Using Price Charts and Technical Indicators for PPM Trading

In The Perfect Portfolio book I advocate that you select 8 specific investments (primarily ETFs) plus a Money Market Fund as the building blocks of your portfolio. And once selected these investments will not change, only your allocation of money to each will change as you take into account your personal situation and market conditions.

What does this do? Going forward it frees up a massive amount of time that you would have otherwise spent on sorting through and analyzing thousands of stocks and bonds and the chaos that surrounds those activities. This is time you can now spend more productively deciding when to buy and sell the ETFs you have identified for each asset category. The purpose of this page is to give you some tools and techniques for doing so by using price charts.

The Art of Using Charts

There are two major factors to consider when deciding whether to place each of the PPM building blocks in your portfolio. These are economic/market conditions and price trends. You have read, or are reading, in The Perfect Portfolio book about the market conditions that favor each of the recommended portfolio asset types. For example growing inflation tends to be bad for stocks and bonds and good for gold. Tensions in the Middle East may cause your Energy ETF to spike in price. World, economic and market conditions tell you which asset types to consider buying. But it is the price chart for each that tells you when to buy and when to sell.

Throughout The Perfect Portfolio book I have suggested simply “eyeballing” a current price chart to decide whether to buy or not and if so how to set up a trading plan for selling to either stop losses or to take profits. By looking at a chart you can readily see if it is trending up, down or moving sideways. It should also be quite evident where prices of support and resistance exist on the chart. These are the elements of the trading plan discussed in the book.

In this document I want to discuss the use of chart indicators in more detail for those of you who are willing to become more involved in the process in exchange for the potential of generating greater returns. I am NOT presenting here a trading “system” with automated buy and sell signals. The goal here is to show you how to use charts to help you make informed decisions. I will show you how to use price charts and simple technical indicators. You will make decisions based on your personal analysis and interpretation of what you see.

Chart Indicators

Some people will be uneasy when approaching the use of price charts and technical indicators. It can be a very complicated activity and professional “chart technicians” use dozens of price indicators to determine the direction of equity price. I don’t believe that the use of chart indicators needs be difficult or time consuming. I believe you can make very effective decisions using only a few, simple indicators.

Let’s start the discussion with some definitions and preferences that I have in this area.

The Line Chart – I’m a big fan of using simple line charts that plot the closing price of an equity each day for the time span specified for the chart. Shorter term or more involved traders will use candlesticks or bar charts. I am fine with a nice, clean line on my chart. Just “eyeballing” a line chart will show to me the price trend and points of price support and resistance. I illustrate this process in the book. However, some of you will want to go beyond simply viewing a chart for information. To do so you will use technical indicators. Following are the ones I use.

Moving Averages – The first chart indicator use is a simple Moving Average (MA). This is a line on the chart having points calculated by adding the closing price of the security for a number of time periods and then dividing this total by the number of time periods. Short-term averages respond quickly to changes in the price of the underlying, while long-term averages are slow to react. I like to use a 50 day MA for my decisions. You may want to use a 20 day, if you prefer to trade more often, or a 200 day if you want to be less involved.
Moving Average Envelopes – The next indicator that I like to use is the Moving Average Envelope. This indicator adds lines that are a certain specified distance above and below the moving average, thus forming an envelope. I show you how I use them below.
On Balance Volume – Then I like to use an indicator that tells me if money is flowing in or out of an ETF. There are several indicators that enable you to do this. I believe that the most simple is the On Balance Volume indicator. OBV provides a running total of volume and shows whether this volume is flowing in or out of a given security. An upward sloping OBV line tends to confirm an uptrend, while a downward sloping OBV is used to confirm a downtrend. Finding a downward sloping OBV while the price of an asset is trending upward can be used to suggest that the "smart" traders are starting to exit their positions and that a shift in trend may be coming.
Relative Strength Index – Finally I like to see where the price of an ETF is within its trading range. If its at the top of its recent price range then there is a greater potential for it to move back down. If it is at the bottom of its normal trading range then it may be poised to move back up. The RSI ranges from 0 to 100. An asset is deemed to be overbought once the RSI approaches the 70 level, meaning that it may be getting overvalued and is a good candidate for a pullback. Likewise, if the RSI approaches 30, it is an indication that the asset may be getting oversold and therefore likely to become undervalued. RSI is most effectively used on non-trending stocks or ETFs, but it also gives us insight on trending ETFs.

