Buying Cheaply Could Cost You Money
Could you buy a rising stock too early? Many people say you can’t. They believe the sooner you buy the better. And this makes sense… clearly, the most profitable entry point is at the lowest price. So it’s totally understandable that many people what to buy at the first sign of strength.
But getting in early can also be a trap. You see, stocks in downtrends also experience periods of rising prices. And traders often mistake these for the start of a new uptrend. But before they know it, the shares are again making new lows.
So how do you put the odds in your favour when you buy?
Well, I’ll tell you what I do. I use a 50 and 100 day moving average. I won’t go into detail about moving averages now… that’s a story for another day. But I will say this… my moving average combination is slow to react to price changes.
Check this out:
This is the price chart for EML Payments. My system gave a buy signal for the shares as they were breaking higher.
Now, look closely at the lines on the chart. These are the moving averages. I’ll only buy if the red 50-day average is above the blue 100-day average. There are of course other entry criteria. But these don’t come into play until the averages cross.
But could the entry point have been better?
Some people say that a 50 and 100 day moving average combination is too slow to react. They’ll say it’s better to use moving averages that respond faster to changing prices. They believe this would potentially give earlier entry signals.
And do you know what? They’re right. Have a look at this:
This chart shows EML over the same time period… but this time I’ve made a change to the moving averages. Rather than using 50 and 100 days, they are now set at 20 and 50 days. This makes them quicker to adjust to price changes.
And this makes a big difference… the entry point is two months earlier than the first trade. There’s no doubt that buying earlier has advantages.
But you know, there’s a bit more to it… a mistake many traders make is to only consider the positives. In doing so, they overlook a strategy’s weak spots. And these could cancel out some, or even all the benefits.
Check this out:
This is a hypothetical trade in Domino’s Pizza. It uses 20 and 50-day moving averages — just like the previous example. But this trade ends in a loss. You see, the rally that triggers the entry isn’t the start of a recovery. It’s simply a correction within a larger bearish trend. The shares still have a long way to fall. This is the flipside of fast-acting indicators: They often produce more false signals.
Now have a look at what happen when we stitch back to the 50 and 100-day averages:
Focus your attention on the moving averages. You’ll notice they never cross. The system classifies the stock as being in a downtrend and does not trigger an entry.
Remember what I said earlier: I use moving averages that react slowly to price changes. This is because they calculate the average share price over periods of 50 and 100 days.
Yes, every trader wants to buy early. But this could come at the cost of higher turnover and more losses. You may find that any extra profit goes towards paying for the false starts and a larger brokerage bill.
My focus isn’t on short-term plays. I aim to get on big medium-term price trends. Some of these moves could last for more than a year. In this setting, buying at the lowest price isn’t necessary. Instead, I believe the better strategy is to give a trend time to develop. This can help improve the odds that a stock keeps running.
So that’s all for this week. If you liked this video, or even if you didn’t, scroll down and leave me a comment, or maybe a thumbs up. Also, if you’re watching this anywhere other than my website motiontrader.com.au then head over and have a look.
So until next time, I’m Jason McIntosh, and let’s find some trends this week.
I'm Jason McIntosh, the creator of Motion Trader. My career began in 1991 on the trading floor at Bankers Trust. Nowadays, I trade my own systems from home in Sydney.
Motion Trader is for investors who value robust analysis, data driven entry and exit signals, commentary, and education. I use engineered algorithms to identify when to buy and sell ASX stocks. No biases or guesswork, just data driven signals.