Technical Analysis: Technical Indicators
Charts speak volumes. Yet sometimes charts may as well be in a foreign language. But help is at hand. Technical indicators are the interpreters of the stock and CFD markets. They examine price information and translate it into simple, easy-to-read signals that enable you to determine when to buy and when to sell.
Technical indicators are based on mathematical equations that produce values that are then plotted on charts. For example, a moving average calculates the historic average price of a stock or CFD and plots it on your chart as a line. As your stock or CFD chart moves forward, the moving average is revised accordingly. The system then plots new points. As you'll see, this moving average irons out a lot of the temporary price fluctuations (because it is based on a larger sampling of data) and provides a smooth line that indicates the direction in which direction the stock or CFD is moving (see Figure 1).
Figure 1–Technical Indicator: Moving Average
Each technical indicator provides unique information. Because traders are individuals they gravitate toward specific technical indicators, but it is important to familiarize yourself with all of the technical indicators at your disposal.
You should also be familiar with the one weakness associated with technical indicators. They are based on historical price data and therefore lag behind the current market, However, they still provide excellent information.
Technical indicators are divided into the following categories:
As the name suggests, trending indicators identify and follow the trend of a stock or CFD. Traders make most of their money when there is a trend on which they can capitalise. It is critical that you therefore know when a stock or CFD is on a trend and when it is consolidating. If you invest shortly after a trend begins, and sell shortly after the trend ends, you will be quite successful.
The following trending indicators are worth examining now:
Moving averages are the most fundamental trending indicator. They indicate the direction in which a stock or CFD is going and where potential levels of support and resistance may be. Moving averages themselves can serve as both support and resistance levels because they will be watched by many traders and will be influential because of that.
Regarding moving averages we shall examine three key topics:
Moving averages utilise the average closing prices of a stock or CFD, plotting these points on a price chart. The result is a fairly smooth line that follows price movements (see Figure 2).
You can influence the volatility of a moving average by adjusting the time-frame the indicator uses to obtain an average price. Moving averages that examine a shorter time are more volatile (and therefore jerky). Moving averages that examine a longer time-frame are less volatile (and therefore smoother).
Figure 2–Moving Average
Moving averages provide useful trading signals for stocks or CFDs that are following trends.
Entry signal - when a stock or CFD is enjoying an upward trend and bounces back up after hitting an upward-trending moving average, or when a downward-trending stock or CFD bounces back down after hitting a downward-trending moving average.
Exit signal - when you invest in an upward-trending stock or CFD you should set a stop-loss below the moving average. As the moving average rises you can move your stop-loss up along with the moving average. If the price ever sinks far enough below the moving average your stop-loss will prompt you to sell.
When you invest in a downward-trending stock or CFD, set a stop-loss above the moving average. As the moving average falls, move your stop-loss down along with the moving average. If the stock or CFD ever breaks far enough above the moving average, your stop-loss will prompt you to sell.
Moving averages enjoy the following strengths:
- They identify simple trends
- They are flexible enough to work in both short-term and long-term time frames
Weaknesses of a Moving Average
Moving averages have the following weaknesses:
- They lag behind the market. The data used to calculate a moving average is historic, which doesn't necessarily influence what will happen in the future.
- They cannot identify trends, or levels of support or resistance, during channeling markets.
Bollinger Bands
Bollinger bands are a trend indicator named after their creator, John Bollinger, and they indicate both the direction and volatility of a stock or CFD's price movement. There are just two Bollinger bands, an upper band and a lower band, which work above and below a moving average.
The following three topics are critical in respect of Bollinger bands:
Bollinger bands are typically based on a 20-period moving average. A moving average is sandwiched between the two bands.
A standard deviation is a statistical term that measures how far various closing prices diverge from the average closing price. The upper band is plotted two standard deviations above the 20-period moving average. The lower band is plotted two standard deviations below the 20-period moving average (see Figure 3).
Therefore, 20-period Bollinger bands tell traders how wide, and therefore volatile, the range of closing prices has been during the past 20 periods. When the price has been volatile, the bands will be wider. When the price has been relatively stable, the bands will be narrower.
Figure 3–Bollinger Bands
Bollinger bands provide useful breakout signals for stocks or CFDs that have been consolidating.
