STOCK MARKET ENCYCLOPEDIA: Indicator

Showing posts with label Indicator. Show all posts

Nov 13, 2011

How to Use Bollinger Bands

Bollinger Bands were first created by and got their name from John Bollinger. I remember him well as a commentator on a financial news network. He has left the TV commentary business and struck out on his own as a financial analyst.

Bollinger bands are an indicator which is primarily intended to show you or warn you of an impending thrust in the underlying's prices. It does not give reliable indications about the direction of those price moves or thrusts nearly as often. Use of the bands can help you time your purchases when you are forewarned a thrust is expected shortly.

Bollinger bands are displayed on your chart as a 3 line envelope of prices. They have at their center for the middle line a normal moving average. This moving average is adjustable just as with any normal moving average. You can adjust how many days you wish to use and also how you wish the
average to be computed; simple, exponential or any other choice you may desire.

This is one of those places where knowing the cycle lengths comes in handy. You might want to find and use a prevalent cycle time period for the construction of the moving average in your bands. Set up the middle line or band, the moving average in the manner you wish and when the calculation is
completed and drawn on your chart you will have also displayed an upper and a lower band which is a standard deviation to compute them. This standard deviation component is another variable which you would set up in your initial construction of the bands. You can use one or more standard
deviations.

By using a standard deviation in the computation of the bands you get a measure of the volatility of the underlying security. These bands will constrict during times of low volatility and will widen when volatility increases.

Four of the indications or interpretations you will get when using Bollinger Bands is the following. #1 - It has been noted that when volatility of an underlying security is weak and the bands are constricted and narrow, there tends to be a break out or a period of sharp price changes and a resulting increase in volatility. The longer the bands constrict and prices remain within narrow bands the more likely a break out becomes. Note that this does not tell you which direction the increase in
volatility and sharp price changes will occur. Only that it is likely to happen in either direction.

#2 When security prices begin a move from one the the two outer bands, the price move of the security tends to continue until it reaches the other band. This is something to look for and use that is pretty straight forward and simple but is not as reliable as # 1 above.

#3 Another tendency of prices when they exceed one of the outer bands is that the trend in that direction will continue. It is a confirmation that this trend is in place and will likely continue for a longer period of time.

#4 When bottoms or tops occur outside the bands, which is then followed by another bottom or top within the bands is a trend reversal indication.

Using Bollinger Bands, as well as technical analysis in general, is much more an art than a science. Bollinger Bands do not provide much in the way of buy and sell point indications but if you have other indicators blaring buy or sell signals while the Bollinger bands are constricted, you have additional evidence to help you with the decision about a trade.

You should study Bollinger Bands and all the variables in the initial set up phase. Pick a stock you routinely analyze and adjust one of the components of the Bolliger bands and see what difference is displayed. Go back to the construction phase and change another variable and look at the same data
on your chart again. Study how to interpret the bands and it's likely they will improve your decision making and trading.

Nov 11, 2011

How to use The Relative Strength Index (RSI)

The Relative Strength is an oscillator that helps measure the momentum of your stocks or what ever you are attempting to analyze. This oscillator was developed in the 70's so it is one of the older technical analysis indicators that are available to you. Being old does not necessarily mean it is outdated and of no use. It has stood the test of time and is still in widespread use today.

The Relative Strength Indicator (RSI) measures the stock or market that you are analyzing against itself. Do not confuse it with a comparative relative strength which compares the stock against the market or another stock.

The RSI was first introduced by Welles Wilder and he recommended using 14 days as the time period in the calculation. Other time periods have been recommended by other analyst since its inception; primarily the 9 day and the 22 day being the most popular.

This is another indicator you might want to use and combine with your cycle calculations. If you can find a relatively short cycle period that is predominant in the security you are analyzing, use that number for the time period and you potentially have a much more accurate indicator for your use.

