By Stockpickr Guest Columnist Ira Krakow

In a previous article, I discussed how to trade General Motors (GM) using basic chart analysis. Looking at movements in price and volume over different time frames is a great start, but it’s by no means the only arrow in the chart technician’s quiver.

Technicians like to draw all sorts of lines, called indicators, over the basic chart, to highlight trends that identify buying and selling opportunities. In this article, I will show how to use the most common technical tool, the moving average, to time your buy or sell.

The financial sector has been in the news a lot lately. In a recent video, Dan Fitzpatrick analyzed the chart of Bank of America (BAC), whose stock price has been affected by how the deal to acquire Merrill Lynch will be funded. (It appears that we, the taxpayers, will end up on the hook, but that’s a bit off-topic.)

Can we use moving averages to help us grab a quick profit in BofA?

The 200-Day Moving Average: A Good Place to Start

Moving averages come in different flavors, the simplest being the simple moving average, or SMA. Here’s a one-year candlestick chart of Bank of America, from Jan. 22, 2008, to Jan. 21, 2009. Its 200-day simple moving average, or its average closing price for the last 200 days, is represented by the red line labeled SMA(200).


Source: Yahoo! Finance

The 200-day SMA is widely used because there are about 200 trading days in a year, giving a long-enough time span to show major price swings. With Yahoo!’s Interactive Chart feature, you can scroll the chart through the year. As you scroll, the closing price and the 200-day SMA will change accordingly. In this example, on Jan. 21, 2008, BofA closed at 6.68, while its 200-day SMA was 26.37.

What does this chart tell us? When a stock closes above its moving average, that’s technically a bullish signal. When the stock closes below its moving average, that’s a bearish signal. For almost the entire year, except for a brief period in late September, BofA closed below its 200-day SMA. The chart shouted Sell! Sell! Sell! for virtually the entire year. In fact, from October 2008 onward, the gap between the close and the SMA(200) increased dramatically. This indicates heightening stress on BofA's stock -- no surprise, given the bleak news in the banking sector during that time.

Shorter-Term Moving Averages Can Lead to Short Term Trading Profits

Stocks, even Bank of America, rarely go down in price every single day. Hope springs eternal. Perhaps today is the bottom and it’s time to start buying again.

Hope, however, is not a strategy. Let’s look at a chart to pinpoint where hope might be profitable. Here’s the same BofA chart the addition of the 50-day simple moving average, shown as a green line.



Source: Yahoo! Finance

Fifty days, or roughly three months of activity, is another common time frame that technicians use. Note how the green line tracks recent price movements more closely than the red line. This makes sense because we’re only taking 50 days into account instead of 200.

One way to trade is to buy when the stock switches from trading below its SMA and sell when it switches from trading above its SMA to when it is below its SMA. Using that methodology, the chart generated a buy signal in mid-July and a sell signal in mid-September -- the red circles on the chart. That trade would have probably broken even. Given the BofA chart, count that as a victory.

How Day Traders Use Moving Averages

Actually, we don’t have to use days. Moving average analysis will work on any chart. Day traders plot moving-average trends in increments as small as one minute, looking for price blips on an intraday chart. Each blip is a possible profit-making opportunity.

To illustrate this, since bank stocks have fluctuated wildly recently, I looked at 10 bank stocks, including Citigroup ( C), JPMorgan (JPM), Hudson City Bancorp (HCBK), Wells Fargo (WFC) and Keycorp (KEY), from Jan. 14, 2009, through Jan. 22, 2009, to see buying and selling opportunities during that time frame. I used an hourly chart (a data point every hour), with a 15-period moving average. I recorded my findings in this Stockpickr portfolio.

The bottom line: Fewer data points mean more trading signals. As you gain experience in chart analysis, you’re not simply staring at a wavy line and crossing your fingers. Instead, you’re basing your buy or sell decision on solid evidence.

Posted on Jan. 25, 2009