Consider the following posers…
"What will a company's share price do?"
"Why will it do it?"
"When will it happen?"
If you can answer the three questions above, then you know all you need to know about a stock. They should be the central themes of any investment analysis.
"Fundamental" analysis, the study of the business-specific forces that drive a company's value, answers the first two questions. But only the first two. Analysts solve the problem of timing best using techniques of "technical" analysis, the study of charting patterns. Combining these two methods will yield better investing results than devoting yourself entirely to a single approach.
The danger is, many people read too much into technical analysis. It's a large field, with more than a few questionable concepts. And it doesn't solve the first two questions listed above. Only the third one. Remember that. If a triathlete rode his bicycle into the swim leg, everyone would laugh at him and he'd finish last.
However, technical analysis has at least one method that every investor should include in their repertoire: the moving average. It's a quick, easy-to-use tool that makes sense.
When you look at a stock chart, most of what you see is volatility. The price observations dance around. On a short-term scale, a lot of this variation is motivated by… well…nothing at all. It follows a random path. But no-one can make money from randomness. We can't, by definition, predict random movements. The underlying purpose of a moving average is to extract a useful, longer-term trend from this bubbling, steaming soup of volatility. Is the price mostly going up, or going down? The moving average will tell you clearly.
There are two main types of moving average. Firstly, the simple moving average (SMA). For a given point on a stock price chart, a 200-day SMA is just an average of the previous 200-days' prices. Hence, if prices have been increasing over the last 200 days, the 200-day SMA will show a positive trend. See the graph of Rio Tinto (ASX:RIO) below for a visual. The main problem with moving averages is that they "lag". Their basis comes from the past, so they can't accommodate or adjust for future events. That's why Rio's moving average (red line) sits below the real price data (black line).
To minimise this effect, some investors like to use an exponential moving average (EMA). The only difference between an exponential and a simple moving average is that EMAs give precedence to more recent prices. And by emphasising more recent prices, an EMA will react more swiftly to a change in trend than an SMA. See RIO's EMA (light red line) below. Each time RIO's price changes direction, its EMA leads its SMA.
Whether you use an SMA or an EMA depends on your investing philosophy and time-frame. Do you want to make short-term trades? An EMA will react quicker. It could be useful. Do you want to know how a potential long-term investment is behaving? A 200-day SMA is probably more appropriate.
Trendlines constructed with moving averages break down complex price behaviour into a simpler, more practical form. But they can also tell you when to act on a stock.
If price suddenly moves against its trend, this can be an indication of a buying opportunity, or a time to exit. Below is a graph of one of the shares we recommend in our Australian Small Cap Investigator newsletter. This shares price crossed its trendline in mid-February 2007, and has been appreciating since. In hindsight, we can see this would've been a good time to buy. We're glad we recommended it one month later.
But the mere fact that price has crossed its historic trend is not enough evidence to induce action from an investor. The most important variable is the volume of shares traded.
Volume indicates how much of the market is behind a price movement. What if volume increases in conjunction with a change in trend? Market sentiment has aligned with price movements. Otherwise, consider the trend change a "false signal".
The volume of the share mentioned above spiked as price broke its trend. The stock's value was rising. We can confirm this symptom as significant. There's a weight of evidence in the form of market opinion. And it's market opinion that dictates price movements. Hence: the stock was a buy.
Technical analysis of a small cap stocks is pretty much like analysis of any stock. Small cap prices may behave more erratically than large caps - in fact, their potential for big gains is what we like about them. But they still give off the same signals. If you've found that your timing has been off, try applying techniques like this one to improve your overall investing. You may already have the "what" and the "why". It's time to add the "when".
Al Robinson
The Daily Reckoning Australia
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About the Author
Dan Denning is the author of 2005's best-selling The Bull Hunter (John Wiley & Sons). He began his financial publishing career in 1997 and has covered financial markets form Baltimore, Paris, London and, beginning in 2005 Melbourne. He’s the editor of The Daily Reckoning Australia and the Publisher of Port Phillip Publishing.
Comment by SugarCain on 13 October 2007:
Nice summary Al, although I'm not one to pay much attention to technical analysis, I think looking at a stock price from the perspective you just outlined and using the graph and MA as a tool of market timing - founded on things from the real world- is an important consideration to say the least.
Comment by Leon Mills on 30 November 2008:
Very interesting article so how do we use Ma's in a bear market with heaps of volatility as at the momment. I think there is some more exploration required, like the effect rises and falls of volume and the relationships of the gaps between the MA and MA envelopes.