For instance with the DJIA one of the predominate cycle periods is 89 days. I use this indicator set for 89 days in looking at my analysis of the DJIA.

Also remember that the predominate cycle time periods fluctuate so don't get locked into one specific time period and expect it to perform for a very long period of time. You will need to go back at regular intervals and check the cycle periods and adjust your other indicators accordingly.

The RSI is displayed on a chart fluctuating between 0 and 100. Traditionally the over bought line is considered to be 70 with the over sold line at 30. These lines too have come under scrutiny by other investors and have caused some debate about what they should be. Some research suggests the
over bought and over sold numbers should be spaced further apart to more accurately reflect the conditions. It has been suggested to use the 75 and 25 lines respectively instead of the traditional values.

Although at extreme readings, over bought and over sold areas or lines give indications of a possible reversal in trend, it should be noted these are only indications and not hard and fast rules. The significance of the RSI signal depends on the length of the time period used for its calculation. The longer the time period used, the more weight should be assigned to the reading of the indicator.

When using the RSI signal with very short time periods you need to be suspicious of the signals. For this reason, you may want to display multiple signals with multiple time periods on your charts. Use a shorter period for short term indications but also keep track of a long term by using a longer signal. The combination of the two will likely give you a clearer picture of what is happening and what the probable outcome may be.

The RSI will provide clues confirming trends or warning of possible reversals. When the analyzed stock or market is making new lows and the RSI is making higher lows is it a good indication of a trend reversal in the making.

Also when the analyzed stock or market is making new highs and the RSI is making lower highs you very well may be looking at a top with a new trend to the downside of indeterminate length. These divergence type of signals are fairly common across all momentum type oscillators.

Another way to use the RSI is to watch the RSI tops and bottoms as they form. The RSI has a tendency to sometimes top or bottom before the price of the security being analyzed. In very short term trading this can be extremely helpful in entering and exiting the markets.

The RSI also forms the same type of patterns that are visible with stocks. The RSI will display head and shoulder formations and well as triangles. Just as with stocks or markets, you can use the RSI indicator to construct trend lines. You would use the same rules as with stocks for trend line violations or areas of support and resistance.

By understanding and accurately using the Relative Strength Indicator you have another lead or hint at what may be coming just around the corner. Combining the indicator with others as well as with multiple time periods may make the difference in your analysis.

The Stochastic Oscillator - The stochastic indicator, it's construction and interpretation.

The definition of the stochastic oscillator is : a comparison of where a security's price is, relative to its price range over a given amount of time. The stochastic is displayed on your computer screen as two lines. The main solid line is called %K and the dashed line is a moving average of the first and it is called %D. Both of the computations, %K and %D, are variable in most computer programs so you may wish to adjust them in your analysis. You should do some testing and see what works the best for you.

There are three main ways to interpret the stochastic oscillator in technical analysis. The most widely used technique is to consider the underlying security over-bought whenever either line moves above 80 on the graph. The security would also be considered over-sold whenever one of the lines falls below 20. This idea is very simple and I am sure you can see many tops and bottoms which are also
stochastic tops and bottoms on any graph.

The second method used to interpret this indicator is to compare the tops and bottoms of the indicator compared to the same peaks and valleys of the prices of your underlying security. Quite often you can see a divergence being set up as higher highs or lower lows are showing up in the security prices while the oscillator will be making lower highs or higher lows.

Look at a graph of the DJIA between August and Oct, 1999. On August 17, you can see a small peak in prices and a peak in the stochastic oscillator as well. Seven days later, on August 24, you see the DJIA makes a higher high, while the stochastic oscillator makes a lower peak.

This type of action is evidence of a classic divergence being set up and is something you should look for whenever you use oscillators. This type of chart formation should lead you to believe the current trend of higher highs and higher lows in the security price may be coming to an end shortly. It could also possibly signify a change in the primary direction or trend of the security price.

