Understanding moving averages and how to use them for buy targets
The Bowser Report focuses on fundamental analysis to determine what stocks to buy. However, we often rely on technical analysis (like moving averages) to know when to buy the stocks we recommend. While this is not necessary to see big profits (just check out this study a subscriber performed), it is helpful to increase those profits.
Last month, we discussed using support and resistance levels as areas to buy penny stocks. Given the current market trend, understanding moving averages is also important to improve your entry points.
In this article, we'll discuss what moving averages to use and how to best use them.
Content for this article was adapted from the July 2021 front page article.
Why use moving averages?
Moving averages help to understand the directing a stock is moving. In other words, they help show the stock's trend.
This is important because it can help avoid buying into 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 help you avoid that situation altogether.
What are 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. If they are sloped downward the trend is bearish.
They can be set to any number of "periods" over any timeframe.
Which is best for long-term investing?
Ideal for long-term investing is the 20 Exponential Moving Average (20 EMA) on the weekly timeframe.
This line not only shows whether the trend is bullish (prices are moving up) or bearish (prices are moving down), but also can act as support. If your platform does not support EMAs, then Simple Moving Averages (SMAs) will work too.
Knowing when to buy
Below is a weekly chart of Deswell Industries (DSWL) with the 20 EMA added:
The 20 EMA started sloping up in September 2020 indicating that the stock was in an upward trend. The 20 EMA then acted as support multiple times over the next 12 weeks.
Each pullback to the 20 EMA offered a buying opportunity because DSWL was in a bullish trend.
When to stay out
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.
Additionally, 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
When a stock is trending higher, the 20 EMA for long-term investments is an effective tool to ensure that you aren't overpaying. This will increase your profits. 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.
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