Written and copyright © 2010-2013 by Thomas N. Bulkowski. All rights reserved.
Imagine that you have found the perfect stock. It was a bargain at 33, and now it's a 22, a drop of 33%! It's like buying a sweater in summer when winter clothes are on sale.
Is it time to back up the 18-wheeler to the stock and load up? Not so fast. You could be buying too soon.
How did the stock get to be 33% off? It first had to drop 10% then 20% and so on. What makes you think it will stop tumbling? The market lore says you're trying to catch a falling
knife, and you can imagine how dangerous that can be. Below I discuss a simple technique to determine if buying when the price is tumbling might be premature.
Buying Too Soon
On the right is a picture of Boeing (BA) on the weekly scale. If
you use a 150-day or 30-week moving average (they are the same, but for the daily/weekly chart, respectively) to qualify your purchases, it could prevent you from buying too soon. Here's how.
I use a simple moving average instead of an exponential moving average or other variety. The simple moving average tends to hug price better in a turn than the exponential moving average,
which surprised me, but that's what I found. If price is below the simple moving average during a strong downtrend, then do not buy the stock.
I show Boeing as it dropped during the 2007-2009 bear market. When price climbed above the moving average at A, that was
a buy signal. If you prefer, B is another buy signal which often occurs when price throws back to the moving average.
In a long down turn, that one step of waiting for price to rise above the 30-week simple moving average can save you a bundle of money. Play with it and see if it helps.
The Head, LS, and RS symbols on the chart are the left and right shoulders of a
head-and-shoulders bottom chart pattern, by the way. The head-and-shoulders bottom confirmed the turn in the stock.
Prevent Buying Too Soon: Discussion
During a bear market, stocks tumble and investors search for bargains. Unfortunately, they find many stocks that have made huge drops. So they buy, and yet the bear market isn't done. The
stock drops more and more and soon, they're down 50% from the purchase price. Oops. That's when they sell, right before the stock turns upward, following the market higher. Looking back
months later, they'll discover that they sold a week or two before the end of the bear market.
That's the way it goes. Using a moving average like the 30-week can help prevent you from buying too soon. Yes, you will give up some profit by missing the bottom as the stock
turns, but it's a lot better than owning stocks that continue to drop.
Prevent Buying Too Soon: Test Results
I looked at my own trades and discovered that the 30-week simple moving average added value. You will have to do the same to prove to yourself that this technique can save you
I used 179 of my own trades from August 2000 to March 2010 to test the theory that the 30-week simple moving average adds value (prevents a loss or makes more money).
In the first category, I counted trades that would have worked better had I waited for price to rise above the 30-week
simple moving average, would have prevented me from making a trading mistake, or if I bought at or above the moving average. I logged 102 such trades.
In the next category, I counted
all trades that ended in failure. Failure means price climbed above the 30-week moving average when I bought, but then price dropped and I sold at a lower price. I counted 38 such trades.
In the final category, I counted trades in which my trading resulted in a better buy price than waiting for price to rise above the 30-week moving average. In other words,
I bought when price was still below the moving average and I got lucky when price continued rising. I counted 39 such trades.
I found that had I used the 30-week moving average method, the trades would have worked or worked better 79% of the time [(102+39)/179 = 79%]. The other 21% of the time, the
method would have cost me money when price failed to continue rising.
In all trades, I looked for price to be trending lower.
Prevent Buying Too Soon: Trading Tip
This technique of adding a moving average to your technical toolbox works best when price makes a sharp downturn like the one shown in Boeing. With such dives, the stocks tend to
make V-shaped recoveries, quickly crossing back over the moving average. Shallower drops could see the stock trail sideways for months or even years before recovering. That can
happen if the drop is related to the stock only (like the CEO ran off with a wad of cash or he was running a Ponzi scheme) and not the entire market (as in bear market).
-- Thomas Bulkowski
Written and copyright © 2010-2013 by Thomas N. Bulkowski. All rights reserved. It's lucky you're going so slowly because you're going in the wrong direction.