Proper Use of Technical Indicators
Technical indicators are used as tools to assist the trader in making buy/sell decisions.
They should be used to supplement price and volume behavior and are most useful when used in conjunction with other indicators. There
is no reason to get too complicated. The simplest indicators are usually the most effective.
Momentum indicators, or oscillators, were created to help measure the rate and strength of a price move and are designed to signal
overbought and oversold conditions. At either one of these extremes there is an increased probability that the stock will reverse,
creating a trading opportunity.
One of the things traders look for are signs of convergence and divergence between price behavior and the indicator. A convergence
is when the indicator and price chart are providing a similar signal (bullish or bearish) and, therefore, a stronger signal. When the
indicator and chart are not saying the same thing, there is a divergence, showing that price is not supported by the indicator.
Volume is one of the most important indicators and is used to confirm price action. It
provides an indication of the degree of enthusiasm of buyers and sellers and is usually shown as a histogram under price. In a healthy
market, price and volume are increasing together. A normal uptrend would include an increase in volume relative to the recent past.
Rising price without an increase in volume shows a lack of enthusiasm by buyers. The opposite is true for downtrends.
Moving Average Convergence/Divergence (MACD) is a momentum indicator and shows the
relationship between two moving averages. It is calculated by taking the difference between a longer Exponential Moving Average (26
Day EMA is common) and shorter (12 Day EMA is common) period moving average. Signals are produced by the constantly changing
convergence and divergence of the two moving averages. A bullish signal is given when the MACD line (9 Day EMA) crosses above the
Relative Strength Indicator (RSI) - This oscillator is plotted on a scale of 0 to 100 with an
upper horizontal line drawn at 70 and lower horizontal line at 30. A reading above 70 is considered overbought while a reading below
30 is considered oversold. The most popular time periods are 9 day Period Moving Average (PMA) and 14 day PMA.
On Balance Volume (OBV) - This indicator relates volume to price change and can help
determine whether institutions are moving in or out of a stock. It provides a running total of volume moving in and out of a stock and
creates an indicator line representing that total. When a stock closes up, all volume is assumed to be up, and when a stock closes
down, all volume is assumed to be down.
Stochastics - This oscillator provides signals about the strength or weakness of a market. It
compares the point at which the price of a security closed relative to its price range over a given time period. It is plotted on a
scale of 0 to 100 with upper and lower horizontal lines drawn at 20 and 80, and a middle point at 50. A reading near 80 indicates an
overbought condition and a reading near 20 oversold. This indicator consists of two lines, %K that is the faster line and %D. When %D
crosses %K, a signal is generated. A buy signal is given when %D crosses above %K below 20. When %D crosses below %K above 80, a sell
signal is produced. Time period is normally 14 days.
Bollinger Bands® - This indicator compares volatility and relative price over a period of time
and creates trading bands two standard deviations from a typical 20 PMA. It includes three lines - an upper line, lower line and
middle moving average line. These bands are designed to include a majority of the stock’s price. The changing distance between the
bands helps interpretation. During a period of high volatility, the bands widen. When a bar or candlestick touches or exceeds one of the
bands, the security is considered to be overbought or oversold. Many traders find that proper interpretation of Bollinger Bands® takes
a little more time to learn than some other indicators.
Money Flow is a momentum indicator that measures the strength of money flowing into and out
of a stock. Money Flow counts the amount of block trades of 10,000 shares or more. The assumption being that this is
institutional interest. A reading above the zero is considered institutional accumulation, while a reading below zero is considered
distribution. Money flow should be moving in the same direction as price to show strength of the price movement.
The CBOE Volatility Index (VIX) tracks the S&P 500 stock index option prices to measure
the expected implied volatility of the S&P 500 index over the next 30 calendar days. A high value on the VIX correlates to a highly
volatile market and, therefore, strong potential for a significant move up or down or a reversal in the market. Typically, values above
30 signify a large amount of volatility, while values below 20 signify more calm market conditions.
Rate of Change (ROC) takes the price today and compares it to the price n periods ago. It is
presented as a histogram under price. The ROC will oscillate above and below the equilibrium level. The longer the time frame used, the
greater the volatility of this indicator. A setting of 10 is commonly used.
Relative Strength is not to be confused with the RSI above. In this indicator, we are looking
at the strength of a stock in relation to the market and all other stocks. It is calculated by taking the percent change over a year
and comparing it to all other stocks over the same period and then producing a rating of 1 to 100. If a stock has an RS rating of 85,
its price performance has been better than 85% of all stocks.
52 Week High/Low - A stock breaking its 52-week high is a sign of strength. This is a bullish
signal that indicates there is a higher probability that the stock will continue to move higher. It does not mean that you should jump
in and hold on for the ride. Always maintain proper trade entry discipline. The opposite is true for shorting.
