Technical analysis is a critical part of our covered call writing success. We use it for both stock selection, exit strategy execution and timing of our trades. We screen stocks fundamentally and technically via the IBD 50, SmartSelect Scan and MSN Scouter. We make sure we have industry diversification and cash allocation equality. Earnings reports and same-store-monthly retail sales reports are avoided as are companies that trade in low daily volume amounts. Ultimately, we create a watch list of the greatest performing stocks in the greatest performing industries.
In our Blue Collar System, we use moving averages, MACD, the Stochastic Oscillator and Volume to ascertain the technical health of our equity. For me the moving average is king of these parameters with the others playing confirming roles. Each indicator by itself will not suffice, but as a whole they paint a very important picture relating to our buy-sell decisions. First, some key terminology.
- Moving Average (MA)– the average value of a security’s price over a set period of time. They are used to measure momentum and define areas of possible support and resistance.
- Simple Moving Average (SMA) – a moving average that gives equal weight to each day’s price data.
- Exponential Moving Average (EMA)- similar to a SMA except more weight is given to the most recent data.
- Support– the price level which a stock has had difficulty falling below. It is a point where a lot of buyers tend to enter the stock.
- Resistance– the price level which a stock has had difficulty rising above. It is a point where sellers tend to outnumber buyers.
- Uptrend– the price movement of a stock is in an upward direction. The stock price forms a series of higher highs and higher lows.
- Downtrend– the price movement of a stock is in a downward direction. The security forms a series of lower highs and lower lows.
- Sideways Trend (consolidation)- the horizontal price movement of an equity where the forces of supply and demand are equal. The stock simply cannot establish an uptrend or a downtrend.
Simple vs. Exponential Moving Averages:
When selling 1-month options, I prefer the ema to the sma because it provides a quicker response to a change in the stock price. It also avoids false positives where a stock may jump above the sma but not above the ema. In the chart of AAPL below (taken from www.stockcharts.com), the red line represents the ema and the blue line depicts the sma. Note how the ema starts moving up faster as the stock price appreciates and how the ema would have avoided the false positive in February where the price momentarily breaks through the sma but then drops dramatically:
When to use moving averages-practical application:
Moving averages have little value when the stock price is in a period of consolidation. In these instances, we turn to our confirming indicators or exclude the stock from consideration. When the stock is downtrending, we opt for another equity. If the security is trending upwards, the price bars are at or above the 20-d ema and the short term ema is above the longer term ema, this is a strong buy signal. The signal is even stronger if confirmed by MACD, Stochastics and volume. Most winning stocks never make a serious breach of the 20-d ema which is now considered support for the share price. This is indicative of institutional support for that equity. On the other hand, when a stock drops sharply below support on high volume, these major players (mutual funds, banks, insurance companies, pension funds etc.) are starting to move out of this stock and so should we.
Moving Averages and the Premium Report:
Moving average information is an inherent part of our weekly premium reports. In the column headed by the term “chart”, a “Y” ranking means the following:
- Uptrending pattern
- 20-d ema above the 100-d ema
- Price bars at or above the 20-d ema
I have highlighted in the chart below equities that meet this criteria as of 4PM EST on the last trading day of the week (Pink columns).
If a stock is trading right at the 20-d ema but not above it, the cell is filled with a “?” and a comment is left stating “Price @ 20 EMA”. I have highlighted this in the “green” rows below:
Moving averages are effective tools for identifying and confirming trends as well as support and resistance. This facilitates our trading system as it assists in making our buy-sell decisions. Since it is a lagging indicator, it is not predictive of change as let’s say the MACD is. But as they say on Wall Street, “the trend is your friend” and we want as many friends as possible when investing our hard-earned money. As with all technical tools, moving averages should not be used alone, but rather in conjunction with our other technical indicators.
This week’s economic reports were highlighted by a positive jobs report on Friday which propelled the market into positive territory for the week:
- Employers added 163,000 jobs in July well ahead of the 100,000 expected based on a survey of businesses
- Unemployment rate ticked up to 8.3% based on the household survey which is a smaller sample size
- The ISM Manufacturing Index showed weakness @ 49.8, lower than the 50.1 anticipated
- Orders for manufactured goods dropped by 0.5% in June lower than the + 0.5% expected
- Auto sales are projecting to an annual rate of 14.1 million, the best since 2007
- On Wednesday, the FOMC declined from making any changes to monetary policy and re-affirmed its commitment to keep the target interest rate between 0% and 0.25% through the end of 2014
- The Conference Board’s Index of Consumer Confidence (a gauge of consumers’ attitudes about the present economic situation as well as their expectations regarding future conditions. Consumer confidence tends to have a strong correlation with consumer spending patterns) rose by 3.2 points to 65.9 in July more than the 61.5 anticipated
- Personal income rose by 0.5% in June while the savings rate rose to 4.4%, the highest level in a year
- The Census Bureau’s report on construction spending was also a positive with an increase of 0.4% in June from the prior month an of 7.0% from the prior year
For the week, the S&P 500 rose by 0.4%, for a year-to-date return of 12%, including dividends.
IBD: Confirmed uptrend
BCI: Cautiously bullish on the economy and the stock market using an equal amount of in-the-money and out-of-the-money strikes. This week many investors re-visited the flash-crash memories of May, 2010 when trading in six equities was halted after an electronic trading system run by Knight Capital malfunctioned. Regulatory agencies are reviewing this matter. This appears to be an isolated incident and does not alter this site’s market assessment.
Much success to all,