In actuality you can see the follow through to the downside which occurred. During the charted period of time from the "2" until the end of the chart, the DJIA lost over 1300 points in a matter of only 7 1/2 weeks.

The third interpretation of the oscillator is comparing the %K and %D to each other. You would consider it a buy signal whenever %K rises above %D and a sell signal whenever %K crosses and moves below %D.

In most computer programs %K is a solid line and %D is a dashed or dotted line. In the chart above %K is the red line while %D is the black line. Using the crossing method to buy or sell the DJIA in the URL chart above would have caused some whip sawing but quite a few large profits as well.

When using the stochastic oscillator within a limited time frame, it is difficult to trade the third interpretation mentioned above because of the possibility of many whip-saws. It does have it's limitations and is NOT for every market condition.

When setting up your stochastic oscillator, you can vary the time periods used by the program. %K is the number of time periods used in the stochastic calculation and you may set it to any number you desire. MetaStock for Windows defaults to 5 with a slowing value of 3. The slowing value controls the smoothing of %K. 1 is considered fast while 3 is said to be a slow stochastic.

The %D periods is also a variable you may wish to test. It is the number used to calculate the moving average of %K which is usually drawn as a dotted line on your computer chart. MetaStock defaults this value as 3.

While the standard defaults of your program will quite often be fine for your analysis in most situations, you should test them and look at the oscillator using other variations. You may discover a setting which more accurately reflects your tradingstyle and time period relevancy.

The stochastic oscillator is a great indicator to use in your analysis, but you must understand that it works best in a trading market or security. It can potentially lead you astray of your objectives in a trending market or security. Stocks and markets can and will get over-bought or over-sold and stay
that way for extended periods of time.

The stochastic oscillator should be considered as only one of many tools to help in your analysis and NOT the holy grail. Use it with all your methods and indicators and it may help you improve your timing and trading.

Moving Average Definition

The moving average is probably THE basic tool of technical analysis. It is used on its own, as well as in combination with other moving averages and even as moving averages of moving averages. It is also one of the most basic of building blocks of many more technical indicators and tools.

The basic moving average is fairly simple to figure, even by hand. To calculate a moving average you must identify two things: 1. The number of days you choose to target in your analysis. 2. The price of the specific item for each day during the target period. To find the moving average of your specific item you must tally up all the prices during your target period giving you a grand total. Divide the grand total by the number of days in the target period. This figure is your Moving Average.

The next day you must subtract the closing price of day 1 from your grand total and add the current days closing price. Divide the grand total by the number of days. This new number is the new average, hence the name Moving Average.

Simple moving averages apply equal weight to the data used to construct the average; all the data is treated equally. It gets fairly complicated when you start using exponential, weighted, time series, triangular, variable and volume adjusted moving averages.

These assign different weights or variables to the moving average and can significantly alter the resulting values obtained. Exponential and weighted averages apply more relevance or weight to recent prices. Triangular averages apply more weight to the middle of the designated time period. Variable weighted averages adjust according to the volatility of the prices and volume adjusted are factored using the volume of the price of the base security.

Probably the most basic indicator used in analysis today is the 200 day moving average of a security or a market. Even fundamentalist pay attention to this indicator.

This average is obtained by adding the last 200 days of closing prices for the security/market and dividing by 200 to plot the value. It is commonly thought you should be bullish, long term, on the security if the closing price is trending above the 200 day moving average. Conversely, if it is below it's 200 day moving average you might be bearish on the security.

One of the basic tools which everyone should explore and understand is a basic crossover moving average indicator. This is constructed of a moving average with the closing price of the security or market used as the 2nd point.

This simple system gives a buy signal when the price moves above the moving average such as the 200 day moving average discussed above. It is also quite common to apply another average of another duration to add into the equation for a total of 3 plotted points. In this case, a buy signal is issued when the price of the security moves above the shorter time period moving average which is also above the longer time period moving average.

