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An indicator is a mathematical calculation that can be applied to a security's price and/or volume fields. The result is a value that is used to anticipate future changes in prices.
A moving average fits this definition of an indicator: it is a calculation that can be performed on a security's price to yield a value that can be used to anticipate future changes in prices.
The following chapters (see page ) contain numerous examples of indicators. I'll briefly review one simple indicator here, the Moving Average Convergence Divergence (MACD).
The MACD is calculated by subtracting a 26-day moving average of a security's price from a 12-day moving average of its price. The result is an indicator that oscillates above and below zero.
When the MACD is above zero, it means the 12-day moving average is higher than the 26-day moving average. This is bullish as it shows that current expectations (i.e., the 12-day moving average) are more bullish than previous expectations (i.e., the 26-day average). This implies a bullish, or upward, shift in the supply/demand lines. When the MACD falls below zero, it means that the 12-day moving average is less than the 26-day moving average, implying a bearish shift in the supply/demand lines.
Figure 28 shows Autozone and its MACD. I labeled the chart as "Bullish" when the MACD was above zero and "Bearish" when it was below zero. I also displayed the 12- and 26-day moving averages on the price chart.
Figure 28
A 9-day moving average of the MACD (not of the security's price) is usually plotted on top of the MACD indicator. This line is referred to as the "signal" line. The signal line anticipates the convergence of the two moving averages (i.e., the movement of the MACD toward the zero line).
The chart in Figure 29 shows the MACD (the solid line) and its signal line (the dotted line). "Buy" arrows were drawn when the MACD rose above its signal line; "sell" arrows were drawn when the MACD fell below its signal line.
Figure 29
Let's consider the rational behind this technique. The MACD is the difference between two moving averages of price. When the shorter-term moving average rises above the longer-term moving average (i.e., the MACD rises above zero), it means that investor expectations are becoming more bullish (i.e., there has been an upward shift in the supply/demand lines). By plotting a 9-day moving average of the MACD, we can see the changing of expectations (i.e., the shifting of the supply/demand lines) as they occur.
Moving averages and the MACD are examples of trend following, or "lagging," indicators. [See Figure 30.] These indicators are superb when prices move in relatively long trends. They don't warn you of upcoming changes in prices, they simply tell you what prices are doing (i.e., rising or falling) so that you can invest accordingly. Trend following indicators have you buy and sell late and, in exchange for missing the early opportunities, they greatly reduce your risk by keeping you on the right side of the market.
Figure 30
As shown in Figure 31, trend following indicators do not work well in sideways markets.
Figure 31
Another class of indicators are "leading" indicators. These indicators help you profit by predicting what prices will do next. Leading indicators provide greater rewards at the expense of increased risk. They perform best in sideways, "trading" markets.
Leading indicators typically work by measuring how "overbought" or "oversold" a security is. This is done with the assumption that a security that is "oversold" will bounce back. [See Figure 32.]
Figure 32
What type of indicators you use, leading or lagging, is a matter of personal preference. It has been my experience that most investors (including me) are better at following trends than predicting them. Thus, I personally prefer trend following indicators. However, I have met many successful investors who prefer leading indicators.
There have been several trading systems and indicators developed that determine if prices are trending or trading. The approach is that you should use lagging indicators during trending markets and leading indicators during trading markets. While it is relatively easy to determine if prices are trending or trading, it is extremely difficult to know if prices will trend or trade in the future. [See Figure 33.]
Figure 33
A divergence occurs when the trend of a security's price doesn't agree with the trend of an indicator. Many of the examples in subsequent chapters demonstrate divergences.
The chart in Figure 34 shows a divergence between Whirlpool and its 14-day CCI (Commodity Channel Index). [See page .] Whirlpool's prices were making new highs while the CCI was failing to make new highs. When divergences occur, prices usually change direction to confirm the trend of the indicator as shown in Figure 34. This occurs because indicators are better at gauging price trends than the prices themselves.
Figure 34
All of the technical analysis tools discussed up to this point were calculated using a security's price (e.g., high, low, close, volume, etc). There is another group of technical analysis tools designed to help you gauge changes in all securities within a specific market. These indicators are usually referred to as "market indicators," because they gauge an entire market, not just an individual security. Market indicators typically analyze the stock market, although they can be used for other markets (e.g., futures).
While the data fields available for an individual security are limited to its open, high, low, close, volume (see page ), and sparse financial reports, there are numerous data items available for the overall stock market. For example, the number of stocks that made new highs for the day, the number of stocks that increased in price, the volume associated with the stocks that increased in price, etc. Market indicators cannot be calculated for an individual security because the required data is not available.
Market indicators add significant depth to technical analysis, because they contain much more information than price and volume. A typical approach is to use market indicators to determine where the overall market is headed and then use price/volume indicators to determine when to buy or sell an individual security. The analogy being "all boats rise in a rising tide," it is therefore much less risky to own stocks when the stock market is rising.
Market indicators typically fall into three categories: monetary, sentiment, and momentum.
Monetary indicators concentrate on economic data such as interest rates. They help you determine the economic environment in which businesses operate. These external forces directly affect a business' profitability and share price.
Examples of monetary indicators are interest rates, the money supply, consumer and corporate debt, and inflation. Due to the vast quantity of monetary indicators, I only discuss a few of the basic monetary indicators in this book.
Sentiment indicators focus on investor expectations--often before those expectations are discernible in prices. With an individual security, the price is often the only measure of investor sentiment available. However, for a large market such as the New York Stock Exchange, many more sentiment indicators are available. These include the number of odd lot sales (i.e., what are the smallest investors doing?), the put/call ratio (i.e., how many people are buying puts versus calls?), the premium on stock index futures, the ratio of bullish versus bearish investment advisors, etc.
