Last week, we looked at the fascinating concept of Ichimoku. We now go up a gear in terms of our analysis. So far, we’ve mostly been looking at tools or analysis directly on price. We’re now going to look at various tools and indicators that are a derivative of the price action. They usually sit under the main price chart. Their role is to help confirm the price action and give the user another objective piece of analysis to aid decision making. Although, a lot of that decision making can become very subjective! I like to break my price confirmation tools down into 5 distinct types of indicators:
In this article we are going to look at the first two: Trend and Momentum
An infinite number of technical analysis tools are available to almost anyone with a PC these days, as technology has allowed the analyst to very simply create their own. Here, we are focusing on some of the most popular and common indicators in use.
As we saw in earlier articles, moving averages, Bollinger bands, price envelopes and Parabloic SAR are all great tools directly applied on top of the price chart to help us distinguish the price trend. In article 12: Trending or Ranging, we also took a look at the Directional Movement Indicator created by Welles Wilder, which was extremely helpful for helping us decipher if the market we were looking at was trending or ranging. All of these indicators mentioned are excellent for helping to determine what the trend of any given market may be at any given point in time. We’re going to take a more detailed look at two indicators previously not written about, that are a derivative of the price action and both very useful for trend spotting: MACD and CCI.
A very good example of a trend indicator which was developed by Gerald Appel. My personal experience with it is that I find it one of the slower signalling indicators. It uses convergence and divergence of moving averages to come up with a leading indicator. Why is it so popular and useful? It combines some of the oscillator principles with a dual MA crossover approach.
Basic set up:
- Difference between the 26 and 12 day Exponential Moving Average (EMA) to generate primary series. (MACD line). Slower line (Signal line) is the 9d EMA of the MACD line.
- 26, 12, 9 are the most common used numbers for this approach (can be adapted).
- Can be plotted as a line or histogram.
- Buy / sell signals when two lines cross.
- Fluctuate <>0 line (oscillator principles) Overbought when lines are too far above zero line and vice versa for Oversold.
- Best buy signals when prices are below zero line.
- Crossings above / below zero line are another possible way to generate trade signals and a trading strategy.
- MACD useful in wide swinging markets.
- MACD Histogram useful for following the trend.
- When the spread between two lines is widening e.g. in an uptrend = strengthening of trend, when narrowing, trend could be weakening.
Example using MACD on Diageo PLC (LON:DGE) (Charts: Stockopedia)
CCI (Commodity Channel Index):
- Designed to identify cyclical turns in commodities and their momentum around the assumption that commodities move in cycles with highs/ lows at periodic intervals.
- Recommended application of the CCI is by using 1/3rd of a complete cycle (high/low) as a timeframe. E.g. 60 day cycle = 20 day CCI
- Very useful for identifying reversals and breakouts.
- 70/80% of price movement between the +/-100 boundaries.
- Trading with the CCI : Signals:
- >100 = strong advance
- <100 = strong decline
- Move +100 = bullish & move back under +100 = bearish
- Move -100 = bearish & move back above -100 = bullish
- Some traders use +/- 200 levels (depends on securities volatility)
- You can use CCI for divergences.
Example using CCI on Diageo PLC (LON:DGE) (Charts: Stockopedia)
We have now got a good handle on trends, but it is also crucially important to know two other variables:
- How fast or slow is the trend moving?
- When is the trend going to change and reverse, if at all?
These two questions can be answered by using momentum indicators and oscillators.
How can Momentum Indicators help you? Quite simply TIMING!
What is momentum? Momentum is the measurement of the speed or velocity of price changes i.e. the rate of the rise or fall in prices. Changes in momentum can thus be viewed as acceleration or deceleration in the price trend. To put that in perspective, imagine a Formula 1 racing car accelerating and decelerating e.g. as the race car accelerates it can’t maintain the level of acceleration and the rate of increase in speed begins to decline – the speed itself is not increasing as fast as earlier. Exactly the same principle as the racing car applies in the markets. Speed is equivalent to the slope of the price trend.
What is important to note, is that momentum leads the price action. How is momentum measured and used in technical analysis? Through the use of oscillators.
Basic momentum rules:
- Peaks and troughs in an oscillator coincide with peaks and troughs on the price chart.
- Some oscillators have a midpoint value that divides the horizontal range into two halves – normally a zero line.
- Some oscillators have upper and lower boundaries ranging from 0 to 100.