These are just a few of the technical indicators available on most brokerages’ access points. Whether you are "online" or
with a direct access firm, these and more are supplied. The trader must remember certain rules when using these tools. First, they were
designed for long-term investment. They must be adapted and interpreted for shorter term trading. Second, there is no one indicator
that is better than others and, certainly, no one indicator works all of the time. You must learn to use them as decision support
guidance, not the ultimate "trigger" in a trade situation. And third, many get caught up in "Paralysis through
Analysis." If you try to use them all, the trade opportunity will pass you by.
Fibonacci is something that constantly comes up in conversations about the stock market and technical analysis. However, most people
remain confused as to what role it can/should play in their own trading strategies and even how to begin to go about actually
implementing some kind of Fibonacci strategy.
In the early 13th century, Leonardo of Pisa published "The Book of the Abacus" in Italy. This was Europe’s first exposure to the
mathematic work being done in India for over 500 years. Fibonacci, Leonardo’s nickname, learned of the efficiency of the Hindu-Arabic
numerals on his travels around the Mediterranean and particularly in Northern Africa. He is most famous for his introduction of, what
is now called, the Fibonacci Sequence to the West. He is not the official originator of the summation sequence, although he is often
credited as such. Its true origins began 1400 years earlier with the work of Pingala. The sequence is perpetuated by adding the
previous number in the series to the succeeding number. The Sequence begins with 0 and 1. 0 and 1 are added together to reach the sum
of 1. The sum, 1, is then added to the preceding number in the series, 1, and the sum of 2 is achieved. 2 is then added to the
preceding number in the series, 1, and the sum of 3 is achieved. The process is repeated and the series is infinite: 0, 1, 1, 2, 3, 5,
8, 13, 21, 34, 55, 89, 144, 233… The ratios between these numbers are often used in the technical analysis of the markets. For
example, if 55 is divided by 89, one reaches 0.618, the golden mean, an important ratio in understanding beauty and balance in the
creative arts and nature, as well as the movement and timing of the markets.
The following ratios are also important extension levels in Fibonacci technical analysis:
- Fourth root of 0.618=0.886
- Square root of 0.618=0.786
- Square root of 5=2.24
The following ratios are also important retracement levels in Fibonacci technical analysis:
* Most Common
- Square root of 0.618=0.786
- Fourth root of 0.618=0.886
The following video illustrates Fibonacci levels:
One common way to apply Fibonacci ratios to your trading can be by identifying retracement levels in order to find an entry into a
trade and also to determine extension levels in order to determine an exit out of a trade. Fibonacci applies to both upward and
downward movements in the market, but for example’s sake, assume a long position. The first step is to identify an upward swing. This
is usually determined by a move through the 50 moving average. Where this leg begins can be labeled point A, where this point turns
around can be labeled point B. You are now looking for a retracement from point B to one of the common retracement levels: 0.382(B-A),
0.5(B-A), or 0.618(B-A). A retracement to one of these levels plots point C. Once point C is identified, you are looking for an
extension to one of the common extension levels: 1(B-A)+A, 1.13(B-A)+A, 1.27(B-A)+A, 1.618(B-A)+A. (Remember: An extension level
exists outside the bounds of the AB leg. A retracement level exists within the bounds of the AB leg.)
Fibonacci analysis is often used in conjunction with Elliot Wave analysis. Elliot wave is a wave principle discovered by Ralph
Nelson Elliot during the Great Depression. It is commonly accepted that the markets are fractal in nature and that they are comprised
of rhythmic waves in price movement. Elliot Wave applies to both upward and downward movements in the market, but for example’s sake
assume a long position. The Elliot Wave basically refers to an Impulse move upward and a Correction move downward. The Impulse move is
made up of 3 smaller moves upward and between them, 2 smaller moves downward for a total of 5 moves. These 5 moves are followed by a
correction move comprised of 2 smaller downward moves and between them, one smaller upward move. Because markets are fractal, Elliot
wave can be especially useful in identifying where the market is in the bigger picture. It may appear that you have a nice Long Setup
on the 5 minute chart but on the hourly chart you may actually be finishing the last upward move of the Elliot Wave and are preparing
for a reversal. Pay attention to the bigger picture. Do not get so focused in that you are unable to see what is really going on.
Always be aware of the Support and Resistance on larger time frames for they hold more ground than the smaller time frames.
Remember that every technical analysis tool is just another in your arsenal. In your research, before you begin to trade with real
money and forever after, you will become more focused. You will have a full array of tools in your tool box but you will only keep a
fraction of them in your tool belt. Along with Fibonacci these may include Bollinger Bands®, Average True Range, Moving Averages
Convergence/Divergence, Relative Strength Indicator, Stochastics, and the Commodity Channel Index.