Using Web-Based Charting Resources

The indicators that I suggest you use are about as simple as you can get. Virtually any charting program on the Web should give them to you. However, some very basic charting capabilities may not allow you full flexibility on specifying parameters for certain of these indicators. For example I like to modify the number of days taken into account by the Moving Average. Most charting resources will give you at least three options: 20, 50 and 200 days and this should be sufficient. But if you want to try something like a 100 day moving average you may be out of luck. Also when using Moving Average Envelopes I like to change the % spread from the center line to the upper and lower envelope bands for reasons that I explain in the examples below.

You will also want to use a charting resource that enables you to set “alerts” when certain technical events occur. An automated alert sends you an email when a predefined price chart event occurs. For example you may specify that you want to be sent an email when the price of the GLD (a gold related ETF) crosses above its 50 day moving average.

For most of you the charting package provided by your online broker will be more than sufficient. Or you can try sites such as bigcharts.com or stockcharts.com. Even the basic charting capabilities mentioned in the book found at finance.yahoo.com will meet most of the requirements discussed above and illustrated below.

Using Indicators

Using charts is an essential component of the trading plans that are discussed in The Perfect Portfolio book. We use them for the following purposes:

To determine current price trends of ETFs we are considering for the portfolio
To determine if money is flowing in or out of an ETF
To determine an ETF’s points of price resistance, support and volatility in order to create a trading plan.

You certainly can do all of this by simply viewing the chart. However if you want to sharpen your pencil and gather more information from the chart to support a decision you will want to use technical indicators. Explaining how to do so is the purpose of the discussion that follows.

Entering a Position

Let’s say that your analysis of market conditions points to the stock market moving higher. The investment you have selected, using techniques shown in the book, to represent this Building Block in your portfolio is SPY, an ETF that tracks the S&P 500. You next need to determine if NOW is a good time to place it in your portfolio. Here is the process I recommend:

First you want to check the trend and buy SPY only if it is currently trending up. As mentioned in the book this is not hard to determine by simply eyeballing the chart. A more sophisticated way to determine an up-trend, however, is to look at the price line in relation to a Moving Average (MA) indicator. If the price is above the MA line then the ETF is in an up-trend for the time period you have specified. Keep in mind that the MA indicator requires that you specify a time period over which the price averages are calculated. I like to use a 50 day MA and will do so in the following examples.

So, create a 6 month line chart as shown below and then overlay it with a 50 day Moving Average indicator (in blue). The time period you select for the Moving Average will depend on how “involved” in the process you want to be. Shorter timeframes will give you more price/MA crossovers to respond to and longer time periods will give you fewer.

SPY Price Chart with 50 day Moving Average Overlay

At the time of this writing SPY is above the 50 MA line but just barely, indicating that it is still in an up-trend. I also notice that the price is “bouncing” up off of the 50 MA line. This may indicate that it is a level of support. While the up-trend seems to be intact, I want more information.

My next step is to add the On Balance Volume indicator to the chart. OBV is shown beneath the price and MA graph.

SPY Price Chart with 50 day Moving Average Overlay and On Balance Volume

I can see that the OBV line has recently been sloping down indicating that money is flowing out of the ETF. This is not a good sign. But the slope seems to be flattening out in the past few days. I need one more piece of information. I will now plot the RSI, which is also shown below the price line.

SPY Price Chart with Relative Strength Index

As mentioned above, the RSI line moves between zero and 100. Two levels of importance are shown on the RSI chart; one at 70 and one at 30. An equity is said to be in “overbought” territory when the line is above 70 and could be poised for a downturn. When it is under 30 it is in “oversold” territory and could be poised for an upturn. Here the line is at 50 so this bit of information will not be a factor.

Now I have the information I need to make a purchase decision. It could go either way based on this analysis. Here I insert my view of market conditions into the analysis to make a decision. Based on my opinion that economic indicators favor the continuation of the upward trend I will decide to buy. I now need to develop a trading plan.

The Trading Plan

Once you decide to enter a position you need to immediately put in place a plan to exit. Simple "buying and hoping" is no longer an option and I explain why in the book. A trading plan consists of these elements:

An exit price to stop losses
An exit price to take profits

Here is how I will use price chart analysis to determine each.

Exits to Stop Losses

As we all saw in the Fall of 2008 simply buying and holding can result in massive losses. So The Perfect Portfolio suggests that you limit losses to a specific percentage. But what percentage? If you set your loss tolerance at say 5% then you may get “whipsawed” out of your position on normal, everyday fluctuations. In other words you my sell then immediately see the price go back up. You need to find a percentage that is outside the range of normal fluctuations but not so low as to jeopardize a significant portion of your investment. To find this percentage I will use an MA Envelope.

