Philip Davis'  Instablog

1. Understanding Market Cycles: The Art of Market Timing (Chp. 1), 

2. Dow’s Theory of Markets (Chp. 2), 

3 & 4. Fundamental vs. Technical Analysis and Types of Technical Trading (Chps. 3 & 4).

5. Stock Charting Basics: How to Read & Understand Stock Charts (Chp. 5 here.)  

All caught up? Here’s Chapter 6:  - Ilene 
 

The use of moving averages (MA) are a mandatory requirement for technical trading.  They are a favorite indicator of chartists.  Chartists do not consider a trade without looking at the relevant MAs.  A MA is the average value of a stock’s price over a certain length of time.  There are several uses for MAs:

• To determine momentum
• To show “invisible” support and resistance
• To give traders a head start in placing high-probability trades
• To signal warning of a breakdown
• To support the consensus of other technical indicators

All MAs are lagging indicators, meaning that they will react to price, and not foreshadow it.  Moving averages work in trending stocks and do not work well when a stock is in a neutral trading range.  Merck (MRK) is an example of a stock that has been trending up since May (Figure 23) and the 50 and 200d MA crossed over in July.  Notice how the 50d MA acts as support for the uptrend:

There are many types of MAs (simple, exponential, variable, linearly-weighted), but only will the two most widely used will be discussed: the simple (SMA) and exponential (EMA) moving averages.

The SMA is calculated by taking the average price of a stock over a certain period of time giving equal weight to each day.

The EMA is calculated as either percent-based or period-based. The exact mathematical formula will not be covered, but the EMA cuts down the lag time by distributing more weight to recent prices and less weight to older prices.  The shorter the EMA (in days), the more weight is designated to the most recent price. Therefore, the EMA is almost always closer to the current price than the SMA. 

Which one is more useful?  The determining factor is small, but there are large differences once a stock becomes more volatile.  The EMA should be used for day/swing trading. The short time frames are factored into the EMA.  The SMA is a better indicator if the holding period is several weeks because the EMA is too sensitive to small changes and will give false signals, which makes it less effective for longer periods.  If a moving average does not provide accurate support or resistance guidance, then there is no point in using it.  Not all stocks follow the same moving averages.  

Here is a sample guideline for which MA’s to use:

Long (buy) or Short (sell) trades:

• 10 or 15-day SMA (short-term)
• 20-day SMA (short-term)
• 50-day SMA (intermediate-term)
• 200-day SMA (long-term)

The key point is to make sure the moving averages actually guide a stock.  Take a look at Verizon (VZ) in Figure 24 and see how the 20 and 50-day SMA guides the stock almost perfectly.  The bottom line: if a stock is about to meet a MA that the stock has used in the past, then there is a very high chance that the stock will react to the MA. 

Besides using MAs as support or resistance, MA crossovers can be employed.  Many times, when an MA “crosses over” another, that movement generates a buy or sell signal (as with MRK).  The most accurate signals come from shorter time frames because remember, MA’s are lagging indicators. 

NOTE: When a shorter period MA crosses above a longer period MA, that is considered bullish.  When a shorter period MA crosses below a longer period MA, that is considered bearish. 

Crash prevention: Here is a recent example of how the 200-day SMA provided early warning to investors/traders that the stock market (The Dow) was about to enter into a downtrend (Figure 25):

Yesterday, we had a nice day with our Short Sale of the Day on Harbin Electric Inc. (HRBN), which was a short sale good for 2.8%. We got into Harbin in the morning at 25.60. We watched the stock sit at 25.75 for the majority of the day, but at 2 PM, HRBN started to lose buyer interest as seller interest rose. The stock plummeted down to 24.21. We exited at 24.90 for a 2.8% gain. The stock is down today to 22.50s, which is good for over 12% in gains. I hope some of you had more risk than I do and took advantage of that gain. Our Buy Pick of the Day did not meet our intraday requirements, so we did not get involved in ERX or ERY. Either way, it was a good day.

Now, we get into today’s Overnight Trade of the Day…

Analysis: It is not typical for me to recommend an Overnight Trade in a stock that is up over 4% already the day before a company reports its earnings, but this opportunity is looking pretty stellar. I want to get involved with GMX Resources Inc. (GMXR), which is a small independent oil and natural gas producer in Texas, Louisiana, and New Mexico. The company is definitely a small player in the oil game, but I think it presents a very solid opportunity going into tomorrow for some nice gains.

The first reason that attracted me to GMXR, which is not even the best reason for investing into GMXR is that independent oil companies, as a whole, have been having pretty good quarterly reports for Q4 of 2009. 24 out of 34 of the companies that reported earnings in the past month, reported surprise EPS gains. Most of these gains were pretty outstanding, as well. GMXR’s closest competitors have done pretty well. The closest company that resembles GMXR is Panhandle Oil and Gas, who produces both oil and natural gas, is involved in the same region as GMXR, and has similar market capitalization. That company produced a surprise estimate of 1900%. Another close company did miss estimates, but it has struggled to pull profits and reduced its losses exceptionally in the past quarter. This company is Petroleum Development Corp. Overall, independent oil and gas has been surprising a lot of estimates. GMXR’s EPS estimate is to hit 0.09, which be only a one cent gain quarter-over-quarter.

Estimates came into low, especially considering the rise in natural gas prices in the final quarter of 2009. Natural gas went from $3 per MMBTU in Q3 to $6 by the end of Q4. A company with good natural gas exposure could really improve on those numbers, and GMXR has significant natural gas exposure. The EPS estimates on PHX were just way too low, and the company blew them away, citing that the stabilization in natural gas prices was extremely helpful.

Panhandle’s CEO Michael Coffman commented, "Current natural gas futures prices point to an average realized price in the $5.00 - $5.50 range during 2010, which is equivalent to the prices used to develop our 2010 capital and operational program and should allow us to have a profitable year."

This comment is good news for GMXR. Another interesting data point that I found that still has not led me to the motherload was the correlation between growth in EPS estimates between GMXR and PHX that have been very similar over the past five quarters. The companies have seen similar growth in estimates, and if GMXR can come even close to the type of results that PHX was able to turn would be great. They should definitely be able to raise one penny. Close competitors rose on average 11 cents quarter-over-quarter. That information makes me very cozy. 

But here is the motherload: One quarter ago GMXR reported a quarterly loss EPS of -7.27, with a miss of -12216.7%. The profit the company will have will be what the writers all talk about tomorrow because of the huge gains they are going to make year-over-year. I think GMXR will be a pretty outstanding move and buy. I think we can see some pretty big gains when all is said and done.

That is why I am not too nervous about the gains the stock has made today because the stock should have major movement tomorrow. The technicals are also really outstanding for GMXR. The stock is about 40% off its 52-week high, and the stock has narrowing bollinger bands, which means that the stock is ready for a break out…which is going to be the upside. 

Get in today and let’s make some money!

Entry: We are looking to get involved at 10.25 - 10.35.

Exit: We will be exiting GMXR tomorrow morning after earnings report.

Good Investing,