Moving Average (4): Can You Predict Future?
This is a 6 month daily chart of a stock. It is recent (up to yesterday). The 15 day 30 days moving averages are also shown in the chart. The vertical grids show months starting from Feb. 2010. There are a couple of nice crossovers… as nice as those usually shown in textbooks or articles promoting the use of moving averages. My question for you is as simple as this: do you think we should buy or sell now?
The question on buying or selling is the basic question that I have been asking, or questioning rather; that is, is moving average good at all for generating buy/sell signals.
- Secret Stock, 6 month daily, 15- and 30-day moving averages
(My apology for the poor chart. I am still looking for an online source where I can capture a chart and use it in my blog without worrying about copyright problem. I still haven’t found it and so I have to download financial data and use Excel to plot the charts myself.)
HOW GOOD IS MOVING-AVERAGE CROSSOVER
If you are just starting in charting, you might be reading a lot in technical analysis and charting. You have probably been convinced to read MA crossovers, so you eyes would naturally look at point B and see how well it is in “predicting” the down trend.
But in order to be fair, you really ought to look at point A too where the crossover is suggesting an up trend. It later turned out to be a false signal. If you had the stock purchased right after point A and you followed the crossover signal and sold right after point B, you would have lost about 9% of your investment in about one and a half months.
But that is not too bad, you said. Sure we have false signals from time to time, but when the signals are right as in points B and C, they are really good.
Afterall, if you sold short at point B and then bought at point C, you could have potentially made about 45% return! If you follow the moving average strictly and only buy after point C, you would have made 28%, but that is 28% in less than 3 months. That is certainly not bad, is it?
So the true question is: had the moving average crossover at point B successfully predicted the down trend that follows? I might have said this a thousand times before. Well, actually I haven’t, but the answer is simple and loud and clear: NO.
STOCK PRICES AND NEWS
I guess it is time to reveal what stock this is that I am talking about. It is BP (BP PLC). Since it has been on headline news almost every day for a while, I figured everyone must be somewhat familiar with it, so it would be good to be used as an example.
Following the chart, point B occurred on May 3 (Monday), but notice that the price has dropped a week earlier. What happened was the Deepwater Horizon drilling rig explosion happened on April 20. Eleven workers died and 17 others injured. At first the impact was still unclear. On April 24, a report from Homeland Security said the problem had “no near-term impact to regional or national crude oil or natural gas supplies.”
But on Apr 25, US coast guard remote underwater cameras report the well is leaking 1,000 barrels of crude oil per day (bpd). BP’s share felt 2% the next day. Very soon it was realized that this was a huge environmental disaster affecting the US and the world. Quite obviously it was (and is) going to cost BP a huge amount of money, so the stock price dropped.
A couple of months after the explosion, it seemed like BP still did not know what to do (or at least the news made it sound so). There had been a lot of blame on BP, on the government, and the president of the US; but frankly, I think the problem was just so big that nobody knew what to do yet (at least at that time). Well, if you had a big problem and you did not even know how to tackle it, people lost confidence in you, so the price continued to drop.
On June 1, US launches a criminal investigation into the oil spill. The price dropped with a gap from previous week. On July 11 to 13, BP removed the old cap and replaced it with new cap. Initial test showed promise. The price went up a little. On July 15, BP said the leak had been stopped by capping the gushing oil wellhead. That is when you see a spike in the price.
I could have given more details, but the point that I want to say it these events are the major reasons for price increase or decrease. And when the price increases or decreases, the chart is affected included how the short-term and long-term moving averages look. It is definitely not the other way around.
WHAT COMES FIRST
On put it in another way: the explosion caused the price drop. The realization of the size of the problem caused it to drop more and so the price crossed the moving average from above. The realization that there was not yet a known solution caused to drop even more and faster and hence the down trend and the crossover of long-term and short-term moving average. It is just that simple, isn’t it?
Or do you really think the crossover of the price with the first moving average caused the explosion? And then the crossing of the two moving average caused the undersea camera to detect the leaking of 1,000 barrels of crude oil per day and hence the down trend? Or BP found that they didn’t have a good solution because the moving average crossover predicted that the price would go down?
BACK TO OUR PREDICTION GAME
Now let us go back to the original question. Is BP stock price going to go up or down? What do you think the moving average crossover is telling you? How much effect will this crossover have on the future price of BP?
As of today, we know the capping the wellhead was not the final fix for the problem. It was part of a test. Other things need to be done to permanently fix the problem. The plan is to drill relief wells around the original ruptured oil well and to permanently plug the leak. BP is facing legal issues and fines as well.
If the repair effort is going well and the leak seems to be permanently plugged, then the price might go up because some investors might see the current price as a bargain. If the repair process is delayed (e.g. by yesterday’s storm) or if unforeseen but not-too-serious problems are encountered, the price might continue to fluctuate. If the new cap burst and so capping doesn’t seem to be able to contain the problem, the price will go down.
BP is also facing a lot of legal issues and fines. If we hear good news on these issues, then the price might go up. It will go down if it is the other way around.
So how is the recent moving average crossover going to affect the price? Quite frankly? Nothing. It will have zero effect on BP’s price. The moving averages and their crossover look this way because of what has happened in the past, not because of what will happen in the future.