Moving Averages

Although most of my topics are geared towards buy-and-hold readers, there are times when learning technical analysis can come in handy. Charters or technicians (both terms are often used) have an arsenal of weapons at hand, including indicators, moving averages, and volume. These patterns are often used by traders to determine enter and exit points and strategies to maximize returns and lower risk.

My friend Christian asked me to write a post about Fibonacci Bands and it got me thinking, maybe I should write about the basics of technical analysis for you guys. It's helped me make a lot of money over the past few years as well.

I won't immediately post about Fibonacci Bands because some of its foundation is built on basic technical analysis theories, so I will start with the most commonly-used pattern - moving averages.

There are two types of moving averages that I've seen: Simple Moving Averages (SMA) and Exponential Moving Averages (EMA).

When it comes to trading, I prefer using the SMA. As it name indicates, it is simple. The moving average takes the closing values of the past x days and takes the average, then plots it on a chart. You can also do this by hand if you really wanted as well. Most traders like to use 20 days, 50 days, and 200 days, and many websites allow for three moving averages to be plotted on a chart.

The chart below (www.bigcharts.com) of Google plots the SMA 20, 50, 200 and creates a line chart for each moving average coloured yellow, blue, and pink respectively. Ignore the red lines; those are Bollinger Bands, a future chapter.



Moving averages can be significant for traders. A moving average charting higher indicates a bullish trend and vice versa. This provides some direction on where the market or stock may be going in the short term.

A second reason moving averages are important is when they cross. When the moving average of a shorter-term (20 for example) moves above the moving average of a longer-term (50), it indicates a bullish trend. This is known as a golden cross and the time to buy is now. When the moving average of the short-term goes below the long-term, it's a signal to sell. This is known as a death cross. The names are quite self-explanatory.

If we use the Google chart above, find a location where the yellow, blue, or pink lines cross. You can see that when the 20-day (yellow) dropped below the 50-day (blue) and 200-day (pink), it was followed by falling prices or stalled rises.

These signals carry more weight when attributed with above average volume. Volume represents the number of shares traded in a day and indicates conviction. Many times on television, you will hear them say, "very little volume" or "heavy volume." Take note of that because it can be very important when you want it to confirm with patterns.

On Monday May 10, I posted this article "Dead Cat Bounce in the Making" and wrote "Tomorrow is the third day, and if it does not trade and close above that level, expect another bad month of May." It is now Friday and the market has dropped again. It took a few days, but shorts are now making good money.

Although signals never work 100 per cent of the time, it is good to ease fears or calm excitement. Many traders do not use charts and as a result, emotions can get the best of them. Charts allow people to understand how a specific stock trades and if the recent drop in the price is nothing but noise over the long-term goal.

Good luck and if you want to try it, follow some big stocks in the next few weeks and see if it works. Let me know about your success.