It would signal a sell signal when the price moves below the shorter term moving average which is also below the longer time period moving average. The problem, for us comes from trying to figure what time periods to use for the equation, as that is the most critical element used in these systems.

Using hindsight or testing by way of a computer, may very well tell you what is the best period of time to use. Using these methods, you may optimize the number of moving average time periods to use in that particular security or market for the most profit possible over that back tested period of time.

The moving average should fit the market cycle you wish to follow or that would result in the highest profits for that period of time and that particular security. The problem is always you are testing for "the most profit possible over that back tested period of time" and you know as well as I, the market's and security's characteristics change constantly.

So what works today, may not work tomorrow but will work again in a couple of weeks or months. This is one of the primary shortcomings of a simple crossover moving average indicator even when it has been tested and refined to work on a particular security.

Many times moving averages are used to "smooth" another indicator which may be so erratic to make it's value useless. Such as, if a stochastic indicator is too volatile to be of use by itself. You may want to plot a moving average of the stochastic and just use it in your analysis and ignore the indicator itself.

Whipsaws are thereby reduced and provide a more smoothed indication of the direction of the indicator itself. This works well with the MACD, momentum and stochastic type of oscillators. All of these indicators will be discussed in a later issue.

Standard technical analysis and most data providers give you the open, high, low, close and volume of the security your are requesting. In most analysis, you see published, it is the closing price which is used for the analysis, be it with moving averages or any other indicator unless in the design of the indicator itself, it is written to use those other data points.

Why not investigate moving averages with the open used instead of the close, the spread between the high and the low or the highs or the lows themselves? I have not seen any studies, recently, using these other prices points which are provided by the data services; they tend to be largely ignored.

Those data points are there to be used and analyzed. It doesn't cost any more to get them and maybe, just maybe, you could come up with something new and revolutionary.

How to Use The Chaikin Money Flow Indicator

One of my favorite indicators tracks the volume and the market’s performance. By combining volume and price, I believe we see a qualitative view of the market. Any experienced trader recognizes that during uptrends, the volume rises on up movements, and the volume subsides during the consolidation. Likewise, if a market is in a down trend, the volume increases as prices fall, and the level of volume recedes as prices recover. My favorite indicator for measuring volume relative to the price movement is the Chaikin Money Flow (CMF) indicator.

Developed by Marc Chaikin, the Chaikin Money Flow indicator is the ratio of the summed price-weighted volume to the total volume over the lookback period. The calculation measures where the market closes within each bar relative to the bar’s range, creating a weighting factor ranging between +1 to -1, which is multiplied by the bar’s volume. This is the numerator and the denominator is the total bar’s volume.

The formula for the CMF indicator:
Each bar’s volume is weighted as below:
(((close - low) - (high - close)) / (high - low)) * volume

Then sum the above values over the lookback period. Divide this result by the sum of the volume over the lookback period.

I use the default value of 21-periods. The chart below is the Diamonds Trust (DIA), a tracking stock for the Dow Jones Industrial Average.

The CMF turned negative in late August, and again positive in early October. You may look at this and think that the CMF lags the trend, and it does. The fact is there is no Holy Grail. However, using this indicator as a basis for the long term trend of a stock is a starting point that tells you that if the CMF is running positive, then you should look to buy pull backs, and if the CMF is negative then you stay on the sidelines, look to another stock, or look for shorting opportunities.

Because the CMF is a ratio of the price-weighted volume to the total volume, it will tend to be positive during up trends, which is due to the fact that a strong market will close the majority of the time in the upper portion of the bar’s range with better than average volume. Pullbacks during an uptrend will be accompanied with less than average volume.

During a downtrend, the market will close in the lower portion of the bar’s range with expanding volume. Countertrend rallies should be accompanied with less volume than the declines. The ratio will reflect this activity with negative readings.

I also look at the CMF on a weekly basis using a lookback period of 4. This filters out the day-to-day noise of the market.