By: Jerry Nix, Freewavemaker, LLC January 12, 2022
Hopefully this article will serve two purposes. First, to start you on the path to learning Technical Indicators when investing in the stock market. This will help those investors who want to attempt to time the market and become what is known as “swing traders.” Swing Traders are those investors who want to have multiple trades where they are attempting to get in at the low and sell at a higher price in the short-run to add real gains to their portfolio a little at a time. I’m not sure if it was Ole Ben Franklin or Ole Will Rogers … or possibly some other witty man or woman … but someone once said, “Add a little to a little and after while you’ll have a lot.” That’s the idea of Swing Trading.
The second reason for this article is to help those who want to “Keep It Simple” when investing for the long-term and still get a good return without a lot of downside swings and a lot of sleepless nights. In other words, “Buy and Hold” long-term trading.
Let’s begin with a discussion of technical indicators. I will be using several sources of information in this article. To name a few …
- Investopedia.com – which provides a lot of information on investing if one cares to venture out and discover education on their own.
- Fidelity.com – an investment site that I don’t personally use but do enjoy articles from them from time to time.
- Charles Schwab at Schwab.com – an investment site that I do use for my personal trading and education from time to time.
- VectorVest 7 – from VectorVest.com that provides market timing and analysis on more than 9,000 stocks and indices at this time. I’ve been using this program for the better part of 2 decades now.
- Finance.Yahoo.com – and other such internet sites.
WHAT IS TECHNICAL ANALYSIS?
Technical analysis is a trading discipline employed to evaluate investments and identify trading opportunities by analyzing statistical trends gathered from trading activity, such as price movement and volume.
Unlike fundamental analysis, which attempts to evaluate a security’s value based on business results such as sales and earnings, technical analysis focuses on the study of price and volume. Technical analysis tools are used to scrutinize the ways supply and demand for a security will affect changes in price, volume, and implied volatility.
Technical analysis is often used to generate short-term trading signals from various charting tools, but can also help improve the evaluation of a security’s strength or weakness relative to the broader market or one of its sectors.
Technical analysis can be used on any security with historical trading data. This includes stocks, futures, commodities, fixed-income, currencies, and other securities. In this article I will focus on the common stock indices (and Exchange Traded Funds or ETFs) that follow these indices. I will also focus on only 1 technical indicator at this time – the one some feel is a complicated one- the Bollinger Bands.
Technical analysis operates from the assumption that past trading activity and price changes of a security can be valuable indicators of the security’s future price movements when paired with appropriate investing or trading rules. Professional analysts often use technical analysis in conjunction with other forms of research. Retail traders may make decisions based solely on the price charts of a security and similar statistics, but practicing equity analysts rarely limit their research to fundamental or technical analysis alone.
Technical analysis attempts to forecast the price movement of virtually any tradable instrument that is generally subject to forces of supply and demand, including stocks, bonds, futures, and currency pairs. In fact, some view technical analysis as simply the study of supply and demand forces as reflected in the market price movements of a security. Technical analysis most commonly applies to price changes, but some analysts track numbers other than just price, such as trading volume or open interest figures.
I will stop my discussion of Technical Analysis here and ask you to do further research on your own … here’s a good starting point and the one I used to present this article so far: https://www.investopedia.com/terms/t/technicalanalysis.asp
What are Bollinger Bands?
Bollinger Bands are a type of price envelope developed by John Bollinger. Bollinger Bands are envelopes plotted at a standard deviation level above and below a simple moving average of the price. Because the distance of the bands is based on standard deviation, they adjust to volatility swings in the underlying price.
Bollinger Bands use 2 parameters, Period and Standard Deviations. In this article the default values are 20 for period, and 2 for standard deviations, although you may customize the combinations to meet your own needs.
Bollinger bands help determine whether prices are high or low on a relative basis. They are used in pairs, both upper and lower bands and in conjunction with a moving average. Further, the pair of bands is not intended to be used on its own. Use the pair to confirm signals given with other indicators. In future article’s I will get into what some of these other indicators may be that you might want to use … but understand there are hundreds of them, and even I don’t know how to use them all. I will forever be learning as I journey into the investment realm.