The Bare Necessities: Chapter Four

Chapter Four: The Basket The third and final major investment vehicle available to retail investors are mutual funds. In Canada and the United States, a mutual fund is a basket of investment vehicles managed by a fund manager. They may contain equities, bonds, notes, or money markets, but are restricted from owning or writing options. As a disclaimer, I very rarely promote mutual funds, as I will explain later, however they are very beneficial under many circumstances. I will provide an unbiased argument for both the benefits and downfalls of mutual funds in this chapter after I go through the basics of mutual funds with you. The Basic Concept Mutual funds operate by pooling money from investors with a professional managing it. The fund manager will purchase investments and trade within the fund, similar to a regular investment account. The fund manager earns a management expense ratio (MER) which typically ranges between 1 to 2.5 per cent. The MER only includes the fund manager's fees and do not include potential brokerage fees, trading fees, and custodian fees. These fees are incorporated into the value of the fund, also known as the Net Asset Value (NAV). The NAV is the total value of the fund's assets minus liabilities, and is presented as a price per unit. It is common for investors to ask for the unit price or unit value, and not the NAV of the fund. The unit value's are determined at the end of the trading day, as a result, purchases and sales are not known until the next business day. Unlike equities, mutual funds allow you to buy using a fixed dollar amount, where as stocks require a price per share the amount of shares. That is, you can call in and ask to buy $1000 of a mutual fund, and you may receive 26.358 units. This can not be done with stocks. Reports of mutual funds are also available on the Internet. Morning Star is the world's number one site for reports. These reports will include MER, historical earnings or losses, major holdings, and the fund manager's information. Other Fees All fees associated with a mutual fund is made very clear in the prospectus. Rarely do mutual funds charge you for an original investment, however if they do, this is called a front-load fee. Many funds may charge a redemption fee upon the sale of any units. This can be a flat fee or a percentage of your original investment. No mutual fund will charge you on both, and many mutual funds now do not charge for buying and selling. That is one benefit of mutual funds. It is standard for all funds to contain an "early redemption fee." This is common and is usually just 30 or 90 days. This is to prevent people from buying and selling mutual funds daily, as the cost of buying and selling is expensive and decreases profits for all investors. Exclusive Benefits of Mutual Funds There is very little to know about mutual funds as they are quite straight forward. Give your money to the manager and hope he does a good job. This is one major benefit because many new investors do not know what stocks to pick. Fund managers will have been exposed in the market for years and decades and possess more experience than most individuals. Funds may also have a team of intelligent people making decisions for you. Another benefit are the low costs. As I stated earlier, most funds do not charge you for purchasing their fund. Those that do not plan to sell for years will never have to pay fees (except internal fees like MER). A third pro is that mutual funds require very little capital. You can start investing in a diverse portfolio with $100 only, and many mutual funds allow for systematic investment plans. That is, you can put in $100 every week, or month, or anything and it will slowly build over time. This can be done with stocks, but commissions would eat away at your savings, and stocks require whole units. Cons of Mutual Funds The major downfall of a mutual fund is control. You have absolutely no control as to what is being invested and you do not get to see the daily transactions. The idea that you have given somebody thousands of dollars to trade for you can be scary for many and the choices made by the manager may go against your investment objective and values. What if you were against tobacco companies? It is possible that your fund manager has invested in one of them, and you may not know it. Another problem is the MER. Although for some, paying a manager is a fair trade off, those who have accounts above $10 or $15,000 should consider building their own stock portfolio that replicates a mutual fund. Remember, a mutual fund is basically a regular account, but with millions of dollars more in it. Thirdly, mutual funds do not pay dividends in the same fashion as if you owned a stock. With a stock, you know when you will be paid and how much. Because of the fund's holdings always changing, the dividend is unknown. Some don't even pay a dividend until the end of the year. Those participating in DRIPs also can control which stocks pay dividends in cash and which stocks pay in stock. The final problem with mutual funds is the inability to hedge and protect the investment. I am referring to writing calls and buying puts. Sophisticated traders who expect a drop in the market can protect their account with options, limiting losses, and even gaining on the down side. Covered calls can provide risk-free income as well. But because of regulation, mutual funds can never touch options. Conclusion Well, that's all to mutual funds. Like I said, they are very simple products, but possess a lot of characteristics that you should be aware of. In the last chapter, I will discuss the benefits and risks of options.

