Understanding how to use moving averages as buy targets
The Bowser Report places a strong emphasis on fundamental analysis to determine what stocks to buy. However, technical analysis like moving averages to know when to buy the stocks we recommend can take interested investors' portfolio management to the next level.
With the stock market back in a bull market as of December 15, 2023, moving averages are sloped upward on most stocks. As micro cap stocks join in, optimizing entry points is increasingly important to avoid chasing spikes in price. While this is not necessary to see big profits (just check out this study a subscriber performed), it is helpful to increase those profits.
In this article, we'll discuss what moving averages to use and how to best use them in your long-term portfolio.
Why use moving averages?
Moving averages help investors understand a stock's overall trend, or the direction it is moving. This is important to help avoid buying into any considerable sell pressure. While it is a viable strategy to buy certain stocks on a dip in share price (see our blog post on buying the dip), any continuation of the downward trend could scare you out.
The Bowser Game Plan suggests cutting losers when they drop 50%, but trend analysis can proactively help avoid such scenarios.
Understanding moving averages
Moving averages smooth out a stock's price data with a line showing average price over time. If sloped upward, the trend is bullish, indicating a higher probability of buying pressure. If sloped downward the trend is bearish, indicating a higher probability of selling pressure.
Moving averages can be customized to show the average price over any number of "periods" across any timeframe.
Ideal moving average for long-term investing
For long-term investing, the 20 Exponential Moving Average (20 EMA) on the weekly timeframe is most effective. This line not only shows whether the trend is bullish (prices are moving up) or bearish (prices are moving down), but also acts as support level (an area where buyers often step in). If your platform does not give the option for EMAs, then Simple Moving Averages (SMAs) will work too.
Strategic Buying with Moving Averages
Below is a weekly chart of Research Solutions (RSSS) with the 20 EMA added:
Weekly Chart of RSSS with 20 EMA added (Source: StockCharts.com)
The 20 EMA started sloping up in September 2022 indicating the potential start of an upward trend and a higher probability that buyers will step in on dips in price. Every time price got over extended above the 20 EMA, it came retreating back. The first few tests of the 20EMA price broke below, showing that buyers were not as strong yet. However, these pullbacks still offered better entries than the price spikes.
Then, as buying picked up in July/August 2023, the 20 EMA increased its slope and became a more formidable support level. Multiple buying opportunities presented as price defended the moving average in October and November before a big spike in December.
Long-term investors can now be patient and wait for price to retest the moving average for another entry.
Exercising Caution
If the 20 EMA is sloped downward, the stock is in a bearish trend and you should avoid buying shares. For this strategy to work effectively, the 20 EMA must be sloped upward.
Take the RSSS chart above for example. In March 2022, price closed a weekly candle above the 20 EMA. However, the moving average was still sloped down. So, while it looked like a base might have been put in, that weekly close actually marked a pivot to new lows.
TIP: Lowering the time frame from weekly to daily or less could result in false signals. Lowering the period of the moving average below 20 (12 or 8, for example) will also result in false signals.
Conclusion
The 20 EMA is a reliable tool for long-term investments to ensure that they aren't overpaying. While you will not pinpoint the bottom, you will increase the likelihood of buying at an attractive price to minimize losses and maximize profits.
To incorporate this strategy into your own, just remember to:
- Set your chart to the weekly timeframe;
- Set the EMA period to 20; and
- Confirm that the EMA is sloped upward.
Then, wait for the price to hit the 20 EMA for your buy order to give this strategy a try. As always, if you are unsure, try backtesting the strategy first and then paper trading to get the hang of this new entry method.
Content for this article was adapted from the July 2021 front page article of The Bowser Report and is updated from an original blog post published on August 13, 2021.
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