Education > Forex - Step5

[SECTION 2.3]

Technical analysis, technical indicators

Charts may speak volumes but can so often seem unintelligible. Don't be daunted- they are not.

The key to interpreting the stock and CFD markets are technical indicators. They examine price information and translate it into simple, easy-to-read signals that enable you to make your buy and sell decisions.

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.

This moving average irons out a lot of temporary price fluctuations (because it is based on a larger sampling of data) and provides a smooth line that indicates the direction in which the stock or CFD is heading (see figure 1).

Figure 1?Technical indicator: moving average

Each technical indicator provides unique information. Traders are individuals so they gravitate toward specific technical indicators. However, it is important to familiarise yourself with all of the technical indicators at your disposal.

You should also be familiar with the one problem associated with technical indicators. As they are based on historical price data, they lag the current market, Despite that, they still provide a wealth of data.

Technical indicators are divided into the following categories:

1. Trending indicators [SECTION 2.3.1]
2. Oscillating indicators [SECTION 2.3.2]
3. Volume indicators [SECTION 2.3.3]

[SECTION 2.3.1]

Trending indicators

As the name suggests, trending indicators identify and follow the trend of a stock or CFD. Where there is a trend, traders are able to capitalise and make money It is therefore critical to 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 do well.

The following trending indicators are worth examining now:

1. Moving average [SECTION 2.3.1.1]
2. Bollinger bands [SECTION 2.3.1.2]

[SECTION 2.3.1.1]

Moving averages

Moving averages are the most fundamental indicator of a trend. They indicate the direction in which a stock or CFD is going and where potential levels of support and resistance will reside. Moving averages themselves can serve as both support and resistance levels because they will be watched by many traders and will be important because of that.

Regarding moving averages, we shall examine three key topics:

1. How moving averages develop
2. Moving average trading signals
3. Strengths of moving averages

How a moving average develops
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 period are more volatile (and therefore jerky). Moving averages that examine a longer time-frame are steadier (and therefore smoother).

Figure 2?Moving average

Moving average trading signal

Moving averages give useful trading signals for stocks or CFDs that are following trends.

Entry signal: When a stock or CFD is enjoying an upward trend and rebounds after hitting an upward-trending moving average, or when a downward-trending stock or CFD turns around 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 peg your stop-loss to the moving average. If the price does fall 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, you should move your stop-loss down in tandem 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.

Strengths of a moving average

Moving averages enjoy the following strengths:

1. They identify simple trends
2. 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 problems:

1. They lag the market. The data used to calculate a moving average is historic and, while that is useful, it is not definitive. It will not always provide a reliable indicator of what will happen in the future.
2. They cannot identify trends, or levels of support or resistance, during channeling markets.

[SECTION 2.3.1.2]

Bollinger bands

Bollinger bands are a trend indicator so named after John Bollinger, their creator. 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:

1. How bollinger bands develop
2. Bollinger band trading signals
3. Strengths of bollinger bands

How bollinger bands are constructed

Bollinger bands are typically based on a 20-day (???) period moving average. A moving average is sandwiched between the two bands.

A standard deviation is a statistical term measuring how far various closing prices diverge from the average closing price. The upper band is plotted two standard deviations above the 20-day period moving average. The lower band is plotted two standard deviations below the 20-day period moving average (see Figure 3).

Therefore, 20-day period Bollinger bands indicate how wide, and therefore volatile, the range of closing prices has been during the past 20 periods. The more volatile the price, the wider the band. A relatively stable price will be typified by a narrower band.

Figure 3?Bollinger bands

Bollinger band trading signal

Bollinger bands provide useful breakout signals for stocks or CFDs that have been consolidating.

Entry signal: When the bands widen and start to go in divergent 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. By doing so, you are capitalising on renewed volatility.

Exit signal: At some point after the breakout takes place, 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

Strengths of bollinger bands

Bollinger bands enjoy the following strengths:

1. They help you identify the trend
2. They identify current market volatility

Weaknesses of bollinger bands

Bollinger bands have the following weaknesses:

1. They lag the market because the data used to calculate bollinger bands is historic and cannot predict the future.
2. The bands do not, as is often perceived, act as support (lower band) and resistance (upper band) levels.

[SECTION 2.3.2]

Oscillating indicators

Oscillating indicators move back and forth as prices rise and fall. They can help you assess the strength of a current trend and alert you to when that trend is losing momentum and rebounding

When an oscillating indicator goes 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 risks losing momentum forcing the trend to reverse or the price to stagnate.

When an oscillating indicator falls too far, the stock or CFD is ?oversold' (too many people have sold it and there are not enough sellers left in the market to push the price down further). This shows 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:

1. Commodity channel index (CCI) [SECTION 2.3.2.1]
2. Moving average convergence divergence (MACD) [SECTION 2.3.2.2]
3. Slow stochastic [SECTION 2.3.2.3]
4. Relative strength index (RSI) [SECTION 2.3.2.4]

[SECTION 2.3.2.1]

Commodity channel index

The commodity channel index (CCI) is an oscillating indicator that indicates the degree of bullishness or bearishness trader sentiment is. You can look at the volatility of a stock or CFD with the CCI, much as you can with bollinger bands.

