What is a Buy Signal
A buy signal is an event or condition that alerts a person to place a purchase order for an investment. Buy signals can be either observed by analyzing chart patterns or calculated by trading systems. For example, momentum traders may look for a short-term moving average to cross above a long-term moving average as a buy signal.
The opposite of a buy signal is a sell signal.
BREAKING DOWN Buy Signal
Buy signals may be used by short-term traders and long-term investors. For example, contrarian investors may look at a significant sell off as a buy signal since the market may have overreacted, or a value investor may look at a price below net asset value per share as a buy signal. On the other hand, a trader using an automated trading system may automatically generate buy and sell signals based on a set of rules.
Some of the most common buy signals include:
- Chart Patterns - Many chart patterns generate a buy signal when the price moves beyond a certain level. For example, an ascending triangle pattern generates a buy signal when the price breaks out from the upper trend line resistance.
- Technical Indicators - Many technical indicators generate a buy signal when certain conditions are met. For example, the relative strength index (RSI) generates a buy signal when it moves below oversold conditions at 30.0.
- Intrinsic Value - Many value investors calculate intrinsic value with discounted cash flow analysis, net asset values, or other techniques. When the price moves below this value, a buy signal is typically generated since the stock is trading at a discount.
While many technical indicators generate buy signals, it's important to note that they shouldn't necessarily turn into purchase orders. Many traders look for confirmation from other technical indicators or chart patterns before actually placing a trade. For example, a moving average crossover may generate a buy signal, but the trader may look for confirmation in the form of a breakout from a pivot point or other strategy.
There are some black box trading systems that generate buy signals for subscribers. For example, an investment research firm may generate a complex neural network that generates buy and sell signals they send to subscribers that pay a monthly fee. Traders should approach these black box models with skepticism since past performance may not be indicative of future performance.
Example of a Buy Signal
The chart below shows an example of a buy signal generated from a moving average crossover in the SPDR S&P 500 ETF (NYSE ARCA: SPY).
In the chart above, a buy signal was generated when the 50-day moving average crossed above the 200-day moving average.
Chart courtesy of StockCharts.com.