The Classroom | Stocks for Breakfast

22 Apr 09

Understanding the Triple Moving Averages

Moving averages are found by calculating the average price of the previous n trading days. For example, the 30-day moving average would be found by calculating the average price of the previous 30 days. The next day, the 30-day moving average would be calculated again. Repeating this process every day would enable us to plot the moving average on the same chart as the original share price chart.

Interpretation

Triple moving averages are simply three different moving averages plotted on the same chart. Many industry professionals believe that the trend is bullish when a short-term moving average is higher than the medium-term moving average and the medium-term moving average is higher than the long-term moving average. For example a bullish trend or buy signal would be indicated by the 15-day moving average being higher than the 45-day moving average and the 45-day moving average being higher than the 90-day moving average. A bearish trend or sell signal would be indicated by the 15-day moving average being below the 45-day moving average and the 45-day moving average being below the 90-day moving average. When the moving averages are not in ascending or descending order as described above, the trend is said the be neutral and there are no buy or sell signals.

Case Study

Today, there a many websites and software packages that can plot triple moving averages automatically. This means that there is no longer a need to manually calculate the moving averages. The chart above demonstrates how triple moving averages may have been used to capture a very profitable bullish trend. The moving averages used in the above chart are 15-days (short-term), 45-days (medium-term) and 90-days (long-term). On 4 April 2000, Woolworths Limited (WOW) was trading at $5.60. The moving averages produced a bullish signal where the 15-day moving average was higher than the 45-day moving average and the 45-day moving average was higher than the 90-day moving average. The moving averages turned bearish on 13 December 2001 with WOW trading at $10.81 capturing a bullish trend of 89%.

SFB

21 Apr 09

Understanding the Symmetrical Triangles

Symmetrical triangles are chart patterns where trend lines can be drawn to show a triangle as shown in the chart below. The price action is a rally to a relative new high, a pullback, a second rally that does not exceed the first high and another pullback that does not breach the first pullback.

Interpretation

Symmetrical triangles can be characterized as areas of indecision where a market pauses and future direction is questioned. Rallies are quickly met by selling and dips are seen as bargains. Each new high is lower than the previous and new bottoms are found above previous lows. The formation of symmetrical triangles is often accompanied by diminishing volume as a result of the market’s indecision. Eventually, this indecision results in an explosive breakout of the symmetrical triangle formation often on heavy volume. Most breakouts occur before the triangle is completed. Breakouts that occur at the end of the triangle’s formation are often false breaks and should be avoided. Symmetrical triangles often breakout in the direction of the original trend and the technical target is derived by adding the largest vertical height of the triangle to the breakout level.

Case Study

Many people believe that chart patterns are very subjective. But many chart patterns can be easily identified like the symmetrical triangle in Foster’s Group Limited (FGL) in the chart above. It can be seen that FGL forms a symmetrical triangle with volume decreasing during this period. The break out is then supported by increased volume and FGL rallies to the technical target.

SFB

21 Apr 09

Understanding Moving Average Envelopes

Moving averages are found by calculating the average price of the previous in trading days. For example, the 30-day moving average would be found by calculating the average price of the previous 30 days. The next day, the 30-day moving average would be calculated again. Repeating this process every day would enable us to plot the moving average on the same chart as the original share price chart. Moving average envelopes (dotted lines) are two moving averages offset by a fixed moving average.

Interpretation

Moving averages are used by many investors as it is believed that prices will generally trade near an average price. The edges of the envelope represent buyers or sellers who have pushed prices to extremes. When price hits an extreme it usually turns around and finds a new stability point. When prices trade above the upper band, the stock is considered overbought and when prices trade below the lower band, the stock is considered oversold. For more volatile stocks, the percentage offset used may be increased to analyse extreme movements better. Larger offsets are more conservative as many stocks do not deviate too far from their moving averages. Using a larger offset would imply that trading opportunities are only signalled when a stock trades very far from its moving average.

