The technical indicator is intended to help you to
improve the timing of your trades. It backs your analysis
of share price trends, but is not a substitute. If
indicators send out a message that contradicts the
price charts, it is a warning sign.
The indicator is structured as a horizontal range
on the lower part of a daily chart, and registers
real-time price movement on a scale of perhaps 1–100.
It is focused on price, volume or momentum. Let us
look at each.
1. Price
Moving averages
Moving averages show changes in the average share
price over a given period. They are a trend-following
indicator, and so lag the share price, but can help
to assess its likely future direction. Moving averages
work best in a fast trend with minimum price fluctuation.
This indicator is so widely used that it is available
through many free online services as well as almost
any technical investment software. To understand in
more detail what this indicator can do for you, it
helps to know how it works, so let us delve into a
little maths. Before you throw down this book in disgust,
I promise you it will be very basic stuff.
To calculate a simple moving average, add up the closing
prices included over the relevant number of days and
divide the result by the number of prices. If you
have 20 prices on the basis of one a day, you will
create a 20-day moving average. This is highly sensitive
because it is over a short time period, which makes
it suitable for keeping track of a short-term investment.
If you have a 200-day moving average, it is less volatile
because the averages are smoothed over a longer period,
which makes it suitable for keeping track of a long-term
investment.
When the share price crosses from below to above the
moving average, it could be leading the trend up and
is a buy signal. The logic is that the shares have
started outperforming the average of the recent given
period. On the same basis, if the price crosses to
below the moving average, this could be leading the
trend down, and is a sell signal.
The golden cross arises when two moving averages cross
over on your chart as they move upwards. It is a bullish
indicator. The dead cross arises when they cross as
they move downwards, and it is bearish. In either
case, the indicator is more reliable if increasing
trading volume backs it. The triple golden, or dead,
cross involves three moving averages crossing (typically
5, 10 and 20 day), and is considered less effective.
All this is the theory and moving averages do not
always stick to it, but they are another quiver to
your bow. US trader Marty Schwartz has found that
moving averages work better than any other investment
timing tool at his disposal.
For the connoisseur, there are refinements. The weighted
moving average gives proportionate extra weighting
to more recent share prices. The exponential moving
average does the same, but includes price data from
outside the period of the moving average.
The moving average convergence divergence
(MACD)
The moving average convergence/divergence indicator,
known commonly as MACD, is a trend-following indicator
that keeps you permanently in the market. The basic
MACD line is formed from the difference between a
12-period and a 26-period exponential moving average
of the closing price and is plotted as a solid line
on the chart. The slow line, known as the signal line,
is a nine-period exponential moving average of the
MACD line and is plotted as a dotted line.
The MACD line and the signal line may swing either
side of a zero line, and there are no overbought/oversold
boundaries. Signals come late. If the MACD line crosses
from beneath to above the signal line, it is the signal
to take a long position. If it crosses from above
to below a signal line, the signal is to take a short
position.
The MACD histogram
The MACD histogram represents the difference between
the MACD line and the signal line as defined above.
The more the lines diverge, a process driven by the
trend, the larger the histogram will become. The signals
are based on how close the lines come together and
so are earlier than those of the MACD indicator, which
rely on the lines crossing each other.
Envelopes
The envelope, like the other indicators based on moving
averages, is trend-following. It consists of a moving
average of the closing price with two bands placed
a given percentage either side of it. The upper band
is the overbought line and the lower band the oversold.
Bollinger bands are the best known member of the
envelope family. John Bollinger invented the bands,
based on his researches into volatility as a derivatives
trader in the late 1970s. Bollinger bands are plotted
at standard deviation, a volatility measure, above
and below a simple moving average. The bands are based
on the intermediate trend, which means a 20-day period
is the most suitable.
When share prices are volatile, standard deviation
becomes high and the bands bulge but, when prices
are stable, it becomes low and the bands tighten.
If the share price moves outside the bands, the trend
is seen as likely to continue. To find out more, visit
the official website at www.BollingerBands.com.
SARs
As we have seen in Chapter 4, if the share price turns
against you, you are well advised to apply a stop
loss. Stop and reverse points, known as SARs, are
a technical solution. They are plotted as dotted lines
defining a trend, and they can stop you out of either
a long position or a short one.
The Parabolic indicator, created by J Wells Wilder,
is a version of SARs named after the parabola formed
by the indicator in a fast upward move. It is sensitive
to time as well as price movements, and works best
when prices are moving up or down, but not sideways.
It has an ingenious, built-in stop loss, which both
follows the price trend and accelerates should the
price have reached a new extreme. If, from this point,
the trade should falter even slightly, you will be
stopped out.
2. Volume
The Accumulation/Distribution line
The Accumulation/Distribution line (A/D), developed
by trader Larry Williams, is a volume indicator that
closely links share price and volume movements and
enables you to monitor the trend. It does not provide
bought and sold perimeters. The A/D line is positive
if the price closes higher than at opening, and negative
if it closes lower.
3. Momentum
A momentum oscillator measures both the rate of change
and the direction of the share price. Traders use
it for trading in ranging markets, which fluctuate
between overbought and oversold lines.
They use the momentum oscillator to time their entry
into a trending market, or their exit, provided the
move is corroborated by a trend-following indicator.
Let us look at two types: RSI and Stochastics.
RSI
The Relative Strength Index, known as RSI, shows the
rate of change in the share price. Do not confuse
it with relative strength, a concept which measures
price performance against peers or the broad market
(see Day 14). Some find the RSI useful, and others
less so.
The Index is simple to calculate, and this is usually
done over a 14-day period. The RS is the average of
the up closes, divided by the average of the down
closes, and it should be added to 1 to create 1+RS.
Divide this figure into 100, and the result should
be subtracted from 100, which gives you the RSI.
The index shows a constant range, between 0 and 100.
If the RSI is 50, it is neutral. Technical analysts
consider 70 overbought, and 30 oversold.
Stochastics
Stochastics, which Dr George Lane helped to develop
in the 1960s, similarly shows when the market is overbought
or oversold.
The oscillator shows the last closing price as a percentage
of the price range over the chosen period. The solid
%K line represents the share price. The dotted %D
line is its three-day moving average and is considered
more significant.
The two lines oscillate between 1 and 100 on a scaled
chart and, as with the RSI, the overbought/oversold
perimeters are usually 70–30. Traders such as
Harry Schultz use Stochastics for timing their trades.
When either line falls below 25 then rises above it,
this is a buy signal, but when it overreaches 75,
then slips back, this is a sell signal. If the moving
average falls below the price line, it is often a
sell signal.
Nowadays, the slow Stochastic is used more than the
original. It excludes the %K (solid) line on the grounds
that it is too sensitive. The former %D (moving average)
line becomes the slowed %K line, and a slowed %D line
is a moving average of this.