Entry signal - when the bands widen and begin moving in opposite directions after a period of consolidation (see Point A on Figure 4), you can enter the trade in the direction the price was moving when the bands began to widen. Clearly you are trying to capitalize on renewed volatility.
Exit signal - at some point after the breakout occurs, the bands will begin to move back toward each other (see Point B on Figure 4). When this happens, you should set a trailing stop-loss to prompt you to sell if the trend reverses (see Point C on Figure 4 ).
Figure 4–Bollinger Bands Exit Signal
Bollinger bands enjoy the following strengths:
- They help you identify the trend
- They identify current market volatility
Weaknesses of Bollinger Bands
Bollinger bands have the following weaknesses:
- They lag behind the market because the data used to calculate Bollinger bands is historic and cannot predict the future.
- The bands do not, as is commonly believed, serve as support (lower band) and resistance (upper band) levels.
As their name suggests, oscillating indicators are indicators that move back and forth as prices rise and fall. Oscillating indicators can help you decide how strong a current trend is and warn when that trend is in danger of losing momentum and being reversed.
When an oscillating indicator moves too high, the stock or CFD is considered to be 'overbought' (too many people have bought it and there are not enough buyers left in the market to push the price higher). This indicates the upward trend is at risk of losing momentum-causing the trend to reverse or the price to stagnate.
When an oscillating indicator moves too low, the stock or CFD is considered to be 'oversold' (too many people have sold it and there are not enough sellers left in the market to depress the price). This indicates the downward trend is at risk of losing momentum-causing the trend to reverse or the price to stagnate.
The following oscillating indicators are worth examination:
Developed by Donald Lambert, the commodity channel index (CCI) is an oscillating indicator that can show you how bullish or bearish traders are and how dramatic their sentiments are. You can see the volatility of a stock or CFD with the CCI, much like you can with Bollinger bands.
The CCI is usually plotted below the price movement on a chart.
We will now examine the following three aspects of the CCI:
The commodity channel index (CCI) is based on the average value of historic price movements and how far those price movements have deviated from the average. It tells you how volatile the price has been.
If an average price rises, the CCI will also rise. Just how quickly the CCI rises depends on how volatile the stock or CFD is. If the price is more volatile, the CCI will rise quickly. If it is less volatile, the CCI will still rise, albeit more slowly.
If an average price falls, the CCI will fall too. Just how quickly the CCI falls depends on how volatile the stock or CFD is. If it is more volatile, the CCI will fall faster. If it is less volatile, the CCI will still fall, albeit more slowly.
The CCI moves back and forth, crossing 100, zero and -100, as it cycles through its progression (see Figure 5).
Figure 5–Commodity Channel Index (CCI)
The commodity channel index (CCI) produces trading signals as it crosses back and forth above and below both 100 and -100. These are, in effect, entry and exit signals.
Entry signal - when the CCI rises above 100 and then falls back below 100, you can sell the stock or CFD knowing that buyer momentum is exhausted and the price is likely to decline soon.
When the CCI falls below -100 and then rises back above -100, you can buy the stock or CFD knowing that seller momentum is exhausted and the price is likely to rise soon.
Exit signal - when a downtrending CCI reverses direction and rises after you have sold a stock or CFD, place your stop-loss just above the nearest level of resistance. If the stock or CFD reverses and rises above resistance, your stop-loss will prompt a sale.
When an uptrending CCI reverses direction and falls after you have bought a stock or CFD, place your stop-loss just below the nearest level of support. If the stock or CFD reverses and falls below support, your stop-loss will prompt a sale.
The commodity channel index (CCI) enjoys the following strengths:
- It helps you identify volatility in a stock or CFD
- It helps you identify potential reversal points for a stock or CFD
- It helps you confirm the strength of current trends
Weaknesses of the Commodity Channel Index (CCI)
The commodity channel index (CCI) has the following weaknesses:
- It lags behind the market because the data used to calculate the CCI is historic and doesn't necessarily influence the future.
- It cannot invariably predict reversal points for a stock or CFD.
The moving average convergence/divergence (MACD) is an oscillating indicator developed by Gerald Appel. It can indicate when trading momentum changes from being bullish to bearish and vice versa. The MACD can also indicate when traders are becoming over-extended, which usually results in a trend reversal for the stock or CFD.
The MACD is usually plotted below the price movement on a chart.
