How Do You Know When a Stock is a Good Buy?
Episode 9: March 30, 2011
by Andrew Horowitz
Last time, we talked about the
basics of
reading a stock chart from any popular stock chart website. This
article, we'll discuss five specific things to look at on a stock chart that
might indicate a stock is rising and is therefore a good buy. I’ll tell you
what to look for to put the odds in your favor!
How to Know if a Stock is a Good Buy
Let me first say that there are no guarantees. By looking at
a chart, we're looking at odds and probabilities instead of certainties. But
there are historical patterns that have led to explosive growth in stocks.
Before you decide to buy a stock, you’ll want to learn the top 5 things to look
for in a rising stock based on its chart.
Tip #1: See if the Stock is in an Uptrend
First, look to see that the stock is in an uptrend. There's
nothing better than price to look at the price! In other words, the stock price
is telling you something. Make sure that as you look from left to right on
the chart,
the price is steadily rising-- though not exploding-- higher. Try to find about
a 30 degree to 45 degree angle at the most that you can trace over the price of
the stock. That is based on a trend analysis. In other words, look for this to
be moving up nice and slowly and gently. You probably don't want to buy a stock
that is flat or going down, and you also don't want to buy a stock that is
exploding higher at a 60 or 70 degree angle or higher: I mean, how much further
can it go when it's skyrocketing? Many times a price crash will follow a
stratospheric or, as chartists say, a parabolic rise. So, the #1 thing you look
for is a comfortable, calm, rising uptrend in price.
Tip #2: Look at Moving Averages
Second, confirm price is in a trend by looking at certain
moving averages. A moving average plots the
average price
of a stock over time. The moving average line is connected and plotted over the
price. When looking at a
stock
chart, we want to see a rising moving average line AND we want to see price
above this moving average. Many people like to use the 200 day moving average,
or the 50 day moving average. Some investors like to go back further and look
at the 50 week moving average on the weekly chart (that plots about a year's
worth of prices). Some like to look at the 20 week moving average on a weekly
chart (that plots about 4 months worth of data). The quick and dirty tip is
that—no matter which timeframe you’re looking at-- you want the moving average
to be rising, and the price remaining above this average.
Tip #3: Compare Moving Averages
Third, you can look at how moving averages themselves relate
to each other. Remember, that idea we talked about that you want price to be
above the moving averages, but you can also look at how moving averages relate
to each other: just plot two or three moving averages from different timeframes
on the same chart. Let's say we're looking at a daily chart of Google (GOOG).
Now, let's select a short term, intermediate term, and long term simple moving
average. Let's look at the 20-day for the short term, 50-day for the
intermediate term, and 200-day for the long term. That equates to price changes
for about one month, two and a half months, and about 10 months (just under a
year since there are around 250 trading days in a year). The “picture of price
strength” would be that the 20-day moving average is higher (or above) the
50-day moving average, and that the 50-day moving average is higher than (or
above) the 200-day moving average. That is exactly what you want to see and
what we call the "most bullish orientation possible."
Tip #4: Look at Volume
Fourth, you can look to make sure volume is confirming the
uptrend. People who look at charts like to view volume, or how many shares are
trading, alongside price movements. Volume reflects the participation or
trading/investing activity inside of a certain stock. The ideal picture would
be a steadily rising trend to volume as well as a continually rising price. We
want to see an increase in volume or trading activity as a stock is rising
comfortably and steadily. That reflects the picture of strength, because it
shows that more people are getting interested in owning the stock as it increases
in value. What we would NOT want to see would be a stock price rising but the
trend of volume bars decreasing. That would be a warning sign that maybe we
would see a reversal down in price because people are becoming less interested
in owning it.
Tip #5: Make Sure there is Stability in Price
Fifth, we want to make sure there is stability in price
instead of lots of gaps or spikes. A gap is where price closes at a certain
price and then opens up the next morning at a much different price. Sometimes
an unexpected earnings announcement can cause a stock to jump much higher or
much lower overnight (
click
here for my episode on which economic announcements affect the
amrket). A small, reasonable gap is acceptable, but we'd prefer to buy a stock
that doesn't jump all over the place if we can. Also, we want to avoid a stock
that is too jumpy-- or a better word would be
volatile.
Look also at volume to see that there aren't frequent spikes in the volume
bars. Volume spikes can be warnings--and though they happen from time to time--
it's best to look at the
chart
historyof the stock you're thinking of buying to make sure there aren't too
many of these spikes. In other words, we want to see stability, not wild
volatility.
The Ideal Picture on a Stock Chart
So what would be the ideal picture of a stock we would want
to buy based on the chart?
We want to see a stock that has been rising steadily--
though not too quickly-- where the price is above the 50 week moving average;
and if we look at the daily chart, we want to see price above the 20-, 50-, and
200-day moving averages.
We also want to see that the 20-day average is above the
50-dayaverage which
is itself above the 200-day moving average.
The best time to buy the stock
would be when price pulls back or retraces to the 20-or 50-day moving average.
Following that guideline is a low-risk buy point. Look back at how many times
price has pulled back and bounced off one of these averages. Finally, we also
would want to see a steady rise in both price and volume, which reflects active
attention and participation in a stock. We don't want to see lots of random
gaps or price or volume spikes all over the chart: we would prefer as much stability
as possible when selecting a stock to buy.
Of course as we’ve always mentioned, these tips won't
guarantee success; but they will help give you a sense of which stocks you
shouldn’t buy (in most instances don't buy stocks in a downtrend, beneath the
200 day moving average). So we’re going to talk more about these things in
fundamental analysis as we stay tuned and discuss more ways to help you become
a winning investor!
This is Andrew Horowitz with The Winning Investor’s Quick
and Dirty Tips for Beating the Market. Talk to you soon.
