Rebalancing requires the act of selling. However, as discussed in the last two articles of this column, the question of “when to sell” is more rooted to the basic objectives of stock investing and trading, which are basically, capital preservation and profit-taking.
Like most of the players in the virtual stock trading challenge, investors normally use mechanical tools, especially for capital preservation. However, seasoned investors use mechanical and conceptual methods at the same time on both subjects.
Mechanical tools are popular because they take away the burden posed by emotion, which oftentimes is the main cause for big losses.
Commonly used among the preferred mechanical tools are the moving averages (MA), relative strength index (RSI), moving average convergence-divergence (MACD), stochastic and the Bollinger Bands.
The moving average (MA) is widely used even today because of its simplicity. Its main strength is that it “tends to smooth out the random price movement that it brings out concealed trends.” It is derived by taking the average closing price of a stock over a period of time. The end result shows an overall idea of the trends, thus, an easy-to-use forecasting technique.
There are many versions of the moving average. Some are elaborate, such as the “exponential moving average (EMA), volume adjusted moving average and linear weighted moving average.”
Nonetheless, the simple moving average method still works as an effective and relevant forecasting tool – when to buy or sell.
For example, the simple 50-day and 200-day moving averages are still considered important parameters. The appearance of the “Golden Cross” is deemed a bullish sign and considered a good time to buy. This happens when the 50-day moving average rises above the 200-day moving average.
The opposite gives rise to the “Death Cross,” a bearish sign and a signal to sell. This comes about when the 50-day moving average drops below the 200-day moving average. A shorter time series is also used for short-term trading needs.
Next is the relative strength index (RSI). It is actually a “technical-momentum indicator.” Its main feature is to show the “overbought” (topped) or “oversold” (bottomed) level of the market or stock on a scale of 0 to 100.
It is considered overbought when the scale is above 70 and deemed oversold when it is below 30. A 14-day RSI was the norm in the past. Now, the “nine-day RSI and 25-day RSIS” were added to refine trading decisions.
Called MACD for short, the moving average convergence divergence method was an invention of Gerald Appel in 1979. Similar to the RSI, it is also a trend following momentum indicator. It uses three moving averages or exponential averages for calculations. These are the MACD series proper, the “signal” or “average” series and the “divergence” series (which is the difference between the two).
Still used are the “12, 26, and 9 days” exponential moving average (EMA) settings, otherwise called the “MACD (12, 26, 9).” These represent two weeks, one month and one-and-a-half week timeline based on the old six-day workweek. It still works as an analytical parameter since majority of buying and selling trades are still based on these standards.
The 12-day EMA is the faster value, while the 26-day EMA serves the slower factor. Closing prices are used in calculating their values. The nine-day EMA, which serves as “the MACD series proper,” is plotted together with the other two EMAs, and “acts as a trigger for buy and sell decisions.”
Simply, the MACD generates a bullish signal when it moves above its own nine-day EMA and sends a sell signal when it moves below it.
The MACD histogram gives a good visual representation. The histogram is positive when the MACD is above its nine-day EMA and negative when below it.
When prices are rising, the histogram grows large. It grows larger when the speed of the price movement accelerates. The histogram contracts when the price movement decelerates. It contracts further as the price deceleration gets faster. The same principle works in reverse as prices fall.
Stochastic is another technical indicator that is widely popular for its handy use. It is another momentum indicator that uses the concept of “support and resistance” levels developed by Dr. George Lane in the late 1950s.
Basically, the term stochastic “refers to the point of a current price in relation to its price range over a period of time.” Based on Lane’s observation, “if the prices have been witnessing an uptrend during the day, the closing price will tend to settle down near the upper end of the recent price range.”
“Alternately, if the prices have been sliding down, then the closing price tends to get closer to the lower end of the price range. The indicator measures the relationship between the asset’s closing price and its price range over a specified period of time.”
The stochastic oscillator contains two lines. The first line is called the “%K.” This “compares the closing price with the most recent price range. The second line is the “%D” or signal line. This “is the smoothened form of %K value and is considered the more important [between]the two.”
“A bullish signal is formed when the %K breaks through the %D in an upward direction. A bearish signal is formed when the %K falls through the %D in a downward direction.” The divergence between the two lines can also be helpful in identifying reversal points.
The shape of the bottom and top of a stochastic can also be an effective indicator. A classic example is that a deep and broad bottom is indicative that the “bears” (sellers) are strong and any rally at such a point could be weak and short lived.
The Bollinger Band is a creation of financial analyst John Bollinger in the 1980s. It is also an indicator that measures overbought and oversold conditions.
The Bollinger Band has a set of three lines. The center line stands for the trend, while the upper and lower lines serve as the respective resistance and support limits of the price of a stock.
When the price of the stock is volatile, the bands expand. And, when the prices of the stock are rangebound, the lines narrow down as to contract.
The Bollinger Band’s claim to fame is that it can “detect the turning points in a rangebound market.” Buying is trigged when prices drop and hit the lower band, while selling is done when prices rise to touch the upper band.
Its observed weakness is when “the markets (or stocks) enter trending, it starts giving false signals, especially if the price moves away from the range it was trading.”
If you want to learn more about them, browse the web or buy the books. However, take note that these mechanical methods have their strengths and weaknesses. This is why seasoned investors use them in combination “as confirmatory triggers” in plotting a trading move, like “when to sell.”
But like what Peter Lynch once said, “when to sell” is as plain as his simple answer about the subject: “I sell when the reason behind my decision to buy is no longer there.”
Lynch is a seasoned investor, best known for his record of making Magellan Fund and Fidelity Investments as “the best performing mutual fund in the world” between 1977 and 1990 and for his popular investing book, One Up On Wall Street.
Den Somera is a licensed stockbroker. The article has been prepared for general circulation for the reading public and must not be construed as an offer, or solicitation of an offer to buy or sell any securities or financial instruments whether referred to herein or otherwise. Moreover, the public should be aware that the writer or any investing parties mentioned in the column may have a conflict of interest that could affect the objectivity of their reported or mentioned investment activity. E-mail address of the writer is firstname.lastname@example.org