Technical Indicators: Simple Moving Averages & Bollinger Bands
Today, we begin to delve into the charts and technical indicators that many people use to find buy and sell points for a stock. The most simple of these is the Simple Moving Average (SMA) which is the sum of all the closing prices for a stock over a given period divided by that period. So, for example, a 20-day moving average is all the closing prices of a stock over the twenty days up to and including the day in question and then divided by twenty. This is done everyday and connected together to give you a simple moving average.
SMAs can be taken for just about any length that you would like. If you are at bigcharts.com and in the interactive charting page, you can change the charting period by entering a number into the text box next to the moving average drop down box. The key to a simple moving average is that all closing prices in the period are equally weighted. That means you are getting the purest representation of the average price of the stock. Simple moving averages also act as support levels for the stock price when it begins to pull back. For a short-term average (less than 50 days-ish for me usually 15 or 30 when I am charting), it is the support level that tells you when an uptrend might have lost its steam. For a long-term average (50+ day SMA usually a 90 or 200 day SMA when I am charting), crossing below it can be an alert to a stock price being headed for trouble and crossing above it is a good sign that the stock is beginning a true uptrend.
Something else that can be done with moving averages is plotting two of them (a short term and a long term one) and watching for crossover points. Take a look at the above graph. The cyan curve is the 50-day moving average and the greenish yellow line is the 15-day moving average. When the short term moving average crosses above the long term moving average, it is often a signal that the stock is beginning an uptrend or has established an uptrend. When the short term moving average crosses below the long term moving average, it is a signal that a downtrend has been established.
It is helpful that we can use moving averages in order to establish a sort of price support level for our stocks and smooth out the price movements of a stock. But, sometimes it may be necessary to be even more specific in deciding whether or not a stock is overpriced or underpriced. That is where the Bollinger Bands come in. Essentially, Bollinger Bands are made up of a 20-day SMA and two more curves corresponding to 2 standards of deviation above and below the 20-day moving average. If you’ve never taken statistics, a simple definition of standard of deviation is measure of the variability of the statistics that were used to construct an average. In this case, we are looking at the variability of our stock closing prices over a 20-day period. Depending on the distribution of the prices, an area that spans two standard of deviations should include at least 75% and as much as 95% of the stock prices in our 20-day sample. Why is this regressive analysis important? Well, assuming that the stock will continue to have closing prices in a similar distribution as it has in the past, we can use the Bollinger Bands as a rough measure of the relative “highness or lowness” of a stock’s price. A stock’s price touching either of the bands is a signal that the stock’s price is trading at an outlier price and maybe poised to turn towards the 20-day moving average. This is not to say that a stock price touching either band is necessarily a buy or sell signal, but it is an alert. The Bollinger Band coupled with other indicators can be used to signal buy or sell. For example, if the price booms through its upper Bollinger Band on high volume and other indicators (we’ll get into this in future posts) show that the stock is healthy and moving with good momentum, you could see the stock continue to rise for a period of time before it begins to readjust back to its mean. (Take a look at our above Bollinger Band graph between February and April for an example)
Now, if you want to start using Bollinger Bands before learning about some other indicators, one way to use the Bollinger Bands exclusively as a buy or sell indicator would be if you see a pattern that looks like the following: a stock’s price pass es or touches one of its Bollinger Bands, then pulls away from the band, then makes another move towards the aforementioned band but does not fully reach it, and finally begins another move towards the mean. This last trend to the mean is in all likeliness going to continue all the way through the 20-day moving average and can usually be used as a pretty good buy or sell indicator depending on if the movement is on the lower or upper bound. (Unfortunately, the above graph does not have an example of this. I will try to find one if people are confused. Leave a comment!)
While the Bollinger Band coupled with SMA analysis is a very useful tool in signalling times to buy and sell, they are not necessarily good for long-term investors. As you can see from the above graph, a stock’s price tends to fluctuate between its Bollinger Bands every few months or even week to week. So, I would personally suggest the use of this analysis in only two situations. First, if you are a short term “investor” or trader, then these signals are obviously very helpful. Second, if you are more of a long term investor, you can use these charts as a method of optimizing your buying and selling. Basically, only use them to time your buys and sells and don’t worry about the regular fluctuation of price between its Bollinger Bands during the time which you are holding the stock.
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