Created by Donald Lambert, the CCI is usually plotted below the price movement on a chart.

We will now examine the following three aspects of the CCI:

1. How the CCI is constructed
2. CCI trading signals
3. Strengths of the CCI

How the CCI is constructed

The CCI is founded on the average value of historic price movements and the degree to which those price movements deviate from the mean. It details the degree of price volatility.

If an average price rises, the CCI will also rise. But just how fast it rises depends on how volatile the stock or CFD is. The more volatile the price, the more speedily the CCI will rise. If it is less volatile, it will still rise, but more slowly.

If an average price falls, the CCI will fall too. Just how quickly it slips depends on the volatility of the stock or CFD. The more volatile, the faster it will fall. 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 progresses through its cycle (see figure 5).

Figure 5?Commodity channel index

CCI trading signal

The CCI produces trading signals as it crosses back and forth above and below both 100 and -100. Effectively, these are entry and exit signals.

Entry signal: When the CCI passes through the 100 barrier and then falls back below 100, you can get rid of the stock or CFD in the knowledge that buyer momentum has waned 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 has dwindled and the price is likely to rise soon.

Exit signal: When a downtrending CCI changes direction and rises after you have sold a stock or CFD, you should 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, then 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.

Strengths of the CCI

The CCI has the following strengths:

1. It helps you identify volatility in a stock or CFD
2. It helps you identify potential reversal points for a stock or CFD
3. It helps you confirm the strength of current trends

Weaknesses of the CCI

The CCI is weak in the following areas:

1. It lags the market as data used to calculate the CCI is historic and carries no guarantee that it will influence the future.
2. It cannot invariably predict reversal points for a stock or CFD.

[SECTION 2.3.2.2]

Moving average convergence/divergence

The moving average convergence/divergence (MACD) is an oscillating indicator developed by Gerald Appel. It shows when trading momentum changes from bullish to bearish and vice versa. The MACD is also able to demonstrate when traders are at risk of being over-extended, which usually leads to 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:

1. How the MACD is constructed
2. MACD trading signal
3. Strengths of the MACD

How the MACD is constructed

The MACD compares a series of moving averages and their relationships. The standard MACD looks at the relationship between the 12-period (day????) 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 goes hand-in-hand with a trigger line. This line is a 9-period exponential moving average of the MACD line.

Figure 6?Moving average convergence/divergence

You can also plot the MACD as a histogram below the chart. When the histogram is above the 9-period signal line (shown by a horizontal line on the histogram), it signals 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 signals 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 histogram

MACD trading signal

The MACD gives out trading signals as it transverses the trigger-line.

Entry signal: When the MACD goes above the trigger line, the market shift from bearish to bullish is a clear signal to buy.

When the MACD slips below the trigger line, the market shift from bullish to bearish signals it is the right time to sell.

Exit signal: When the MACD falls below the trigger line after a buy, you can sell as the market moves from bullish to bearish.

When the MACD goes above the trigger line after a sell, you can buy as the market goes from bearish to bullish.

Strengths of the MACD

The MACD has two critical strengths:

1. It helps to pinpoint when the momentum of a stock or CFD changes.
2. It helps to confirm the strength of current trends.

Weaknesses of the MACD

The MACD is weak in these areas:

1. It lags the market as the data used to assess the MACD is historic. Future outcomes can not be safely predicated on this data.
2. It can generate misleading signals.

[SECTION 2.3.2.3]

Slow stochastic

The slow stochastic is another type of oscillating indicator. Developed by George Lane, it identifies shifts in investor sentiment from bullish to bearish or vice versa. The slow stochastic can also pinpoint when traders are in danger of 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 need to be looked at:

1. How the slow stochastic is constructed
2. Slow stochastic trading signals
3. Strengths of the slow stochastic

How the slow stochastic is constructed

The slow stochastic consists of two lines?%K and %D?that fluctuate 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 zenith of historical closing prices, then the %K line (followed by the %D line) will rise.

If the closing price is near the nadir of the range of historical closing prices, the %K line (followed by the %D line) will go 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 zenith), %K will move toward the top of the indicator's range.

Figure 7?Slow stochastic

Slow stochastic trading signal

The slow stochastic sends trading signals as it enters its upper and lower reversal zones.

The upper reversal zone is 80 and above. When %K passes 80, it indicates a stock or CFD that may be overbought and could suffer an imminent reverse.

The lower reversal zone is 20 and below. When %K slips below 20, the stock or CFD may be oversold and could begin an imminent reverse.

Entry signal: When %K dips below 80, you can sell aware that investor sentiment is going from bullish to bearish.

When %K rises above 20, you can buy in the knowledge that investor sentiment is becoming bearish rather than bullish.