The Bare Necessities: Chapter Three

Chapter Three: The World of Bonds Fact: The bond market is the largest investment market in the world. Its world wide value, as of March 2009, is $82 trillion. Compare that to the stock market; its world wide value is approximately $36 trillion. Yet, even with its huge valuation in the world, very people fully understand how a bond works. In this chapter, I hope to give the average investor a better understanding of the bond market, how you decide to invest in them is up to you. The first thing you need to know is that a bond is just a loan sold by the government or a corporation. Governments or companies may sell bonds to raise money to pay for infrastructure, equipment, investments, or to take advantage of low interest rates. You may also hear the term "debenture." Debenture is a term to describe bonds sold by companies, however, it is not wrong to call a corporate bond a bond. It is taboo to call a government bond a debenture, so try not to make that mistake. Because they are loans, there is no guarantee that you will receive all your money back. Therefore, there are risks involved with bonds. All bonds will have a grading. BBB+ is considered investment grade and are safe. A, AA (or double A), AAA (or triple A) with the last being safest. The value of safe bonds will be higher, and bonds with more risk will be lower in value. If that part doesn't make sense, think of it this way. In reality, you don't charge your friends interest, so you would rather lend $1,000 to a friend who has a higher chance of paying you back. With bonds, if you have a higher chance of getting paid back, you would pay a little more today for that safety net. The next feature of bonds are its three key elements: maturity date, par value, and coupon payment. A maturity date is the day the bond expires. That is, this is when the company or government will re-pay the loan, similar to a friend borrowing $100 from you. The par value is always $1,000 and is the amount you receive. Bonds are always quoted in 100, but pay in $1,000. Lastly, the coupon payment is the amount of interest you receive for lending your money. This is quoted in a percent. For example, you may hear somebody say, "A 5-year US Steel bond paying 4% is worth 109.80." This means that the bond's coupon is paying you 4% a year based on the par value, which is always $1000. This equals $40 a year per bond. (Note, the term per bond is not proper, but I will use it for simplicity). However, if you want the 4%, you must pay 109.80 or $1098.00 (as explained above). Therefore, the amount you actually earn is less than 4%. That is where the term yield and yield-to-maturity arise. A common misunderstanding with bonds are the coupon and the yield. This is because bond quotes will always show the coupon in the bond name, but also show a yield next to it. For new investors, this can be confusing. In the above example, the real yield is simply the coupon ($40) divided by your original investment ($1098.00) which equals 3.64%. The yield-to-maturity (YTM) calculates the amount of cash you receive over the lifespan of the bond. So, if the bond matures in 4 years from today, you should determine how much you receive as a total yield through the steps below. 1. Calculate the amount you gain (or lose) on the purchase of the bond. This is -$98. 2. Calculate all the coupons you would recieve. This is $40 x 4 years = $160. 3. Divide that number by your original investment. So, [160-98]/1098 = 5.65% 4. Take the total earnings in percent and divide by the amount of years left. 5.65%/4 years = 1.41%. As you can see, there is a drastic difference between the coupon, the yield, and the YTM. When investing in a bond, the goal is to receive a YTM higher than the free-interest rate. If a money market is paying 1.5%, then why take on the risk of a bond which pays you less? In reality, bond YTM's will never be lower than the free-interest rate. If this were to happen, bond values would decrease due to massive selling, and allowing YTM's to go back to normal. Other tidbits of bonds that you should know is that longer term bonds will have a higher yield. Again, this is because of the risk factor. If a bond matured in one month and another matured in ten years, the one maturing in ten years has a higher probability of defaulting (not paying you back) and therefore, should have a higher yield. As discussed earlier, the higher the risk, the higher the reward. Government bonds are also considered safer than corporate bonds. You will normally see government bonds values much higher than an equal corporate bonds. Treasury bills, although not actually called a bond, is essentially a short-term bond maturing in less than a year. Because of the varying features of bonds, nobody really day trades bonds. Bonds are not traded on an exchange, but done through institutions. This presents problems for those who want a specific bond, but may not be offered or available at a brokerage. However, many good brokerages will look in their inventory to find bonds with similar yields, investment grades, coupons, and time. So, when opening an account highly fixed on bonds, consider if the company have dedicated representatives for bonds. Another problem that arises from a lack of an exchange are the pricing. When you purchase a bond, you pay a little more than the bond is actually worth, and when you sell, you receive a little less. This is known as the spread. With bonds, the more you buy/sell, the smaller the spread will be. Well, I think that's all I can write about bonds. There's a lot more to bonds than what I have described, but this should give you a better understanding. I would also highly suggest you consistently review yields and coupons so that you do not make rookie mistakes.