Case Study

There is no set rule as to how wide the envelope should be. Many professionals use trial-and-error to test the suitability of the offset applied. Today, there are many websites and software packages that can plot moving average envelopes automatically. The chart above demonstrates how moving average envelopes may have been used to capture trading opportunities with Australian Gaslight Company (AGL). The moving average envelope used in the above chart is a 30-day moving average based off closing prices with an upper and lower offset of 4%. The chart shows how a moving average envelope may have been used to determine buying and selling opportunities between 2002 and 2004.

SFB

21 Apr 09

Understanding Double Tops

Double Tops are major reversal patterns that form in extended uptrends. The chart pattern looks like an “M” Shape and is made up of two roughly equal peaks and a trough in between which acts as key support. If the second peak is formed on lower volume, this is often a sign that the uptrend is coming to an end.

Interpretation

Double Tops occur when prices are in an uptrend and the market reaches a point where buying interest is met and begins to dry up. Sellers may begin to take profits and that price level will become a major resistance level due to supply and demand. After reaching this market top a corrective phase will usually push the market lower. A temporary bottom is reached and acts as the key support level. As the market rallies back to major resistance, the market may anticipate that prices will trade above the previous high. If this does not occur, the second top may continue to hold resistance and push the market lower. If price trade below the key support level is established, this signals a change from an uptrend to a downtrend.

The projected downside target is the measured height between the key support level and the double top (see chart above).

Case Study

Lend Lease Corporation Limited (LLC) enjoyed a bullish trend and first peaked at $24.00. From the peak, LLC declined around 26% to find support and form a trough at $17.80. In October 2000, LLC failed to rally through the first peak at $24.00 and the reversal was confirmed when key support at 17.80 was quickly broken on heavy volume. Sellers entered the market and LLC quickly traded to the projected downside target.

SFB

21 Apr 09

Understanding the Relative Strength Index (RSI)

The Relative Strength Index (RSI) is a technical analysis indicator that compares the days that a stock closes up against days when a stock closes down. RSI is an oscillator which ranges from 0 to 100. In general, oscillators aim to indicate when an asset is “overbought” or “oversold”. A stock is considered overbought when the RSI is above 70 and considered oversold when the RSI is below 30.

Interpretation

In depth explanations on how the RSI is calculated is very advanced and beyond the scope of this newsletter. However, a simple explanation will be made here. The RSI is calculated in several steps: within a given period (n-days), the individual differences between the upward closing prices (Close today > Close yesterday) and downward closing prices (Close today < Close yesterday) are added up and afterwards divided by the number of observations (n-days) minus one. The result is the day’s average value of the upward and downward strength of the underlying stock. The relative strength is calculated by dividing the average upward strength by the average downward strength. Finally, the RSI is found by the following formula: RSI = 100 – 100 1 + Relative Strength Many industry professionals believe that the best time to use the RSI is when a stock is trading sideways. A buy signal occurs when the RSI trades
below 30 and trades back above 30. A sell signal occurs when the RSI trades above 70 and trades back below 70. In summary, buy and sell signals occur as the RSI is leaving the overbought/oversold area.

Case Study

Today, there a many websites and software packages that can plot the RSI automatically. This means that there is no longer a need to manually calculate the RSI. The chart above demonstrates how the 14- day RSI may have been used to capture very profitable trading opportunities in Telstra Corporation Limited (TLS).

SFB

21 Apr 09

Understanding the Head & Shoulders Pattern

A Head & Shoulders pattern is a major reversal pattern that forms in an extended uptrend and its completion also marks a trend reversal. As the name suggests, the pattern contains three successive peaks with the middle peak (Head) being the highest and the first and third peaks (Shoulders) being lower and roughly the same height. A trendline can be drawn to connect the troughs between the two shoulders and the head to signify key support (also known as the Neckline).

