stock price is due to fall as people begin to sell off) and it is a sell signal. An RSI reading under 30 signifies it is oversold (this may mean the stock price is due to go back up as people start buying more of it) and that is a buy signal. The usual time frame is a 14-period timeframe. One last point as noted by Jason Kelly, you should wait until the reversal happens before making the move. For example, in the example below, ideally, once the RSI crossed down below the oversold line, you would wait until it starts to tick back up before buying. The reasoning being it signifies the trend is now moving back up and the “worst” is over.
Don’t forget what we as beginner investors are using these charts for – that is, to round out our stocks to watch worksheet. Most of us are not looking to start day trading by attempting to read these charts and make timing calls based on them! That sort of thing is way beyond us at this point. These measures, if you choose to use them, help indicate what the price trend of the stock is looking like. Is it going up? Down? Etc. You obviously want to buy stocks that are in a strong uptrend. They are just another tool to help you monitor what might be good stocks to purchase. Don't lose sight of the big picture which is to find good companies that are good investments. These charting tools just help us with price trends and assist in determining when to buy that good company or sell it.
I realize these charts are a lot to take in! But, they aren’t THAT complicated and with a little effort, you will be reading them in no time. I need to practice reading them and will see how it goes once I set up my worksheet. Stay tuned for Part 5 next week where we move out of the numbers.