Many investors do not believe in technical analysis and do not use it as a tool when investing in the markets. However for income orientated portfolios, it can be an invaluable tool to have in one’s arsenal from a variety of standpoints. It is all about perception and objectives. For example a long term investor looking to hold a stock for years on end is not distracted by short term wiggles in the share price. Here the investor is looking for long term appreciation in the share price. However we are looking for price extremes whether they occur at bottoms or tops. As explained in a previous post when discussing Walmart (NYSE:WMT) over the first part of this century, selling volatility or even just buying and selling the stock once it got over overbought and oversold would have easily beaten a long term buy and hold strategy for this particular company. Therefore technical analysis definitely is a tool to have in one’s arsenal as besides spotting bottoms and tops, it forces you to take profits which is the name of the game for an income derived portfolio.
The first indicator I use is the Relative Strength Index (RSI) which is a momentum oscillator that measures the speed and change of price movements. This particular indicator oscillates between 0 and 100 but I prefer to just use the 30 and 70 parameters which basically means that we are looking at an oversold stock (short term) when the oscillator is under 30 and overbought when it has gone over 70. Remember we want to clearly see from the oscillator when a particular stock is overbought and when it is oversold. I have played around with the parameters of the oscillator and I like to use 5 as the oscillating number. If you prefer to hold stock for a longer period of time, you can bump up this number to 6 or 7 which would mean you would see less occurrences when the stock would actually get to extremes which would mean you would probably miss some opportunities. It all depends on how often you want to trade and how strong you want your signals to be. I like to use 5 but this number will be different for everyone so play around with the numbers.
Now if you have the proper fundamental and valuation work done on a particular security, then we should be dealing with a security that should over time keep grinding to the upside. Again this is subjective as currently US equities are enjoying a 8 year long bull market and we don’t look to be running out of steam just yet. Therefore when equity markets are rising, stocks can remain overbought for quite some time and this usually is a sign of underlying strength in a bull market. We can see this in the charts below of Emerson Electric Co.(NYSE:EMR) & McDonald’s Corporation (NYSE:MCD). In the McDonald’s chart for example, you can see that price remained overbought pretty much for the whole month of February here (even on the slower 7 parameter setting). This is what I meant when I stated that sustained overbought conditions are generally a sign of strength. It would have been difficult here to catch the exact top here if one was only trading stock.
On the Emerson chart, upside would have also been missed on occasions as illustrated. However this only happens when one is just buying and selling stock as opposed to using options. For example, as illustrated, Emerson became overbought at around the $55 level in November of 2016. Instead of selling the stock at this juncture, one could also have sold a call option against the long stock position. The great benefit of this strategy is that one could have sold for example the $57 or $58 call maybe 30 to 40 days out and still collect any dividends due plus take advantage of any more upside. In a bull market where earnings are increasing, this strategy ( which we will go into more detail) gives the position more leeway to grind to the upside plus the investor would also collect the premium from the call option into the bargain.
This also works in reverse. Between 2014 and 2016, Emerson’s moving averages crossed over and it was clearly in a downtrend. When the 50 day moving average is below the 200 day moving average, investors should be extra cautious about the risk to the downside. This happened to Emerson in August 2014 and the stock became oversold in July of the following year. Many investors would have bought here (or also sold some covered puts if they were short the stock) but as the chart illustrates, the stock ended up falling a further $12 or 23% more. Granted that this particular stock got caught up in the massive slide in the price of crude oil in 2014 and 2015 but once the moving averages crossed over, it was time to vacate this stock and look for better opportunities.
Furthermore f you want more accurate turning points, just use the 10 day moving average with the 50 and ignore the 200. Using these technicals, one could learn when to sell or when to actually sell calls against their positions. In fact, Emerson’s 10 and 50 moving averages have just crossed over which may mean a downswing is on the horizon.
Just remember momentum indicators are useful such as the RSI index and are there to spot temporary tops and bottoms especially when used with moving averages. They only though are an addition to an overall trading/investment strategy but do have their place after solid fundamental work has been done.
Sentiment is still pretty elevated in Emerson at present. I believe one will pick up this stock cheaper.
Source : Sentimentrader.com