- As a general rule, when the oscillator reaches an extreme value (either up or down) this suggests that the current price has gone too far and is due for either a correction or consolidation. This is also known as Overbought or Oversold.
- Another general rule is that a trader should be buying when the oscillator is at the lower end of the band and selling when at the higher.
- The crossing of the midpoint line is often used to generate buy and sell signals.
Something to bear in mind and remember:
TRENDS MEAN REVERT
- When price > long term trend it will revert back to the mean = OVERBOUGHT
- When price < long term trend it will revert back to the mean = OVERSOLD
Why bother with these sort of oscillators?
- Oscillators are extremely useful in a non-trending environment.
- They give the trader a tool to profit from those periods.
- Oscillators can also warn when a trend is losing momentum before that situation becomes evident in the price action itself.
- Times when oscillators are more useful than others e.g. at the beginning of important moves oscillator info can be misleading but towards the end though can become very useful.
Again, there are many. For example, Williams %R, ROC, basic momentum, DeTrended Priece Oscillator etc etc. We’re going to take a look at two popular momentum indicators in some more detail: The RSI and the Stochastic.
RSI (Relative Strength Indicator)
Not to be confused with the Relative Strength tool, the RSI was developed by Welles Wilder (who also developed the DMI) to measure the strength of a trend relative to previous activity. Wilder’s basic thinking behind it was that in an uptrend, closes tend to be higher and in a downtrend closes tend to be lower. The RSI only uses the closing price in its calculation. The RSI smooths out erratic and sharp changes in price.
- RSI = 100(100/1+RS)) where
- RS = (av. of X days up closes)/(av. of X days down prices)
- 14 days is a very popular default input – to speed things up try for example 10 or even 7 periods. To slow things down 20, 30 etc.
- Basically comparing the average gains on the ups with the downs over a chosen period of time expressed as a number between 0 and 100.
- Overbought > 70, Oversold <30. (Stronger trending markets use 20/80).
- Identifies Support and resistance levels.
- Gives overbought / oversold levels.
- Can present chart formations that may or may not be visible from the chart.
- Classic divergence.
- “Failure swings”:
- “Top failure” – when a peak in the RSI > 70 fails to exceed a previous peak in an uptrend.
- “Bottom failure” when the RSI in a downtrend fails to set a new low and then proceeds to exceed a previous peak.
- Faster trend breaks – trend line analysis carried out on the oscillator for signals.
Example using RSI on Diageo PLC (LON:DGE) (Charts: Stockopedia)
- Developed by George Lane. The Stochastic is a momentum indicator that shows the location of the current close relative to the recent X days price range (on a % basis). Closing levels that are consistently near the top (80) of the range indicate buying pressure and those near the bottom (20) indicate selling pressure.
- Uses high, low and close info, so in some respects factors in the volatility of the underlying instrument.
- Displayed as two lines:
- %K = 100 ((C-L14 / (H14-L14))
- %D = 3 period MA of %K (Fast stochastics)
- (Slow stochastics = 3 period MA of %D)
- Most traders use the ‘slow’ version as it gives more reliable signals.
- %D Fast and %D slow crossing over can indicate buy / sell signals.
- Divergence between price action and stochastics can warn of market turns.
- Useful in ranging markets.
- Can combine Stochastics with RSI.
- Useful for cycle analysis.
Example using Stochastics on Diageo PLC (LON:DGE) (Charts: Stockopedia)
Further reading and learning:
If you are interested in learning more about trend and momentum, then the following reading may help:
- Technical Analysis of the Financial Markets, John J Murphy, New York Institute of Finance, 1985.
- Technical Analysis, The Complete Resource for Financial Market Technicians, Charles D Kirkpatrick, FT Press, 2006.
- Technical Analysis Explained – 5th Edition, Martin J Pring, McGraw-Hill Education, 2014
The three most important uses of our price confirmation tools are:
- When they indicate Overbought / Oversold conditions.
- When there is a divergence between the oscillator and price action; when the oscillator is in an extreme position it can warn of a potential turn in prices.
- When the crossing of the zero line can give important trading signals in the direction of the price trend.
Some trade using just these indicators and basic price action analysis. What is known, is that when you combine both your price analysis and oscillator analysis it can hugely strengthen your decision making process.
Next time: Technical Analysis (Part 17): Price Confirmation Tools (PCT): Volume, Volatility and Sentiment