Investing is a long-term game. You should invest in stocks for your future, not to get rich quick. Time in the market is always better than timing the market.
But sometimes you can make a decent dollar trading. And sometimes looking at technical indicators can help give you a great entry point for a long-term position.
Technical indicators can help identify the trend of a stock and help predict how it will move in the future. Good technical analysis is essential for short-term, and sometimes long-term, gains.
Moving Average
Moving averages are the beginning of technical analysis. Think of moving averages like trend lines. Has the stock recently been going up or down? The direction of a stock is important. There are whole chapters of technical analysis books dedicated to moving averages, but I’ll give you the condensed version in a few paragraphs.
A moving average is the average price of a stock over a specified period. It creates a line that smooths out the price data. It is called a moving average because as the most recent trading day closes, that price will be included in the average and the oldest price will be dropped.
There are two types of moving averages. There is simple moving average (SMA) and exponential moving average (EMA). A simple moving average is like your normal mean in statistics class. Everything has a fair weight. An exponential moving average gives more weighting to recent prices. So a 100-day simple moving average adds up the closing price of the stock the last 100 days and then divides by 100. A 100-day exponential moving average also uses the closing price of the stock for the last 100 days, but gives different weightings to each day.
Another variation when it comes to moving averages is the duration. A moving average will look at the previously specified duration, but you need to specify how long you want the duration of data to be from. The four most popular durations are (in days) 20, 50, 100, and 200. 20-day moving averages are used more for short term trading while 200-day averages are used more for long term investing. The shorter the average, the more reversal signs it will have because in the short-term a stock price fluctuates more than in the long-term.
Whether it’s standard or exponential, 20-day or 200-day, moving averages show where the stock price has been. And they can help give clues to where the stock price may be going. Moving averages can also be used as support or resistance for a stock.
A great resource to look at moving averages of stocks and learn more about them is finviz.com
MACD
MACD stands for moving average convergence/divergence. The MACD is used to reveal potential changes in the strength, direction, momentum, and duration of a stock’s trend.
Most investors don’t know the math or details behind the MACD. But they would know the purpose of it: To help predict the trend of the stock. Is the price going to go up or down, pretty much the only question you care about when investing.
The MACD consists of two lines. There is the MACD line and the signal line. Without getting into the background of the lines too much, the purpose of having two lines is to see when and how they cross. While moving averages are on the same graph as the stock price, MACD’s are below the stock’s graph. It is sort of a separate graph on its own.
When the MACD crosses above its signal line it indicates a good time to buy. And when the MACD crosses below the signal line it indicates a good time to sell. Essentially if the lines cross, the stock price’s current trend may change. There are some limitations to the MACD, in that it is not a perfect predictor and often gives off false reversals.
Walmart 6-month stock chart with MACD – from Yahoo Finance
A great way to look at a MACD is to look at the chart of a stock on Yahoo Finance and then add the MACD indicator.
RSI
RSI stands for relative strength indicator. It is used to look at the current and historical strength or weakness of a stock. Simply, it can tell when something is being overbought or oversold.
The RSI is, like the MACD, not on the actual chart but on its own chart below the chart of the stock price.
The RSI is a singular line that moves similarly to the price of the stock. It will always move between 0 and 100. It almost never reaches those numbers though, as most people use high and low levels at 70 and 30, respectively, or at 80 and 20.
If the RSI crosses above the high level it means the stock is overbought, and the stock price will likely fall, signaling a good time to sell. Conversely, when the RSI crosses below the low level it indicates the stock is oversold, meaning the stock price is lower than it should be, and it is a good time to buy.
Walmart 6-month stock chart with RSI – from Yahoo Finance
Similar to the MACD, the RSI is not perfect. If it was, everyone would use it to buy and sell at the perfect time and get rich. An RSI can easily provide a false alarm.
Again, a great way to look at an RSI is to look at the chart of a stock on Yahoo Finance and then add the RSI indicator.
Trust Your Gut
Lastly, and maybe most importantly, there is such a thing as too much technical analysis.
If you are looking at a stock chart with several moving averages on it, in addition to other lines you drew in, it could get messy. All these added indicators may take away from the actual movement of the stock and cloud your judgment. Or sometimes it may convince you to see things that aren’t really there.
Another point to remember is that less is more. The Goldman algorithm implemented in Cook County Hospital (it’s a really interesting lesson to read more about if you have the time) proved this. Doctors were able to assess heart attacks better when they were given less information. You don’t need to know every little detail to pick a stock, and sometimes it’s better to be ignorant.