It is worth looking at the following three aspects of the MACD:
The moving average convergence/divergence compares a series of moving averages and their relationships. The standard MACD looks at the relationship between the 12-period and 26-period exponential moving averages of a stock or CFD. When the 12-period moving average is above the 26-period moving average, the MACD line will be positive. If the 12-period moving average is below the 26-period moving average, the MACD line will be negative (see Figure 6).
The MACD line is accompanied by a trigger line. This line is a 9-period exponential moving average of the MACD line.
Figure 6–Moving Average Convergence/Divergence (MACD)
You can also plot the MACD as a histogram below the chart. When the histogram is above the 9-period signal line (illustrated by a horizontal line on the histogram), it is signaling that the 12-period moving average is above the 26-period moving average (see Point A of Example 1). When the histogram is below the 9-period signal line, it is signaling that the 12-period moving average is below the 26-period moving average (see Point B of Example 1).
Example 1–Moving Average Convergence/Divergence (MACD) Histogram
The moving average convergence/divergence (MACD) produces trading signals as it crosses the trigger-line.
Entry signal - when the MACD rises above the trigger line, you can buy as the market shifts from being bearish to bullish.
When the MACD falls below the trigger line, you can sell as the market shifts from being bullish to bearish.
Exit signal - when the MACD falls below the trigger line after you buy, you can sell as the market shifts from being bullish to bearish.
When the MACD rises above the trigger line after you sell, you can buy as the market shifts from being bearish to bullish.
The moving average convergence/divergence (MACD) enjoys two key strengths:
It helps to identify when the momentum of a stock or CFD changes.
It helps to confirm the strength of current trends.
Weaknesses of the Moving Average Convergence/Divergence (MACD)
The moving average convergence/divergence (MACD) has the following weaknesses:
- It lags behind the market because the data used to calculate the MACD is historic and doesn't necessarily help to predict the future.
- It can generate misleading signals.
Slow Stochastic
The slow stochastic is an oscillating indicator. Developed by George Lane , it can alert you to a shift of investor sentiment from bullish to bearish or vice versa. The slow stochastic can also alert you to when traders are becoming over-extended, which usually results in a trend reversal.
The slow stochastic is usually plotted below the price movement on a chart.
The following three aspects of the slow stochastic are worth your attention:
The slow stochastic consists of two lines–%K and %D–that oscillate in a range between 0 and 100.
%K reflects the most recent closing price of a stock or CFD in relation to the range of historical closing prices.
%D is a moving average of %K.
If the closing price is near to the peak of historical closing prices, then the %K line (followed by the %D line) will rise.
If the closing price is near the bottom of the range of historical closing prices, the %K line (followed by the %D line) will move lower (see Figure 7 ).
As an example, if the EUR/USD has closed between 1.4200 and 1.4300 during each of the past 14 trading periods, and it now closes at 1.4295 (near the peak of the range), %K will move toward the top of the indicator's range.
Figure 7–Slow Stochastic
The slow stochastic produces trading signals as it enters its upper and lower reversal zones.
The upper reversal zone is the area of the indicator that is above 80. When %K exceeds 80, the stock or CFD may be overbought and could suffer a reversal soon.
The lower reversal zone is the area of the indicator that is below 20. When %K is below 20, the stock or CFD may be oversold and could suffer a reversal soon.
Entry signal - when %K dips below 80, you can sell knowing that investor sentiment is shifting from being bullish to bearish.
When %K rises above 20, you can buy knowing that investor sentiment is shifting from being bearish to bullish.
Exit signal - when %K reverses direction after having risen above 20 or fallen below 80, and crosses over %D, you can sell knowing that investor sentiment is changing direction again.
The slow stochastic is strong because:
- It helps you spot when investor sentiment changes
- It helps you confirm the strength of current trends
Weaknesses of the Slow Stochastic
The slow stochastic has the following weaknesses:
- It lags behind the market because the data used to calculate the slow stochastic is historic and doesn't necessarily have any bearing on the future.
- It can provide false signals.
Volume indicators provide a very different kind of indicator because, instead of relying solely on the price, they take volume into account.
Prices tell you in which direction an investment is moving, but volume can tell you what kind of support is influencing the price. For instance, if you see a price rise accompanied by high volume, then you know that there are a lot of traders who have confidence in this investment. Seeing this support should give you confidence too. On the other hand, if you see the price of a stock of CFD rise on low volume, you know that there are only a few investors pushing the price. This should discourage you from buying yourself.