Using a Moving Average Envelope

To make a decision on both stop loss and take profit points I like to use Moving Average Envelopes as illustrated below. Here I have charted an envelope around the 50 day MA with an 8% variation both above and below the MA line. I can see that above the 50 MA line, an 8% variation seems to enclose most of the prior 6 month price fluctuations on the upside. Below the line an 8% dip is well outside the previous 6 month downside fluctuations. Note that your charting resource should allow you to change the envelope spread percentage to either narrow or expand it in order to find an optimal setting that encloses “normal” price fluctuations.

SPY price chart showing an envelope with an 8% variation above and below the 50 day MA

Based on this simple indicator and analysis I would feel safe setting my stop loss at 8% below the current purchase price. This loss is acceptable to me if things go immediately bad yet I feel it is far enough away from the current price to prevent a premature sale while the up-trend continues.

To implement this stop use a type of order called a “trailing stop”. This order type is explained in the book. It enables me to set a price drop in terms of either dollars or percentages at which my position is automatically sold. For example if I were to buy at the current purchase price of $104 and then created a trailing stop that specified a sell if the ETF dropped by 8%, then my initial exit price would be approximately $96. If SPY immediately fell to this price my position would automatically be sold. But the beauty of a trailing stop is that if follows the price up. So if SPY goes from $104 to $110, then my stop automatically goes up to $101, maintaining the 8% drop limit. But if SPY starts to decline from $110, the trailing stop DOES NOT go down with it. It stays at $101. It goes up but never goes down. The only change at this point will be an increase in the stop price if SPY goes back over $110. So, I have limited losses and while letting profits run.

For stop losses I recommend an automatic sell instead of an email alert. For take profit exits, an email alert may make more sense. Let’s take a look.

Exits to Take Profits

Too often investors make a good purchase decision, watch their investment rise and then stay on the sidelines as it gives back all of its returns. Just as you need to sell to stop losses you need to sell to take profits. So, as part of an overall trading plan you need to set prices at which you will sell to take profits.

The question then becomes at what price point you would be happy to take some money off the table for an ETF that is in your portfolio.

To answer this question again we use the price chart. You should be able to identify points of price resistance i.e. where the price line tends to “bounce” down. As with the stop loss analysis we can use MA Envelopes to get a percentage rise where we may want to consider selling before the price bounces down. Look again at the chart presented above for SPY. An envelope with an 8% spread from the centerline (the 50 day MA) forms an almost perfect point of resistance at the top of the envelope. Remember, what you are trying to do is to avoid selling on small, transient dips while the price is still in an up-trend.

In this case I would look at setting a hard sell order if SPY increased by 10% from my purchase price. This would mean that the price has significantly penetrated the top line of the envelope and could be poised for a pull back.

I would also set an 8% price increase “alert” that would send me an email when this price point is hit. When I get that email I would then check other chart indicators such as volume, OBV and RSI as discussed above. Based on what I see from these indicators and my interpretation of where this ETF is going in the near future I have these options:

If all indicators are positive, I may not sell anything but keep the 10% gain sell order in place
If indicators show that the up-trend is weakening I may sell everything and take the 8% gain
If indicators are inconclusive, I may sell a portion, perhaps half, of the position and leave the other half invested.
In cases where I decide to keep a some or all of the investment I would consider tightening my trailing stop to lock in gains e.g. from perhaps an 8% drop to a 3% drop, and also setting a new profit alert above the previous alert.

Human psychology makes it just as hard to sell equities that are moving up as it does to sell and accept losses on equities moving down. But a vital component of your trading plan MUST be to take profits when they are available to you. The PPM trading plan gives you the logic and tools to do so.

Using a Watch List

And finally, for those building block ETFs that you decide not to put in your portfolio, perhaps because when you looked at their chart the price line was below the Moving Average you have selected, e.g. 20 day, 50 day, 200 day, you will want to place them in a watch list, as explained in the book. Here you will set an email alert that informs you when the ETF crosses above a moving average line that you have specified. When it does, analyze the chart with the indicators and techniques discussed above to decide if now is a good time to place this ETF in your portfolio. Using the Perfect Portfolio Methodology while you may not have all 9 suggested building blocks in your portfolio at any one time, you are still monitoring all of them.