In Part 1 and Part 2 of our series, we have covered how to screen for SMART stocks. There are two main ways to analyze a stock: fundamental analysis and technical analysis. In Part 2 we covered fundamental analysis. In this article we cover technical analysis.
Whereas fundamental analysis measures the value of the company through its financial data, the state of the economy, its competitors and company management, technical analysis looks at the price and volume of the stock to identify patterns.
It has little to do with the intrinsic value of the company itself. Technical analysts believe that the historical performance of stocks and markets are indications of future performance. If you were at a store, a fundamental analyst would study the value of the products being sold. A technical analyst would observe the number of people going in and out and study the patterns, disregarding what was being sold.
Here are two key things technical analysts look at:
- Relative Strength Indicator (RSI). The RSI ranges from 0 to 100 and measures the strength or weakness of a stock. It is based on the stock’s recent trading period compared to its past. It measures the speed and momentum of the stock price changes and whether it is being overbought or oversold.
Look for a company that has an RSI approaching 30 (which means it is oversold and will likely rise in price) and avoid companies with an RSI of 70 or higher (which means it is overbought and most likely expensive). An RSI of 30 or less typically means the company has experienced some really bad news lately and the stock price has collapsed. A company is often still a good investment if the RSI is 50 or less.
- Moving Averages (MA). A Moving Average is the average price of the stock for a set number of previous days. It measures the price trends of the stock. A 50-Day Moving Average is the average stock closing price of the previous 50 days, the 100-day MA is the average stock price of the previous 100 days, and the 200-day MA is the average stock price of the previous 200 days. The MA is perceived to be the line between a stock that is technically healthy and one that is not.
The percentage of stocks that are above the MA helps show the overall health of the market. Look for a company that is moving above its 200-Day MA. If the stock is 10 percent more than its 50-Day MA, you may see a pullback in stock prices. Also, check out the stock’s trading volumes. On days when the stock price rises, is the trading volume also higher than the day before and higher than the average trading volume over the past month? An increase in trading volume on an up day for the stock price is good.
As you can see, picking a good stock takes a great deal of research and has risks associated with it. But over the long-term, stocks have provided some of the highest returns for an investment portfolio. This is why many choose to invest in mutual funds or get advice from a professional. Regardless, it is important to make sure you can devote time to study and make sure it is right for you!