Buying and selling using technical analysis is a method of analyzing price movements in a market based on past prices and volume in an effort to predict its future activity and is used as part of a more comprehensive trading strategy. Many tools have been developed for this purpose. These range from a simple trend line to technical indicators that use rather involved calculations. Each give the trader a better idea of where the market will probably be going and where to enter and exit a trade. No trader should rely on just one of these tools, rather two or three should be used and they should each be different.
A technical indicator is a formula applied to the price of a market asset during a chosen time period for the purpose of arriving at a set of data points. This data is used by traders to get an idea of where the price movements may be going on a chart in relation to past price movements within the period in a form that can be readily interpreted. Their complexity ranges from the simple, such as moving averages, to the more involved formulas of the Stochastic Oscillator and the Money Flow Index.
Leading and Lagging Indicators
Technical indicators can be divided into two categories known as leading and lagging indicators. A leading indicator does just as its name implies, it leads the price action utilizing an algorithm calculated for a short time period. All of the previous prices before the period aren’t included in these calculations which makes these indicators more sensitive to current price changes than those that follow trends.
Lagging indicators follow the price movements of trends and are used to indicate when a trend has begun, is in progress or has ended. Indicating when a trend is beginning or ending is a somewhat late affair for these indicators. By the time a signal is generated the new trend is already well in progress. This lag can cause missed trading time for those who waited. It’s at these times that a trader should probably wax philosophical about the reduced trading opportunity and proceed with his work.
During a sustained trend these indicators generate few signals and a highly profitable trade can be performed with little or no other trading. When a trend cannot be established and trading becomes range-bound, confined within a certain price range for a period of time, these indicators are of no use due to their lack of sensitivity to the quickly changing directions of the price movements. Some lagging indicators are moving averages (MA), Moving Average Convergence Divergence (MACD) and the Parabolic Stop And Reverse (PSAR).
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Oscillators are considered leading indicators and are of two types, centered oscillators and banded oscillators, some of them are both. A centered oscillator has a horizontal centerline along which the line formed by the algorithm’s set of data points fluctuates. Usually fluctuations above the centerline indicate an upward movement (bullish) of prices, and fluctuations below the centerline indicate downward movements (bearish). Some centered oscillators are the MACD and the Rate Of Change (ROC).
Banded oscillators display their movements between two extreme margins, or bands, located at the top and bottom of their charts. These extremes indicate overbought or oversold conditions in the price movements. This is very useful when prices are range-bound as some simple signals can be generated in these areas either by a line crossing into the banded areas or by two moving averages crossing over each other. Some of these indicators are the Relative Strength Index (RSI) and Stochastic Oscillator.
Two other indications of price strength using oscillators are positive and negative divergences that occur between the movements of the indicators and the price movements on the chart. When the movement of the oscillator begins to advance while the price declines a positive divergence is occurring. This indicates that though prices are declining, there may be a rebound or trend change on the way. The opposite holds true for a negative divergence.
Technical Indicator Types
Signals from technical indicators are used to help indicate that market conditions may be right for a trade setup that is part of a trading strategy. The conditions that they measure are trend, momentum, volatility and volume. As mentioned previously, some indicators are better for measuring certain conditions than others. A few of the most commonly used are:
- Trend – Moving Averages, MACD, Parabolic SAR Momentum – Stochastic, RSI Volatility – Bollinger Bands, Average True Range Volume – On Balance Volume, Money Flow Index
Moving averages are used to smooth out the volatility that occurs on a price chart by calculating the average price for a number of time periods. The longer the time periods are used, the smoother the line becomes. Signals indicating trends are typically generated by the crossing over of one moving average over another. The 20 day MA is commonly used by traders for this purpose and the second MA is more a matter of preference. It could be a 50 day MA, 100 day or another one. The smaller they are, the earlier and more frequently trade signals will be generated and this also produces more false signals, or whipsaws. The larger MAs produce fewer signals and whipsaws but this also increases the lag time involved when generating them. When the prices move sideways and become range bound, MAs aren’t practical to be using because the price fluctuations become fast and short-term.
Moving Average Convergence Divergence (MACD)
The MACD is a popular tool that exhibits the best of two worlds. It’s a trend following indicator and also an oscillator. The momentum of price movements are plotted using the difference between two exponential moving averages (26 day EMA – 12 day EMA) overlaid on a centerline. Another MA (9 day) is added that is the average of the existing MA that confirms the direction of the momentum. The distance between the two MA lines indicates the strength of a trend. The greater the distance, the stronger the trend. Signals are generated when crossovers occur at the extreme upper and lower areas of the chart and when the MAs cross the centerline. The MACD also indicates price strength or weakness when the two averages begin converging or diverging in relation to the price movements on the price chart. As mentioned before, this could be a signal that a reversal might soon be imminent.
Relative Strength Index (RSI)
The RSI is a momentum oriented banded oscillator that indicates overbought or oversold conditions on a price chart. The range is set between zero and 100 with the overbought and oversold margins set at 70 and 30 respectively. It uses a 14 day MA that can be adjusted for longer or shorter term readings. A signal is generated when the MA crosses into the two extreme regions. This indicates that there is some price weakness that can become a price reversal.
Bollinger Bands are a volatility oriented indicator that utilizes a 20 day exponential MA that is flanked by two bands that form a channel. The upper band is a positive two standard deviations from the MA line and the lower channel is a negative two standard deviations below the 20 day MA. Signals are generated using the upper and lower bands. The price touching or breaking through one of the bands could be a signal that conditions are good to be buying or selling in anticipation of a return to the MA line.
On Balance Volume (OBV)
The OBV is a volume oriented indicator that measures the momentum of price movements in relation to the trading period volume. Its calculations are quite straight forward. It’s an adjusted accumulation of the periods volume compared to the price chart. The upward movement of one days price would be a positive value and the downward movement of the price would be negative. These are just added together each day to produce a chart.
Signals are based on the trend of the OBV in relation to the movement of prices on the price chart. When there is a positive divergence between the OBV and the price movements, it is considered an increase in selling pressure, as prices are rising and the trading volume is falling from a lack of interest. This will mean an eventual drop in the prices. The opposite holds true for the decreasing buying pressure during a negative divergence. These signals are usually used to confirm the strength of trends. When they are moving in the same way, the trend is strong and when they aren’t, the trend is weak and could change.
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Buying and selling using technical analysis demands the use of technical indicators. They can be divided into two categories known as leading and lagging indicators. Leading indicators are calculated for short time periods ignoring all the prices before the period making them quite current. Lagging indicators are trend followers and are used for indicating the strength of a trend and when reversals might be near. Together they help the trader get an idea of price conditions that might produce the setups that are part of his trading strategy.