What Is a Buy Signal?
A buy signal is an event or condition selected by a trader or investor as an alert for entering a purchase order for an investment. Buy signals can be either observed by analyzing chart patterns or calculated and automated by trading systems.
For example, momentum investors may compare the relative strength of several investment choices over the last few months and select the best performing choice as a candidate to add to their portfolio in the coming month. On the other hand, short-term traders may use tools such as moving averages or other technical studies to enter a position on any given day.
- Buy signals help people follow a predefined pattern of trading or investing.
- Traders and investors should research the value of such signals carefully.
- Automated systems which produce black box signals should be given serious scrutiny.
Understanding Buy Signals
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. Typically they will use one or more preferred ratios to develop a model for the company's theoretical value compared to its actual value. When the price moves significantly below a theoretical value they trust, this becomes a buy signal for them. Value investors may then use other methods to determine the more immediate timing of their investment.
While many technical indicators generate buy signals, it's important to note that even the developers of these indicators don't advocate that anyone should blindly use these signals to automatically generate a purchase order. It is useful to confirm from a variety of sources, including technical and fundamental data, that conditions are favorable for investment or trading.
For example, a moving average crossover may generate a buy signal, but the trader may look for confirmation in the form of a breakout above a designated price level that implies increased value propositions.
Some software developers do publish and promote 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 and due diligence 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. This is an example of the well-known Golden Cross signal that is occasionally mentioned in financial media stories.