Sunday, November 18, 2007

Screening to Win: Moving Averages

This is the start of a series of articles that describe how to successfully screen for stocks. The initial essays will cover some common technical indicators. The follow-up articles will provide examples of winning screens that utilize both fundamental and technical indicators. This material will eventually be placed on the HingeFire website.

At HingeFire, we believe that investors should take advantage of every aspect of screening to put the market edge in their corner. Fundamental criteria are an excellent gauge of the prospects for a company over a lengthy period of time. Technical indicators provide important clues about the short term momentum in the market, effectively reflecting the fear and greed of traders.

Investors with long time horizons can use technical indicators to enhance their returns. Studies have demonstrated that using technical indicators to time the entry and exits of long term investments can increase the basis return by over 4% points. It makes sense to use technical screening in conjunction with your fundamental examination of potential equity selections to boost your portfolio.

The good news is that technical indicators are not magical voodoo, most have sound theories behind their logic that all derives back to the innate psychology of the market. Additionally, technical values are simple to understand and helpful in implementing your market execution decisions so it behooves investors to comprehend them.

The overview below describes one of the common technical indicators - Moving Averages, and provides insights on how to utilize it in your stock selection. Hopefully this outline will provide traditional fundamental investors with some solid insight on how to incorporate technical indicators into their screening. The free HingeFire Stock Screener which can be found at is one of the few tools available that includes a wide selection of fundamental and technical criteria for selecting stocks. Using a combination of fundamental and technical screening is a powerful tool for winning in the market.

Moving Averages

Moving Averages Overview

There is an old expression that “Bulls live above the 200 Day Moving Average and Bears live below the 200 Day Moving Average”. In many ways this adage holds true. Associating a stock’s price level with its moving average is a very reliable approach to determine the trend.

The two most common types of Moving Averages are SMA (Simple Moving Average) and EMA (Exponential Moving Average). Simple Moving Averages are created by simply totaling the closing prices for the defined time period and dividing the total by the total number of days.

An EMA applies more weight to recent prices relative to older prices. The weighting applied to the most recent price depends on the specified period of the moving average. The shorter the period of an EMA, the greater the weight applied to the most recent price.

An exponential moving average will always tend to be closer to the current price then a simple moving average. From a reliability perspective, EMA has a tendency to “whip-saw” more then SMA moving averages, providing short-term false breakout and directional change signals, due to its reliance on more recent information. Conversely EMA provides a quicker indication of the underlying changes in the pricing of the equity, allowing an investor to jump on board changes in trend. The question of which moving average is best is subject of a “religious debate” among theoreticians. Investors should try both and determine which is most useful for their selection process.

The HingeFire tool provides support to incorporate moving averages in your creation of screens for stocks. Support for both SMA and EMA is included. Users can scan to determine if a stock price is greater than or less than a particular moving average, and also determine if the price just crossed above (JCA) or below (JCB) the moving average today. The tool also provides the capability to compare the levels of different moving averages.

How to use Moving Averages in screening

The HingeFire screener supports allowing users to determine if today’s closing price is above or below the SMA or EMA for multiple time frames. Most investors view that closing prices above or below the moving average in longer time frames such as 200 day, 100 day, or 50 day provide a solid indication of a stock being bullish or bearish. Many investors use this assessment as a filter for their entries, typically going long on stocks whose prices are above their long term moving averages and tending to short stocks below these levels.

Short-term moving averages provide information on quick price acceleration or deceleration. A stock that is above its 5 day and 20 day moving average is likely to be accelerating in an uptrend and is prone to continue an upside breakout. A cross-over back below a short-term moving average can serve as a signal that a stock upswing is exhausted and it may be time to take profits.

AeroCentury Corp (ACY) recently broke out above its 20 day and 5 day SMA. Many momentum investors look for these conditions as entry points, and would view the stock price dropping back down below these levels as a sign of exhaustion and exit the trade. ACY was simply one of many stocks found when using the HingeFire tool to screen for the closing price being above the 20 day and 5 day SMA levels.

The HingeFire tool also supports determining if the pricing has just crossed above (JCA) or just cross below (JCB) a moving average level. These cross-overs potential indicate a change in trend from bearish to bullish or visa-versa. Many investors screen for these cross-over changes in order to scope out stocks that have potential before they become widely exploited by the market.

For example the stock price of Techwell (TWLL) just recently broke out above its 200 Day SMA near $12.65; this many times serves as notice of a change in momentum for the stock. Many investors would view this as a possible entry point if they believed that the stock had sound fundamentals.

The comparative level of moving averages to each other also reveals noteworthy information about stocks. The HingeFire screener supports comparisons such as the 200 and 50 day moving average levels. Support for JCA and JCB is also provided for comparing these moving averages. Many investors view that when a 50 day moving average crosses over the 200 day moving average, it serves as confirmation of the bullish signal for the stock. This type of confirmation usually lags the exact start of the trend but helps investors avoid situations where the trend quickly reverses.

Recently the 50 Day SMA of Avon Products (AVP) crossed above the 200 Day SMA; many investors would view this as solid confirmation of the bullish trend. Avon is one of the stocks that came up this past week in a scan of the 50 day SMA (red line) crossing above the 200 day SMA (blue line) using the HingeFire stock screener.

Moving averages can also serve as a support level, occasionally news will come out about a stock that causes the price to drop near its 200 day or 50 day support level. Sometimes the stock price will bounce-off of these support levels rather then diving below them with significant volume. Numerous investors screen for these situations as entry points and purchase their stocks near these support levels.

A recent example is CSCO dropping to its 200 day support level shortly after its recent earnings report. A regular screening of Cisco would show the price dropped slightly below the 200 day moving average (blue line) near the 9th of November. Many investors with a bullish fundamental long-term outlook on the stock would view this as an entry point to purchase CSCO.

Note that long term moving averages can also serve as resistance levels with some stocks having difficulty penetrating this barrier with volume sufficient to carry them higher. Investors focused on shorting commonly screen for scenarios where prices fail to breakout solidly above larger time frame moving averages.

In summary, many knowledgeable investors use the HingeFire tool to screen for the following situations with moving averages:

  • Equity prices being above or below long term moving averages function as a filter to either purchase the stock long or sell the stock short.
  • Prices rising above or dropping below short term moving averages act as a momentum breakout indicator or serve as a profit taking point.
  • Prices crossing over larger time frame moving average levels indicate a change in long term momentum. This serves as a possible entry point for investors to beat the crowd.
  • Comparison of moving average levels act as a confirmation of a trend.
  • Moving average levels serving as support or resistance levels.

Combining technical indicators such as moving averages with commonly used fundamental criteria when selecting your investments helps put the market edge in your corner. The HingeFire Stock Screener provides support for both fundamental and technical indicators, a powerful combination that will enable your success in the market.