Exit signal: When %K changes direction after having risen above 20 or fallen below 80, and crosses over %D, you can divest as investor sentiment is on the reverse again.

Strengths of the slow stochastic

The slow stochastic is strong because:

1. You can pinpoint when investor sentiment changes
2. You can establish the strength of current trends

Weaknesses of the slow stochastic

The slow stochastic has the following weaknesses:

1. It lags the market as the data used to assess the slow stochastic is historic. As a predictor of the future, it is not necessarily reliable.
2. It can give out misleading signals.

[SECTION 2.3.3]

Volume indicators

Volume indicators are a very different kind of indicator. Rather than relying solely on price, they take volume into account.

Prices indicate the direction in which an investment is moving, but volume can show the kind of support influencing the price. For example, if you see a price rise accompanied by high volume, then you know a lot of traders have confidence in this investment. Seeing this should give you confidence too. But, if you see the price of a stock of CFD rise on low volume, then it is only being propelled by a few investors. This should be a warning to you not to rush into buying.

There are two volume indicators that you need to be aware of:

1. On-balance-volume [SECTION 2.3.3.1]
2. Accumulation/distribution [SECTION 2.3.3.2]

[SECTION 2.3.3.1]

On-balance-volume

Developed by Joe Granville, on balance volume is a volume indicator demonstrating positive and negative volume flow. It can also show when a 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 need to know:

1. How on balance volume is constructed
2. On balance volume confirmations
3. Strengths of on balance volume
4. Weaknesses of on balance volume

How on balance volume is constructed

On balance volume is a calculation that utilises the day's volume and the previous trading day's on-balance-volume level.

If the day's closing price is higher than yesterday's, you add today's volume to yesterday's on balance volume level. You then record the resulting value below the price chart.

Alternatively, if the day's closing price is lower than yesterday's, you subtract today's volume from yesterday's on balance volume level. You then record that below the price chart.

Connecting each on balance volume value gives you a smooth line that demonstrates if volume has supported the price movement of the stock (see figure 8).

Figure 8?On-balance-volume

On balance volume confirmations

Traders need to know if a trend will sustain momentum. On balance volume can help you assess if enough momentum exists behind a price to sustain or push it even higher.

Positive confirmation: On balance volume can give positive confirmations of both upward and downward trends. If the on balance volume line is in an upward trend while the price is also rising, strong buying support clearly exists. If the on balance volume line is in a downward trend as the price also falls, you know selling support is strong.

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 the upward trend is not underpinned by strong support .If the on balance volume line is in an upward trend while the price is in a downward trend, you know there is weak selling support underlying the downward trend.

Strengths of on balance volume

On balance volume enjoys the following strengths:

1. It does not rely on price alone in its calculation
2. It helps you to confirm the strength of current trends

Weaknesses of on balance volume

On balance volume suffers from the following weaknesses:

1. It lags the market since the data used to assess on balance volume is historic. As a predicator of the future, it is not reliable
2. It can give false indications of trends.

[SECTION 2.3.3.2]

Accumulation/distribution

Marc Chaikin's accumulation/distribution line is a volume indicator that shows the cumulative flow of money into and out of a stock or CFD. The accumulation/distribution line can also illustrate when price rises are not matched by increasing volume. This usually leads to 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 you need to know:

1. How the accumulation/distribution line is constructed
2. Accumulation/distribution line confirmations
3. Strengths of the accumulation/distribution line
4. Weaknesses of the accumulation/distribution line

How the accumulation/distribution line is constructed

Although the accumulation/distribution line shares similarities with the on balance volume line, the calculation has one specific difference. It does not look at the current trading period's price movement in relation to the previous period's price movement in the way that the on balance volume line does. 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 demonstrating whether volume has supported the price movement (see figure 9).

Figure 9?Accumulation/distribution

Accumulation/distribution line confirmations

Traders always want to know if a trend can sustain momentum. The accumulation/ distribution line can help you assess if the momentum behind a price rise is enough to propel the price further upwards.

Positive confirmation: The accumulation/distribution line generates ?positive' confirmations of both upward and downward trends. If the accumulation/distribution line is soaring at the same time as the stock price, buying support is strong. If the accumulation/distribution line is on a downward trend and the price is doing likewise, you know selling support is strong.

Negative confirmation: The accumulation/distribution line generates ?negative' confirmations of both upward and downward trends. If the accumulation/distribution line is diving parallel to a rising stock price, you know buying support is weak. If the accumulation/distribution line is on an upward trend when the price is on a downward trend, you know selling support is weak.

Strengths of the accumulation/distribution line

The accumulation/distribution line enjoys the following advantages:

1. Calculations do not depend on price alone
2. It helps confirm the strength of current trends

Weaknesses of the accumulation/distribution line

The accumulation/distribution line has these weaknesses:

1. It lags the market because the data used to calculate the accumulation/distribution line is historic. It can not reliably predict the future.
2. It can give false indications of some trends.