How Do You Know When a Stock is a Good Buy?

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How Do You Know When a Stock is a Good Buy?

Episode 9: March 30, 2011

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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.