The Bare Necessities: Chapter Two

Chapter Two: Equities and Value Investing Equities, also known as shares, are the most mainstream investment vehicle in today's current market. Financial websites, televisions, and newspapers put a lot of focus on the stock market's ups and downs. The reason why it is so popular amongst people is because of its liquidity, vast information availability, and volatility. The vast amount of money that can be made trading the ups and downs in a typical day is huge. It is possible to double your money in half a year with the average daily movements. Of course, this is not suitable for most people. So, in this chapter, I will try to focus on a method of smart investing called "value investing." When it comes to investing, buying companies of any well-run company that will survive any economic turmoil or crisis is beneficial. Sometimes selecting companies can be a hassle and time consuming, so if this is not for you, I suggest sticking to big companies like McDonald's, Wal-Mart, and Microsoft, but if you have time once a week, or even once a month, consider value investing. Value investing consists of buying stocks that appear to be under-priced. Most people who value invest tend to buy blue-chip companies [1] because they have had a history for comparison. As well, profits and cash-flow are much more stable, limiting volatility and surprises. Another possible reason is the ability to write options, which can add 25 per cent or more a year, through covered calls. I will be going through this in Chapter Five too. Although there are many ways of value investing, I will discuss two common methods, which are also the easiest to research: Dividend Yields and Price-to-Earnings Ratio. Dividend Yields Dividends can add a little bit of income to your account, usually around 3 to 4 per cent annually. Dividends are paid in cash to owners (stock holders). Think of it as a small portion of the company's profits being paid back to its owners. It is like owning your own business. A benefit of dividends is also something called the dividend re-investment program (DRIP). DRIPs allow share holders to take their dividends and purchase more shares of that company, with no fees, at the current market price. This strategy is great for long-term holders because these DRIP shares also pay a dividend too! However, one drawback is that the dividends are still subject to tax. Many big firm traders use the dividend yield to buy and sell. If the yield becomes lower than normal (that is, $1/$50 = 2%), then it could be time to sell. The stock's value has increased too much compared to its dividend. If the dividend yield is high, ($1/$20 = 5%), then it could be time to buy. Stocks that trade in ranges are great for this technique, and prove profitable. But what is considered a respectable yield for a blue-chip company? Below is a table of the Dow Jones 30, as of Feb 16, 2010. (For some reason, blogger keeps putting this huge gap. If you know how to fix, let me know. Thanks!)

NAME	SYMBOL	DIV	STOCK	YIELD	P/E
Alcoa	AA:NYSE	$0.12	$13.74	0.87%	N/A
3M Company	MMM:NYSE	$2.08	$80.47	2.61%	17.85
American Express	AXP:NYSE	$0.72	$39.62	1.82%	25.76
AT&T	T:NYSE	$1.68	$25.32	6.64%	11.96
Bank of America	BAC:NYSE	$0.04	$15.16	0.26%	N/A
Boeing	BA:NYSE	$1.68	$61.26	2.74%	33.54
Caterpillar	CAT:NYSE	$1.68	$57.12	2.94%	40.52
Chevron	CVX:NYSE	$2.72	$72.99	3.73%	13.93
Cisco Systems	CSCO:NASD	$0.00	$24.00	0.00%	23.12
DuPont	DD:NYSE	$1.64	$32.74	5.01%	17.03
Exxon Mobil	XOM:NYSE	$1.68	$66.28	2.53%	16.64
General Electric	GE:NYSE	$0.40	$16.04	2.49%	15.58
Hewlett-Packard	HPQ:NYSE	$0.32	$49.44	0.65%	15.76
Intel	INTC:NASD	$0.63	$20.72	3.10%	26.77
IBM	IBM:NYSE	$2.20	$125.23	1.76%	12.51
Johnson & Johnson	JNJ:NYSE	$1.96	$63.61	3.08%	14.47
JP Morgan & Chase	JPM:NYSE	$0.20	$40.07	0.50%	17.94
Kraft Foods	KFT:NYSE	$1.26	$28.97	4.00%	17.94
McDonald's	MCD:NYSE	$2.20	$64.01	3.44%	15.55
Merk	MRK:NYSE	$1.52	$37.66	4.04%	9.91
Microsoft	MSFT:NASD	$0.52	$28.35	1.83%	15.60
Pfizer	PFE:NYSE	$0.72	$17.72	4.06%	13.07
Coca-Cola	KO:NYSE	$1.64	$54.82	2.99%	18.71
Home Depot	HD:NYSE	$0.88	$29.44	3.06%	21.49
Proctor & Gamble	PG:NYSE	$1.76	$62.83	2.80%	17.39
Travelers Companies	TRV:NYSE	$1.32	$51.61	2.56%	8.07
United Technologies	UTX:NYSE	$1.72	$66.33	2.56%	16.09
Verizon	VZ:NYSE	$1.88	$29.18	6.51%	22.71
Wal-Mart	WMT:NYSE	$1.08	$53.56	2.04%	15.48
Walt Disney	DIS:NYSE	$1.40	$30.47	1.15%	17.36

