How to generate buy and sell signals using technical indicators ?

When it comes to investing in stock market, I always insist on finding fundamentally strong companies and investing for long term. However, there are some times when market offers a great opportunity for a short term investment, where investors can take advantage of irrational behaviour of masses and make money in a short period of time. To do this an investor must learn to identify and exploit such opportunities. This can be done by the help of some technical indicators such as RSI, MACD and EMA. Before we start using these indicators it is important to understand them in order to use them in a better way. For explanation purpose, I am going to use one year daily chart of Asian Paints as an example.

What is EMA (Exponential Moving Average):

EMA is a moving average where more weightage is given to the recent data, this type of moving averages act faster than traditional simple moving averages. A moving average is the average of closing price of a stock for specified number of days. For example a 10 day moving average means, we take average of previous 10 days closing price of a stock, from the first day to the tent, then from second day to the eleventh, from third day to the twelfth, and so on. This gives us a trend of the price movement of a stock in the past days. If the average is falling, it means stock is correcting, and if the average is going higher, it means the price of the stock is rising.

This is how line of moving average looks like.

What is RSI (Relative Strength Index):

RSI is a momentum oscillator that measures the speed of change of price movements. It is used to predict the general trend. Traditionally, RSI is considered overbought when above 70 and oversold when below 30. This is how RSI looks like.

As you can see, there is a red line at the top, and a green line at the bottom. The line moving between them id the 14 day Simple Moving Average of the stock. If the moving average crosses the red line, stock is considered to be overbought, which means, it has moved at a very high levels and a trader should expect some correction or reversal in the price.

If the 14 day Simple Moving Average crosses the green line at the bottom the stocks is considered to be oversold or weak and trader has the opportunity to enter the stock.  

What is MACD (Moving Average Convergence Divergence):

MACD is a trend following momentum indicator. MACD is calculated by subtracting 26 day EMA from 12 day EMA, the 9 day EMA is used as signal line and is plotted on MACD, functioning as a buy and sell signal indicator. The MACD has a horizontal mean line. When the 9 Day EMA moves below the line, it indicates downward momentum in a stock. Farther the line goes down, stronger the momentum. If the 9 DMA moves above the mean line, it’s a sign of stock being overbought and a correction can be seen very soon.This is how MACD looks like.

How to use them?  

An investor must not rely on a single indicator for buy and sell signals, as a single indicator may generate false signals about the trend. To confirm if a trend is real, one should use all the three indicators together.

Getting Buy signal:

First signal that you must use is EMA. To find the price movement of a stock, use two to three EMAs of different time period. Here I am using 30 day, 60 day, and 120 day EMA. A buy signal is generated when 30 day moving average line cuts the other two EMA lines from above and moves below both the EMAs. This is known as golden crossover. This shows that the price of the stock has seen a deeper correction in the past 30 days compared to the past 60 or 120 days. It’s the first confirmation that price of the stock is seeing a downtrend. See the chart below:

Second signal is RSI, As mentioned earlier, RSI below 30 is considered oversold, and above 70 is considered overbought. When 30 day EMA crosses 60 and 120 day EMA from above, and if RSI is near or below 30, it is a stronger signal of confirmation that the stock is oversold. See the chart below:

Third and final confirmation signal comes from MACD. When MACD moves below its zero line, it’s a strong sign that stock is now entering the oversold category. Deeper the MACD goes below the zero line stronger the confirmation. See the chart below:

The date at which all the three indicators generated a buy signal was 21 November 2016, and the closing price of Asian Paints stock was Rs. 900.

Getting Sell Signal:

Sell signals are generated the same way as the buy ones, If 30 day EMA crosses the 60 Day and 120 Day EMA from below and moves above them, it’s the first confirmation of a sell signal.

The second confirmation signal for sell is generated if the RSI moves above the overbought line that is the red line of 70. RSI moving above the red line is a confirmation that the stock has entered overbought category, and trader should be watchful of the price movement.

The third and final confirmation is when 9 day EMA of MACD moves above the mean line. When this happens, it’s a sign that stock is overbought and it’s time to consider selling the stock.

The date at which all indicators generated sell signal was 16 March 2017, and the closing price of Asian Paints was Rs. 1088 

Had a investor used these indicators to to invest in Asian Paints, he would have made a profit of 20% in 4 months.

Time = Selling Date-Buying Date = 16/03/2017 – 21/11/2016 = 4 months (approx)
Profit = (Selling price – Buying Price)/Buying Price*100 = 1088-900 = 188/900*100 = 20.8%

Few important points to remember:

There are certain points that an investor must keep in mind while using these indicators for generating buying and selling signals. First, at least two of the three indicators must agree, that is, two out of three indicators must show the buy signal. If that does not happen, avoid trading in that scrip.

Once the signals are generated, do not jump in with all your money, these indicators may generate false signals together if there are some dramatic changes in the fundamentals of the company. It is always advised to check the fundamentals of the company before looking at its charts and finding a trading opportunity.

Third, trends do not change overnight, be patient and wait for the trend to reverse. It may take a week or a month for the stock to come out of oversold territory and start moving upwards. You need to be patient and keep tracking the stock’s chart once in two or three days.

Conclusion:

Technical charts could be a great way to find good, oversold stocks that will turn around in a short period of time. Investors need to be cautious about the false signals generated and avoid jumping too soon in a stock. With some practice and patience you can master this art and become a successful trader.