There are two volume indicators that you ought to know about:
Developed by Joe Granville, on balance volume is a volume indicator that demonstrates positive and negative volume flow. It can also show you when price movement is not reflected in increasing volume, which usually results in a trend reversal.
On-balance-volume is usually plotted below the price movement on a chart.
There are four aspects of on balance volume which you ought to know about:
On balance volume involves a calculation that utilizes today's volume and the previous trading day's on-balance-volume level.
If today's closing price is higher than yesterday's, you add today's volume to yesterday's on balance volume level. You then record the resultant value below the price chart.
Alternatively, if today's closing price is lower than yesterday's, you subtract today's volume from yesterday's on balance volume level. You then record the resultant value below the price chart.
Connecting each on balance volume value gives you a smooth line that illustrates how volume has, or has not, supported the price movement of the stock (see Figure 8 ).
Figure 8–On-balance-volume
Traders need to know whether a trend will sustain its momentum. On balance volume can help you decide if there is enough momentum behind a price to sustain it or continue pushing it higher.
Positive confirmation- on balance volume can provide positive confirmations of both upward and downward trends. If the on balance volume line is in an upward trend while the price is likewise rising, you know there is strong buying support. If the on balance volume line is in a downward trend whilst the price is also falling, you know there is strong selling support.
Negative confirmation- on balance volume can provide negative confirmations of both upward and downward trends. If the on balance volume line is in a downward trend while the price is in an upward trend, you know there is only weak buying support underpinning the upward trend. If the on balance volume line is in an upward trend whilst the price is in a downward trend, you know there is weak selling support underpinning the downward trend.
On balance volume enjoys the following strengths:
- It does not rely on price alone in its calculation
- It helps you to confirm the strength of current trends
On balance volume suffers from the following weaknesses:
- It lags behind the market since the data used to calculate on balance volume is historic and will not necessarily reflect what will happen in the future.
- It can give misleading indications of trends.
Marc Chaikin's accumulation/distribution line is a volume indicator that reveals the cumulative flow of money into and out of a stock or CFD. The accumulation/distribution line can also indicate when price rises are not mirrored by increasing volume, which usually results in a trend reversal.
The accumulation/distribution line is usually plotted below the price movement on a chart.
There are four aspects of the accumulation/distribution line which need to be examined:
The accumulation/distribution line is similar to the on balance volume line, but the calculation has one distinct difference. It does not compare the current trading period's price movement in relation to the previous period's price movement. Whereas the on balance volume line is calculated based on the closing price in the current period compared to that in the previous period, the accumulation/distribution line shows where the price closed in relation to the mid-point of that period's price movement.
If the stock price closes above the mid-point, you must add a value between 0 and 1 to the cumulative value of the accumulation/distribution line. If the stock price closes below the midpoint, you subtract a value between 0 and -1 from the cumulative value of the accumulation/distribution line.
Therefore, if the stock price closed at the high for that trading period, you would add 1 to the cumulative value of the accumulation/distribution line. Conversely, if the stock price closed at the low for that trading period, you would subtract 1 from the cumulative value of the accumulation/distribution line.
Connecting each accumulation/distribution data point gives you a smooth line that illustrates how volume has, or has not, supported the price movement (see Figure 9).
Figure 9–Accumulation/Distribution
Traders are always eager to know whether a trend can sustain its momentum. The accumulation/distribution line can help you decide if the momentum behind a price rise is sufficient to continue pushing the price up.
Positive confirmation - the accumulation/distribution line generates 'positive' confirmations of both upward and downward trends. If the accumulation/distribution line is soaring whilst the stock price is doing likewise, you know there is strong buying support. If the accumulation/distribution line is on a downward trend whilst the price is doing likewise, you know there is strong selling support.
Negative confirmation - the accumulation/distribution line generates 'negative' confirmations of both upward and downward trends. If the accumulation/distribution line is diving whilst the stock price is rising, you know there is only weak buying support. If the accumulation/distribution line is on an upward trend whilst the price is on a downward trend, you know there is weak selling support.
The accumulation/distribution line has the following advantages:
- The calculations do not rely on price alone
- It helps confirm the strength of current trends
The accumulation/distribution line has these weaknesses:
- It lags behind the market because the data used to calculate the accumulation/distribution line is historic and may have no relevance to the future.
- It can give false indications of some trends.
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