"Contrarian" investors use sentiment indicators to determine what the majority of investors expect prices to do; they then do the opposite. The rational being, if everybody agrees that prices will rise, then there probably aren't enough investors left to push prices much higher. This concept is well proven--almost everyone is bullish at market tops (when they should be selling) and bearish at market bottoms (when they should be buying).
The third category of market indicators, momentum, show what prices are actually doing, but do so by looking deeper than price. Examples of momentum indicators include all of the price/volume indicators applied to the various market indices (e.g., the MACD of the Dow Industrials), the number of stocks that made new highs versus the number of stocks making new lows, the relationship between the number of stocks that advanced in price versus the number that declined, the comparison of the volume associated with increased price with the volume associated with decreased price, etc.
Given the above three groups of market indicators, we have insight into:
Figure 35 shows the Prime Rate along with a 50-week moving average. "Buy" arrows were drawn when the Prime Rate crossed below its moving average (interest rates were falling) and "sell" arrows were drawn when the Prime Rate crossed above its moving average (interest rates were rising). This chart illustrates the intense relationship between stock prices and interest rates.
Figure 35
Figure 36 shows a 10-day moving average of the Put/Call Ratio (a sentiment indicator). I labeled the chart with "buy" arrows each time the moving average rose above 85.0. This is the level where investors were extremely bearish and expected prices to decline. You can see that each time investors became extremely bearish, prices actually rose.
Figure 36
Figure 37 shows a 50-week moving average (a momentum indicator) of the S&P 500. "Buy" arrows were drawn when the S&P rose above its 50-week moving average; "sell" arrows were drawn when the S&P fell below its moving average. You can see how this momentum indicator caught every major market move.
Figure 37
Figure 38 merges the preceding monetary and momentum charts. The chart is labeled "Bullish" when the Prime Rate was below its 50-week moving average (meaning that interest rates were falling) and when the S&P was above its 50-week moving average.
Figure 38
The chart in Figure 38 is a good example of the roulette metaphor. You don't need to know exactly where prices will be in the future--you simply need to improve your odds. At any given time during the period shown in this chart, I couldn't have told you where the market would be six months later. However, by knowing that the odds favor a rise in stock prices when interest rates are falling and when the S&P is above its 50-week moving average, and by limiting long positions (i.e., buying) to periods when both of these indicators are bullish, you could dramatically reduce your risks and increase your chances of making a profit.
Line studies are technical analysis tools that consist of lines drawn on top of a security's price and/or indicator. These include the support, resistance, and trendline concepts already discussed.
Figure 39 illustrates several line studies. These and numerous additional studies are explained in later chapters.
Figure 39
Regardless of the "periodicity" of the data in your charts (i.e., hourly, daily, weekly, monthly, etc), the basic principles of technical analysis endure. Consider the following charts of a Swiss Franc contract shown in Figures 40, 41, and 42.
Figure 40
Figure 41
Figure 42
Typically, the shorter the periodicity, the more difficult it is to predict and profit from changes in prices. The difficulty associated with shorter periodicities is compounded by the fact that you have less time to make your decisions.
"While we stop and think, we often miss our
opportunity."
- Publilius Syrus, 1st century B.C.
Opportunities exist in any time frame. But I have rarely met a successful short-term trader who wasn't also successful a long-term investor. And I have met many investors who get caught by the grass-is-greener syndrome believing that shorter-and-shorter time periods is the secret to making money--it isn't.
The discussion that began on page explained the open, high, low, and closing price fields. This section presents the time element.
Much of technical analysis focuses on changes in prices over time. Consider the effect of time in the following charts, each of which show a security's price increase from $25 to around $45.
Figure 43 shows that Merck's price increased consistently over a 12-month time period. This chart shows that investors continually reaffirmed the security's upward movement.
Figure 43
As shown in Figure 44, Disney's price also moved from around $25 to $45, but it did so in two significant moves. This shows that on two occasions investors believed the security's price would move higher. But following the first bidding war, a period of time had to pass before investors accepted the new prices and were ready to move them higher.
Figure 44
The pause after the rapid increase in Disney's price is a typical phenomena. People have a difficult time accepting new prices suddenly, but will accept them over time. What once looked expensive may one day look cheap as expectations evolve.
This is an interesting aspect of point and figure charts, because point and figure charts totally disregard the passage of time and only display changes in price.
There are many technical analysis tools in this book. The most difficult part of technical analysis may be deciding which tools to use! Here is an approach you might try.
Much of your success in technical analysis will come from experience. The goal isn't to find the holy grail of technical analysis, it is to reduce your risks (e.g., by trading with the overall trend) while capitalizing on opportunities (e.g., using your favorite indicator to time your trades). As you gain experience, you will make better, more informed, and more profitable investments.
"A fool sees not the same tree that a wise man
sees."
- William Blake, 1790
This concludes the Introduction to Technical Analysis. I suggest you refer to Section Two while you continue to explore this exciting and potentially profitable pursuit.
A fitting conclusion to an introduction on technical analysis is a list of lessons I have learned, both from others and the hard way.
"Opportunities flit by while we sit regretting the
chances we have lost..."
- Jerome K. Jerome, 1889
This Online Volume is a concise reference to a vast array of technical indicators and line studies.
The discussion on each tool includes an overview, an explanation of its interpretation, and an example of the indicator or line study in action. When space has permitted, I have also included a step-by-step explanation of the relevant calculations.
Most of these techniques can be applied to any type of security, including stocks, bonds, options, futures, mutual funds, and indices.
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