Interpretation

When a Head & Shoulders pattern forms in an uptrend, the market begins to slowdown and the forces of supply and demand come to balance. Profit takers sell at the high (Left Shoulder) and first support is found at the beginning of the neckline. Buyers return to the market and prices are pushed to a new high (Head). Sellers step in again and the price retreats to test the downside to find support at the joining point of the neckline. Tentative buying re-emerges and prices rally again but fail to break the previous high (Right Shoulder). The pattern is complete once the price retreats and falls below the neckline. After breaking neckline support, the projected downside target is found by measuring the distance from the neckline to the top of the head and subtracting that distance from the break of the neckline. It is
important to note that volume usually declines during the Head & Shoulders formation and increases as the neckline is broken (see chart above). As the market trades to new highs, the decline in volume is an early indication that buyers are not committed. The increase in volume as the neckline is breached demonstrates the commitment of sellers and previous buyers getting out.

Case Study

Woolworths Limited (WOW) enjoyed a bullish trend and first peaked at $16.33 (Left Shoulder), then pulled back and rallied to $16.89 (Head). From the peak, WOW declined to $15.76 to find support (at the Neckline) and rallied back to $16.48 (Right Shoulder). Recently, WOW has been sold heavily and has broken support at the neckline. The chart above shows volume declining during the formation of the Head & Shoulders pattern. Volume during the recent sell-off volume has been increasing and demonstrates the commitment of sellers. The neckline now acts as resistance and the projected downside target is somewhere near $14.55.

SFB

21 Apr 09

Understanding the MACD

Moving Average Convergence Divergence (MACD) is one of the simplest and most reliable indicators available. MACD uses moving averages to include some trend-following characteristics. These lagging indicators are turned into a momentum oscillator by subtracting the longer moving average from the shorter moving average. MACD (solid line) and its 9-day moving average (dotted line) oscillate above and below zero, without any upper or lower limits (See chart).

Interpretation

The MACD is a trend following momentum indicator that shows the relationship between two moving averages. The MACD is calculated by subtracting the 26-day moving average from a 12-day moving average. A 9-day moving average (dotted line) called the signal line is then plotted on top of the MACD.

There are 3 common methods to interpret the MACD: Moving average crossovers, centreline crossovers and divergences. Moving average crossovers occur when the MACD crosses its 9-day moving average (or signal line). When the MACD falls below the signal line it is a signal to sell and when the MACD rises above the signal line it is a signal to buy. Centreline crossover occurs when the MACD moves above the zero line and into positive territory. This is a clear indication that momentum has changed from negative to positive and vice versa. Divergences occur when the security diverges from the MACD indicating the end of the current trend. For example, the price of the security may be trading a new low, but the MACD may have already turned upwards diverging against the price of the security. The concept of divergences is a more advanced topic and will be covered later.

Case Study

Today, there a many websites and software packages that can plot the MACD automatically. The chart above demonstrates how the MACD may have been used to capture very profitable trading opportunities in St George Bank Limited (SGB) by identifying turning points in changing trends.

SFB

21 Apr 09

Beliefs, Focus, Values, Behaviours, Greed, Hate, Money, Trading, Emotions,

..Trading Plans, Mission Statements, NLP

We read and hear about these things yet what do they mean and more importantly how can we use then to our benefit?

What most people fail to realise is that we are all trying to achieve something – the question is what? That’s where we get stuck because if we have no purpose, we have no drive and with no drive life is just one long rut. Each day blends into the next and we dream of escape, escaping into the markets and making millions trading stocks, or to a villa in Tuscany, or a beach in Brazil. We read the books, subscribe to the charting software, read the papers, listen out for tips hoping for the next big winner, or religiously study our charts for the next breakout.

When it finally does happen we say to ourselves ‘I’d better wait for more of a confirmation’ or ‘it’s too early’ and before we know it, we just missed the big one. The thought of putting our hard earned cash on the line becomes too nerve-wracking…yet we’ll go out and buy the first tip some so called expert gives us!

Shifting Paradigms

So this begs the question, ‘what are we actually trying to achieve?’ Put simply, if we don’t know where we’re going, how will we know when we get there? It’s just like planning a holiday, first we select our destination, then we work out how to get there.