This is what Bollinger Bands may look like in a typical stock chart where they are being used:
How this indicator works:
- When the bands tighten during a period of low volatility, it raises the likelihood of a sharp price move in either direction. This may begin a trending move. Watch out for a false move in opposite direction which reverses before the proper trend begins.
- When the bands separate by an unusual large amount, volatility increases and any existing trend may be ending.
- Prices have a tendency to bounce within the bands’ envelope, touching one band then moving to the other band. You can use these swings to help identify potential profit targets. For example, if a price bounces off the lower band and then crosses above the moving average, the upper band then becomes the profit target.
- Price can exceed or hug a band envelope for prolonged periods during strong trends. On divergence with a momentum oscillator, you may want to do additional research to determine if taking additional profits is appropriate for you.
- A strong trend continuation can be expected when the price moves out of the bands. However, if prices move immediately back inside the band, then the suggested strength is negated.
Let’s look at the chart again …
First, the tool in most stock graphing software will calculate a simple moving average. Next, it calculates the standard deviation over the same number of periods as the simple moving average. For the upper band, add the standard deviation to the moving average. For the lower band, subtract the standard deviation from the moving average.
Typical values used:
Short term: 10 day moving average, bands at 1.5 standard deviations. (1.5 times the standard dev. +/- the SMA)
Medium term: 20 day moving average, bands at 2 standard deviations.
Long term: 50 day moving average, bands at 2.5 standard deviations.
In my examples I am using the medium-term Bollinger Band with a 20-day Simple Moving Average and 2 Standard Deviations for the upper and lower bands.
THE INDICES WITH BOLLINGER BANDS FOR THE PAST 6 MONTHS …
This part of the discussion will focus on the stock indices that I personally watch daily and how I use the Bollinger Bands when looking at the stock charts. The charts you see below are from my StreetSmart Edge trading platform that is currently available to most Charles Schwab Investors. Since Schwab recently purchased Ameritrade, which uses the Think or Swim Platform it is my understanding that in the near future this will replace the StreetSmart Edge trading platform and I will have to learn a new system. Change is constant – that is the one thing we can all be sure of.
Dow Jones Industrial Average Index over 6 months:
We can see in this graphic that even though the DOW has been volatile since about September (see the widening of the bands and erratic price movements from the upper to lower bands), this index is still up about 4% over the past 6 months. The price has touched the upper band and the lower band and has gone above and below the 30-day simple moving average (white line) many times over the period. Currently over the past 3 trading days the price has closed above the 30-day simple moving average price.
In swing trading a good time to buy this, if it were a stock, would be when the price is below the 20-day simple moving average and closer to the bottom band and sell it when the price is above the 20-day simple moving average and closer to the upper band.
The green line is simply the 0% line for the past six months. With the price well above this line we see the trend – regardless of the news you may hear – has been up for the period shown. You could naturally do this for longer or shorter periods (years or months), depending on what you are comfortable with.
Standard & Poor’s 500 Index:
The S&P 500 has also trended up for the past 6 months with volatility causing the price to cross above and below the 20-day SMA several times. As of this writing today the price just crossed back above the 20-day SMA and overall, the price is up about 8% for the six-month period with the value going from 4,380.17 six months ago to 4,725.75 as of now.
As shown here there has been a lot of volatility over the past 6 months and it appears to be widening. Three days ago, there had been no overall increase in value for the 6-month period but over the past three trading days (including today) the price has been increasing off the bottom band and is up 3% – though it is still trading below its 20-day SMA.
NASDAQ 100 Index:
This happens to be an index of 100 stocks of the NASDAQ Composite Index … all having to do with technology of one form or another. Again, we see periods of varying volatility over 6 months from low in August 2021 to relatively high from October through the end of the year. In addition, volatility seems to be increasing if you consider the bands range of the past few days. While the price is well above the 0% line in the 8-month period (at about 6.25%) it is still below the 20-day SMA. However, it has definitely trended up nicely over the past 3 trading days including today.
Russell 2000 Small Cap Index:
Here we see an index of the small cap stocks that has actually gone down in value over the past 6 months. It is off about 2% and while the price hit the 20-day SMA today … it is currently trading below it.
I tell you all this and show these charts to help you understand, I hope, that it pays to know where the market has been and what the future may hold before investing any capital in the markets. These same graphs can be displayed on individual holdings as well. For example, look at the following chart for Apple Computers …
If I were interested in buying Apple Computer today (AAPL) I’d first take a look at this chart to see where the price has been and which way it is likely headed.