As we can see, most of the top American companies pay dividends between 2.5 to 4 per cent. This is typical around the world as well. Price-to-Earnings Price-to-Earnings Ratio, or P/E, is a calculation of the companies stock price divided by their annual earnings per share(EPS). Historically, P/E ratios are considered fair value between 12 and 15. A low P/E suggests the company is under valued, where as a high P/E may signal a sell. One problem with using P/E is that it does not factor in growth, and many use the PEG ratio (P/E divided by growth in percent) to fully calculate. For example, if a company announces they expect to double their profits, then an extremely high P/E of 80 may be fair value. A company that can double its profits should, in theory, double its stock as well. That is where it can get sticky, and why I suggested large companies who have stable profits. Now that we have gone through two simple strategies, I must point out the common errors new investors fall prey to. Comparing apples to oranges is a saying we've all heard before, and this runs true with investing. When comparing two companies, you should select companies in the same sector or industry. Chevron and Merck, yes, they are both huge companies, worth over $100 billion each, but they are in different sectors. It is more appropriate to compare Chevron with Exxon and Merck with Pfizer. Varying factors in each industry can lead to substantially higher yields, such as risk and potential sector growth, as proven in the table above. Note that there have been many instances where using high dividend yields and low P/E ratios to invest can backfire. A high dividend yield, especially well above the norm, can be a sign that the company is going to decrease the dividend. This occurred in 2008 when banks were at near all-time dividend yield highs. Banks then slashed their dividend because of cash problems and stocks continued to fall. Low P/E ratios can be a sign the stock will fall, if people do not expect the company's current financial situation to prove positive. A prediction in a bad earnings season could eventually justify the low stock price. Again, investing in blue-chips could offset any unexpected surprises discussed. [1] Market capitalization is used to determine the size of a company. This is calculated by taking all outstanding shares and multiplying it with the value of the stock. Most companies mentioned above are worth at least $50 billion, well above the $5 billion classification.