Why would trading or investing or anything to do with money be any different from say, planning a holiday? If the average person put as much effort into their finances as they did planning a holiday their life would be very different indeed.

Beliefs – The What and the Why

Beliefs, as defined by Merriam Webster’s Dictionary are “a degree of conviction of the truth of something esp. based on a consideration or examination of the evidence.” Beliefs are the rules we live by. All our behaviours are based on them, and you wouldn’t be reading this if you believed it held no value. Yet have you considered where your beliefs come from and have you ever evaluated your beliefs to see if they are serving you well? They act as self-fulfilling prophecies, regulating what you will and won’t do and we all follow them religiously, without question.

What beliefs do you have about money?

Take a few moments with pen and paper to answer the following;
1) What does money mean to you?
2) How do you feel about it?
3) What is your first memory of money?
4) How is money discussed within the family unit?
5) How do your mother and father deal with money?
6) How do they differ in their approach?
7) Do you feel rich or poor?

Consider your answers to the seven questions. If you investigate further do you notice how your beliefs are essentially nothing more than feelings of certainty about what something means to you? In other words, a belief is a degree of conviction, and the stronger the conviction the stronger the belief. Yet beliefs are dynamic and they change. We’ve all believed things as kids that we now think are silly. Our lives are governed by our beliefs and our beliefs govern our behaviour.

There’s a saying that goes-

“If we always do what we have always done, we will always get what we have always got”.

Do you have any negative beliefs about money from your childhood because that is going to directly affect your decision making today. Have you ever purchased a stock on a tip? Have you ever purchased a stock without a stop in place? Worse still, have you ever purchased a stock and not followed your stop? We are guilty because we are all human. Everything you do, you do for a reason and it’s either to avoid something or to gain something because that’s what you believe to be true.

Consider the following…

A recent study published earlier this year by Physicist Yi-Cheng Zhang and other researchers from the University of Fribourg in Switzerland set up an internet-based game in which human traders play a virtual market populated by virtual traders. The human players looked at recent market movements and had to decide whether the next change would be up or down. When the market changed in a relatively simple way, the players were quite good at spotting the likely next movement. But when the market dynamics became complex, the players effectively abandoned their attempts to work out rationally what would happen next (Physica A, vol 331, p 651). Many of them just kept repeating the same prediction. ‘It seems,’ said team member Joseph Wakeling, ‘that the capacity of humans to act logically is limited, and in more complex situations they try other methods to make decisions.’ *

How do we change our beliefs? Well, that’s the 64 million dollar question; however it’s actually much easier than you may think. Stay tuned for Part 2 of this article, where we will go into the practices you can implement to bring about these shifts in beliefs.

* Source New Scientist Mark Buchanan article “It’s the economy, stupid”

SFB

21 Apr 09

Are you a ‘Jack of all trades…’?

Are you a ‘Jack of all trades master of none’? Do you know a little bit about everything and not a lot of something specific?

Can you make decisions quickly or does everything seem to take forever? If you do get around to making that decision do you question yourself?

The word decision, as defined by the Merrian-Webster Online dictionary is “the act or process of deciding; a determination arrived at after consideration.” So why is it often so hard to decide?

What’s really going inside these heads of ours? Cast your mind back to the June Diamond Report – did you answer the questions from the previous education feature (Issue 9, June 05, 2005 ‘Beliefs, Focus, Values…’)? Were you surprised with the results; did you even complete them?

Well, if haven’t well here’s another chance. If you did do them, we suggest you do them again and
compare your answers;

1) What does money mean to you?
2) How do you feel about it?
3) What is your first memory of money?
4) How is money discussed within the family unit?
5) How do your mother and father deal with money?
6) How do they differ in their approach?
7) Do you feel rich or poor?

Last time we discussed beliefs and how they affect every area of our lives (see Article 7), from how we feel to our choice of clothing. Today we are going to discuss beliefs and how they control us in a little more detail and start to measure the impact they have upon our lives.