The first thing we can see is that it has gone from $148 per share to $175 per share in the past 6 months (almost 20% gain). However, we can also see that it has fallen from a recent high of $182.63 on 01/04/2022 to a low of $168.17 on 01/10/2022 before beginning to trend back up. With the price bouncing off the bottom band and heading back up to the upper band – yet trading at about the 20-day SMA – if I were interested in buying this stock … it may be a good time to get in. I would guess that it will be higher than it is now in the next month or two. There are no assurances the price would be higher in the future … but there is a reasonable chance it will.
Now let’s take a look at what this chart would look like if I change the SMA time to 50 days and the standard deviation from 2 to 3 – for the longer-term investor.
Here you can see, though the price numbers are the same, the appearance of the chart and the Bollinger bands are totally different. You can also see the periods of volatility a lot clearer when using the 3-50-3 option vs. the 2-20-2 option for setting up the bands.
BUT, CAN YOU BUY THE INDICES?
Simple answer NO … correct answer YES. However, you have to buy them as an index Exchange Traded Fund (ETF). While there are many Index ETFs that can be purchased from many different vendors or companies … the four I will talk about here are as follows:
- SPDR Dow Jones Industrial Index ETF (DIA)
- SPDR S&P 500 Index ETF (SPY)
- Invesco NASDAQ 100 Trust ETF (QQQ)
- iShares Russell 2000 Growth Index ETF (IWO)
Now Let’s take a look at the same 6-month charts as we did when we looked at the indices that these funds track. I think you will see there are a lot of resemblances, which means the funds are doing their jobs.
SPDR Dow Jones Industrial Index ETF (DIA)
SPDR S&P 500 Index ETF (SPY)
Invesco NASDAQ 100 Trust ETF (QQQ)
iShares Russell 2000 Growth Index ETF (IWO)
What if you don’t want to keep up with the market on a daily basis?
If this is the case, you should definitely not consider swing trading. Simply by some investment funds (such as ETFs) and let the professionals keep up with it for you. However, since there is likely more than 20,000 mutual funds and ETFs on the market … you will still need some guidance and will still require some research.
A good financial planner or advisor can offer a great assistance to you for doing this, however, he/she will have to be paid. They don’t do things for nothing … there is no free lunch. In addition … there are few, if any, that will do swing trading for you. When managing the accounts of 100 to 1,000 or more clients they simply do not have enough time in a day to do the clients justice – and the honest ones will tell you this.
People that manage mutual funds and ETFs are called “Money Managers” and all financial planners and advisors have a list of money managers that they believe in and rely on. A good financial planner or advisor will recommend products and services of money managers that have performed well for the advisor’s clients in the past. As these managers begin to under-perform the good financial advisor or financial planner will fire them (actually just stop using them) and find new ones to handle their clients’ money.
You should demand a meeting with your financial advisor at least annually (or even more often) to review your investment plan and make sure it is keeping up with your investment desires. As a retired financial advisor, I can tell you that I met with most (not all) of my clients at least quarterly. But I did try to meet with all that would meet with me at least one time each year for a thorough review of their goals, financial plan and investments.
If that even seems to be too much of a burden for you then consider being what I call a LAZY but SMART Investor by doing the following.
Buy the Stock Indices and let them work for you:
What I mean by that is to distribute your money evenly in 3, 4 or 5 index or sector ETFs and let them work for you. Let me give you an example:
Assume that on January 3, 2012 you had $100,000 in your IRA that you wanted to invest for the long-term but that you did not want to have to worry about it and look at it daily. Here’s just one idea (and I have many) that you could consider doing on your own.
Invest about $25,000 into each of four Index Funds and sit back and let them work for you. I am using only domestic stock index funds … but there are index funds that focus on foreign/international markets as well.
In the case below I used the Dow Jones Industrial Index Fund (DIA), the S&P 500 Index Fund (SPY), the iShares Russell 2000 Small Cap Index Fund (IWO) and the Invesco NASDAQ 100 Index Fund (QQQ).
Here are the results through the date of this article:
On January 3, 2012 (assuming purchases at the market open) you would have invested and seen the following results.