The Bare Necessities: Chapter One

Chapter One: The Real First Step Most people who start investing get their information from pamphlets, the television, and the Internet. These are great sources of information, but people often do not understand that investing is more than just dollars. The first step is determining your current and future objectives through risk tolerances, needs, age, employment conditions, and even capital. A small difference in any of these variables may produce an entirely different portfolio. Sadly, for most people who want to start investing, they can not afford an advisor to determine this, so here are some textbook ways to do this yourself. Risk Tolerance Being able to handle risk will ultimately shape your account. However, it can be quite difficult determining your risk tolerance. One suggestion is to sign up for a free mock trading account. These mock accounts allow you to trade and invest using pretend money with real-life quotes. It is not as effective as using your own money, but it is a great way to figure out if you can handle losing a few hundred dollars over night. It is also a great way to get real-life experience without risking a cent. Once an individual's level of tolerance is fully understood, advisors can build an appropriate account. Those with a low risk profile should have little exposure to stocks, allowing them to maintain their capital with limited exposure to the market, however keeping enough to create some growth. Traditionally, low risk vehicles are money markets, treasury bills (t-bills), guaranteed investment certificates (GIC), commercial deposits (CD), and bankers' acceptances (BA). These products are usually backed by an issuer, the government, or the CDIC (FDIC in US), therefore have almost no risk. Medium-risk vehicles may include mutual funds and bonds. These products are not backed by an issuer, and the risk of losing all your money is possible, but due to its features, is quite unlikely. We will discuss this more in-depth later on. High-risk vehicles are considered to be stocks, real estate, options, commodities, and foreign exchange. These vehicles provide no guarantee on your capital and losing it all is very possible. The adage higher risk, higher rewards runs true historically. The high-risk vehicles average over 8 per cent annually, but with volatility, that is, years of ups and downs. Needs What is the difference between a 40-year married male with two children and a 25-year old single male? That was rhetorical by the way, but these life needs can factor into a portfolio as well. There are a multitude of options each of these have. The man with children may have less capital to invest, but could also open up education accounts for their children, could pool funds with his spouse and open a joint account, or may be able to make spousal contributions into an RSP. The single male will also have many options because of his needs. Lower expenses could mean more can be contributed to RSPs and TFSAs (sorry to my American readers. I believe it's 401K's), investing in more products, and potentially taking on more risk. Other needs may include liquidity. Many people may invest the majority of their savings in their investment account, but what if there is an emergency or an opportunity arises outside of the market? The ability to release funds in a timely manner is also a factor. A person who may have a large savings account will not need to access their investments, therefore, has the ability to lock in to long-term products for better returns. Age A person's age can be an influence when building a portfolio because of its inverse relationship with risk tolerance. The younger somebody is, the higher the appetite and fit for risk. A 20 year old will have ten more years to save and recover from high risk losses compared to a 30 year old. For most, this means investing a little more in high-risk ventures like penny stocks, new companies, and even companies nearing bankruptcy. The opportunity for huge returns outweighs the potential for losses. Employment An investor's source of income can also have a factor on the portfolio. Those employed with a fixed salary have more stability and therefore can build an account with more risk. The certainty of a paycheque next week provides for this basis. Another option with fixed salary workers is their ability to make periodic investments into mutual funds or registered accounts. Mutual funds allow investors to put in just a few dollars, usually just $100 a month at no additional cost. This dollar-cost averaging allows investors to stabilize their purchases instead of going in all at once. This strategy would not be practical for stocks, with the exception of Dividend Re-Investment Programs (DRIPs). The purchase of stocks will always have a commission, which can eat away at returns. Therefore, those who plan on making periodic payments should consider mutual funds appropriate with their risk apetite. Again, we will discuss mutual funds in a future chapter. Those that may be free lancer or have unstable sources of income may want to consider a more stable account filled with preferred shares, bonds, and risk-free assets. Preferred shares and bonds generally are less volatile and do not move up and down with the market. They provide higher returns on dividends and coupons because of their lower risk profile. The inclusion of the risk-free assets (money markets) provide the liquidity required during times void of income. These products clear within one business day, meaning access to the cash is available in 24 business hours. Capital The final variable an advisor may look at is start-up capital. Those that head to a broker typically have half a million dollars and want a professional to maintain their wealth, but in reality, most of us start with just a few thousand dollars. For those that have less than $3,000, I would suggest mutual fund investments, which I will discuss in the coming chapters. The larger the account is today, the more options one has. Those that want to avoid fixed income or mutual funds should stick to large blue-chip companies that are expected to be around for a few decades. Historically, these are banks, utilities, energy, technology, and consumer staples that pay dividends. Again, consider your risk factors, needs, etc. to determine what are appropriate for you.

The Bare Necessities: Prologue

The concept of investing and saving is something that should be developed early. My mother forced me to open up a savings account once I got my first job at age 15, and I assume most of you are in the same boat, but she was right. The earlier you start, the more you will have in the end. Time is on your side because of the power of compounding. However, people often forget about retirement because it seems so far away, and this could pose problems in the future. Over half of Canadians and Americans do not have a retirement plan and maybe even worse, have not saved enough for retirement. In fact, some believe winning the lottery is one. In my first year of college, my investments professor made me realize how important it was to save every extra penny. He presented us with a typical financial math question, and we inputted the data into our newly-found financial calculators. At the time, I had no idea how to use it, but the resulting sum was over one million dollars. We were all amazed how little it took to earn a million dollars, only to realize it was over forty years of saving. Disappointment ensued, until my professor asked, "When else will you need one million dollars?" - immediately answering his own question with, "When you have no income." He was dead on. For the majority of us, it takes a lot of hard work and a lot of time to build up such wealth, but you're building the wealth for a great retirement. There's nothing wrong with enjoying your life early on, and I don't want to stop you at all. Life is for living, but these next few lessons are here to help guide you with ways to enjoy it today and tomorrow, without making sacrifices. Before I provide you with my opinions on investments, let it be known that I have worked in the financial services industry for almost three years, dealing with million dollar accounts, CEOs of major multi-national corporations, and even the little guy. I am currently on hiatus, taking time off, actively trading in the equity and options market, but plan to re-start my career with investments very shortly. In the next few chapters of this series titled, "The Bare Necessities", I will discuss the strategies used by financial and investment advisors to build a well-balanced long-term portfolio, as well as fully explain the typical vehicles and products seen in the market. This is targeted for buy-and-hold investors looking to safely park wealth and allow it to grow with little concerns. In a future series, I can discuss the basics of day and position trading through the explanation of basic technical analysis.