Stop for a moment and reflect: you want to become a successful trader / investor; you want to make lots and lots of money trading the markets, yet there are some unresolved / underlying issues with money, and decision-making. Do you want to make money or lose it? The first rule of investing / trading is cut your losses short and let your profits run. When the chips are down could you make the cut?

Be honest here, would you hire yourself if you applied for a job as a professional trader? Honestly, if you answer ‘no’ how do you expect to make money from trading and investing, if you yourself admit you would not cut it as a professional?

What’s really going on inside that head of yours? Who’s in control up there? Again in our last session we covered “beliefs” and how beliefs are nothing more than feelings of certainty about what something means to you. What beliefs do you have about the decisions you make?

What does all this really mean decisions, beliefs, emotions….? We experience the world from the inside out; what you are focusing on right now directly affects your experience of the world.

How you sit or stand, the rate of your breathing, any sensations you are feeling, your beliefs, representational systems, physiology, all contribute to our experience. If something is happening externally to us, how does this information get inside and cause an experience?

The five senses- sight, sound, touch, taste and smell are all external stimuli, yet all are somehow represented internally within our mind and bodies.

Take for example the feeling of ‘stress’. How do you experience this, what do you feel, where does the feeling originate? What do you say to yourself, what pictures do you imagine? Something external is happening and yet we feel this on the inside.

What is it?

SFB

21 Apr 09

Understanding Falling Wedges

Falling wedges are bullish patterns. The pattern begins wide at the top and contracts as prices move lower. The price action forms a downward sloping triangle. Falling wedges can also be found in continuation patterns and will slope against an existing uptrend. (To be discussed at a later date)

Interpretation

Falling wedges are reversal patterns which often form in extended downtrends. These patterns often take 3-6 months to form and the preceding downtrend should be at least 2-3 months old. It takes at least two reaction highs to form the upper resistance line and each high should be lower than the previous high. At least two reaction lows are required to form the lower support line and each low should be lower than the previous low. The upper and lower resistance lines should form a downward sloping triangle. Shallower lows indicate a decrease in selling pressure and create a lower support line with less negative slope than the upper resistance line. Bullish confirmation does not come until the upper resistance line is broken firmly on the upside.

Case Study

The downtrend in BHP begins in 1996 and new lows were formed with BHP in late 1998. The upper resistance line formed with 3 successively lower peaks. The lower support line formed with 3 successively lower lows. The upper resistance line and lower support line converged as the pattern matured and selling pressure gradually eased. The supply overhang remained, but the slope of the upper resistance line was more negative than the lower support line. In early 1999, BHP broke out above the upper resistance line and the change in trend was confirmed in late 1999 after which BHP traded in a strong bullish channel as seen in the chart above.

SFB

21 Apr 09

Understanding the Stochastic Oscillator

The Stochastic Oscillator is a momentum indicator that shows the location of the current close relative to the high/low range over a set number of periods. Closing levels that are consistently near the top of the range indicate accumulation (buying pressure) and those near the bottom of the range indicate distribution (selling pressure).

Interpretation

A 14-day %K (14-period Stochastic Oscillator) would use the most recent close, the highest high over the last 14 days and the lowest low over the last 14 days. The number of periods will vary according to the sensitivity and the type of signals desired. Because %K is a percentage or ratio, it will fluctuate between 0 and 100. A 3-day simple moving average of %K is usually plotted alongside to act as a signal or trigger line, called %D. Readings below 20 are considered oversold and readings above 80 are considered overbought. It is important to remember that a security can continue to rise after the Stochastic Oscillator has reached 80 and continue to fall after the Stochastic Oscillator has reached 20. The best signals occur when the oscillator moved from overbought territory back below 80 and from oversold territory back above 20.

Case Study

Today, there a many websites and software packages that can plot the Stochastic Oscillator automatically. This means that there is no longer a need to manually calculate the Stochastic Oscillator. The chart above demonstrates how the Stochastic Oscillator may have been used to capture very profitable trading opportunities in Telstra Corporation Limited (TLS).