- $24,911.94 invested into DIA would have given you 201 shares that would have grown to $48,120.41 as of today for an overall return of 193.16%. An average annual return of 19.32% per year (simple) which is a compounded annual rate of return of about 6.81% per year.
- $24,986.40 invested into IWO would have given you 290 shares that would have grown to $55,158 as of today for an overall return of 220.75%. An average annual return of 22.08% per year (simple) which is a compounded annual rate of return of about 8.24% per year.
- $24,913.20 invested into SPY would have given you 195 shares that would have grown to $67,011.75 as of today for an overall return of 268.98%. An average annual return of 26.9% per year (simple) which is a compounded annual rate of return of about 10.40% per year.
- $24,983.49 invested into QQQ would have given you 439 shares that would have grown to $145,102.67 as of today for an overall return of 580.79%. An average annual return of 58.08% per year (simple) which is a compounded annual rate of return of about 19.23% per year.
Summary of Investments:
- A total of $99,795.03 invested on January 3, 2012 would have provided 1,125 shares of quality ETFs in four different stock indexes that over a 10-year period (not counting dividends, which all these pay) would have grown to a value of $415,187.86 for a total gain of $315,392.83 or 316.04%. This would be an average gain per year of 31.604% or an annual compounded return of about 15.32% per year.
There may have been two short-term periods during this ten-year period where you may have had a little doubt slip into that gray matter between your ears. Looking at the chart this would have been in the last quarter of 2018 and the first quarter of 2020 (Covid Decline). Other than that, the equity line would have been pretty stable over the 10-year period.
Now you may be thinking … but if I’d put it all in QQQ I would have been far better off … and you would have been correct … 19.23% per year is better than 15.32% (see the rule of 72 below). However, keep in mind, this is looking in hindsight and hindsight is always 20/20 – but none of us have a “crystal ball” to look into the future.
The Rule of 72:
This rule states that if we know the interest rate and divide 72 by that rate … the result will be the number of years needed to double our money. Or if we want to double our money in X number of years simply divide 72 by that number and the result will be the interest rate we need to obtain to double our money during that period.
So, 72 divided by 15.32 means that our money should double in about 4.7 years. If this is the case and the trend of 15.32% continues, we could see our nest egg (with no work and no dividends reinvested) grow as follows into the future.
For purposes of illustration, I will round the number of years to 5:
How about that?
A total of 3.3-million-dollar potential in a period of 15 more years (a total of 25 years from start to finish with less than $100,000 at the start) – and you should be able to sleep at night.
Summary to this article:
I hope that this article has helped some of you understand at least one technical analysis technique (Bollinger Bands) and how to use it when considering Swing Trading. I also hope it helps understand the difference between Swing Trading and Long-term Investing.
In future articles we will discuss more technical indicators and how they can be used for swing trading. It is important to understand that none of them used alone is very good and should be used in combination with others.
It is also important to understand that in using a swing trading technique to your investing you can ultimately make more money – if done properly and if money management techniques are used to reduce losses – but there will be times when you will likely have bigger draw downs in value than you would see with longer-term buy and hold investing across multiple asset types.
I will discuss “Money Management Techniques” as well in future articles.
I do encourage you to work with a licensed professional financial advisor or financial planner who can advise you on how to structure a portfolio based on your overall financial situation (assets, debts, income and expenses as well as risk tolerance needs such as insurances) at least until you learn enough to do it on your own. Use these people, not only for “investment guidance” but also for “investment education.” If they are not willing to educate you, then by all means find one that will.
It is not a bad idea to have various portfolios for different investment types. I have a long-term buy and hold portfolio, a swing trading portfolio as well as a portfolio where I do nothing but options investing.
Finally, you don’t need $100,000 to start an investment portfolio. Most of what I talked about in this article can be started with as little as $100 per month. You must start somewhere if you ever want to take a small amount of money and build a large amount of money.
There are only 4 ways to acquire wealth …
- Inherit it – not likely for most of us
- Steal it – not recommended for any of us
- Work for it – unless you’re retired or supporting a working spouse, we should all be doing this … don’t depend on the government to make you rich … and
- Let your money work to create your wealth – which, in my opinion, is the best and easiest way to create wealth.
Have a great investing future!