SFB

21 Apr 09

Money Making in Volatile Markets

The main aim of short term trading is to take advantage of short-term price movements, whether the move is up or down. Most people are familiar with making money from a move to the upside (typically referred to as going ‘long’) but, not many are familiar with how to take advantage of a downside move (typically referred to as going ‘short’).

A simple but very successful strategy involves going short when a stock breaks an all time low. Let’s take AMP for example. It broke an all time low of $13.58 on August 5, 2002 and subsequently fell to a low of $5.90 on March 11, 2003.

If one had shorted stock at $13.58 and then bought back at $5.90, a spectacular 56% return could have been made over eight months. Going short can also involve the use of derivatives, typically put options that have the advantage of leverage but also come with a higher risk.

Some of the most important elements in successful short term trading are to make sure the markets are very liquid (can easily buy and sell) and that risk management (risk to capital ratio, stop losses, and profit stops) is adhered to.

Strategy 2: Selling Covered Calls

Writing Covered Calls, a strategy that ‘experts’ often charge thousands of dollars for in a weekend seminar, is one of the simplest strategies that can be very effective.

This strategy is recommended for those that already hold blue chip stocks and wish to write or sell calls each month to receive a premium. Let’s take an example like JUP that was trading at $6.36 on February 24, 2003 and the $6.50 March 2003 Call was trading at 20c. Hence, if an existing JUP shareholder sold the $6.50 March Calls, they would have received an extra 20c per share, as JUP closed below the exercise price of $6.50 on expiry at $6.28. This is a 3.14% return in approximately one month, which can be achieved every month and bring fantastic results.

The risk in this strategy is that if the underlying share price trades significantly higher than the strike price sold. Periods of high volatility increase the value of the option premium because of the higher risk associated with the writer/seller. Hence, it is more attractive to be a writer/seller of a call option than a buyer in times of high volatility.

Strategy 3: Picking Outperforming Stocks

Even in the worst stock market conditions, there will always be stocks that appreciate in value. People will often prefer to buy stocks at all time lows, hoping for a bounce when the market recovers. However, history proves that stocks that are outperforming or trading at highs during market down turns, or increased volatility, will continue to go higher. Outperforming stocks often have a number of characteristics in common.

These include:
* A turn around in earnings or even record profit figures

* Sound management team that has a strategy in place for any downturn in the economy

* Usually a market leader in their industry or have a strong research and development team

* A competitive advantage or differentiation known as a ‘Unique Selling Proposition’

* Small to mid cap stocks that are still in the growth stages of their business cycles

* Technically trading at recent highs and not lows

21 Apr 09

Understanding Triple Tops

Triple Tops are major reversal patterns that form in extended uptrends. The chart pattern is made up of three roughly equal peaks followed by a break below support. A Triple Top is very similar to a Head & Shoulders pattern.

Interpretation

Triple Tops occur when prices are in an uptrend and the market reaches a point where buying interest is met and begins to dry up. All three highs should be roughly equal and well spaced out marking significant turning points. As Triple Tops develop, volume usually declines while often increasing near the highs. Decline from the third high is often accompanied by expanding volume as support is breached on the downside. Similar to Double Tops, the Triple Top pattern is not complete till the support level is clearly broken. The distance from the highs to the support line can be subtracted from the support level to project the downside target (see chart above).

Case Study

Telstra Corporation Limited (TLS) was in an uptrend and remained above the trend line extending up from 1997 until the break in 2000. Over the period between December 1998 to April 2000, TLS bounced off resistance near 9.20. The first attempt happened in February 1999, the second in July 1999 and the third in December 1999. The decline from the third high broke trend line support and the stock continued to fall past support from the previous lows. Triple top support should be drawn from the lowest low of the pattern, which would be around $7.30. Volume expanded after the stock broke trend line support. Chaikin Money Flow turned negative and sellers entered the market and TLS quickly traded to the projected downside target of $5.40.

SFB