1/12/2013 Introduction to Technical Indicators By Stephen, Research Analyst NUS Students Investment Society NATIONAL UNIVERSITY OF SINGAPORE
Introduction Technical analysis comprises two main categories: charts and indicators. Indicators are essentially calculations based on the price and the volume of a security and measure factors such as money flow, trends, volatility and momentum. They are commonly used in two main ways: to confirm price movement and the quality of chart patterns, and to form buy and sell signals. An investor should never rely on indicators solely in making his buy/sell decision; indicators only serve to predict, not confirm. My personal preference is to look at the price and chart pattern first, before considering the indicators to reinforce my analysis. Leading and Lagging Indicators Indicators can be categorized into two main types: leading and lagging indicators. A leading indicator precedes price movements, giving them a predictive quality, while a lagging indicator is a confirmation tool because it follows price movement. Lagging indicators alert traders to situations where trends have started and that it is time to pay attention to developments that have already become apparent. Leading indicators aim to signal trend changes before they develop. This might seem to suggest that leading indicators will lead to instant riches but the fact is that the signals generated are not always accurate. Traders using leading indicators will, in many cases, encounter head fakes and erroneous breakouts. Trades taken on these inaccurate signals eat into the advantages created by the leading nature of these indicators. But this does not mean that they cannot be used to generate consistently profitable signals over the longer term. A leading indicator is thought to be the strongest during periods of sideways or on-trending trading ranges. Trading ranges refer to a market with no discernible move in either direction; prices tend to rise up to the previous highs and falls to prior lows. On the other hand, lagging indicators are regarded as more useful during trending periods. A trending market is one where prices move strongly in one direction, either up or down. This market is often characterized by a steady move to higher highs and higher lows (in an uptrend). Conversely, in a downtrend, prices would be making lower lows and lower highs.
Relative Strength Index The relative strength index (RSI) is one of the most used and well-known leading indicators in technical analysis. It is a momentum indicator that measures the market s current price relative to the price n periods ago. RSI helps to signal overbought and oversold conditions in a security. The indicator is plotted in a range between zero and 100. A reading above 70 is used to suggest that a security is overbought, while a reading below 30 is used to suggest that it is oversold. RSI helps traders to identify whether a security s price has been unreasonably pushed to current levels and whether a reversal may be on the way. Stochastic Oscillator The stochastic oscillator is another well-known momentum indicator used in technical analysis. The idea behind this indicator is that in an upward trend the price should be closing near the highs of the trading range and in a downward trend the price should be closing near the lows of the trading range. When this occurs it signals continued momentum and strength in the direction of the prevailing trend. The stochastic oscillator is plotted within a range of zero and 100 and signals overbought conditions above 80 and oversold conditions below 20. The stochastic oscillator contains two lines. The first line is the %K which is essentially the raw measure used to formulate the idea of momentum behind the oscillator. The second line is the %D which is simply a moving average of the %K. The %D line is considered to be the more important of the two lines as it seen to produce better signals.
Application of Leading Indicators in Trading Market A trading market can often confuse traders because in such market, there is no discernible pattern that can be observed. In such market, leading indicators, such as RSI and stochastic oscillators, often prove to be useful. While a particular leading indicator may not confirm a buy/sell signal, a trader can look at other leading indicator to detect any buy/sell signal. Firstly, let s look at the trading market below with its RSI. As the RSI did not cross over the 70 or 30 line, there is no discernible buy/sell signal from the RSI. However, we can look at the same chart with its stochastic oscillators.
From the stochastic oscillator, we can detect a few signals during the trading range. The first signal is an oversold signal as the stochastic oscillator crosses below the 20 line. Here, we can take a long position and then sell this long position at the overbought 80 level. Subsequently, we can take a short position when the stochastic curls down below 80 and cover this short when it becomes oversold again below the 20 line. Moving Average and Application in Trending Market Moving average is one of the most well-known lagging indicators and it is defined as the average price of a security over a set amount of time. By plotting the security s moving average, price movement is smoothed out. A moving average is often used as a support/resistance line, and hence it can be used to detect buy/sell signal. When the price crosses below the moving average line (the support), it often indicates a sell signal and vice versa. Here s an example of price crossing a 20 period moving average. The green arrows correspond to buys and the red arrows correspond to sells signals. At the far left is a dotted box containing two parallel lines. The market was trading, or going sideways within that period and the severe down slope of the MA created a couple of bad signals. When a MA is so severely sloped, it is advisable not to trade against it. One way to improve this method of detecting buy/sell signal with MA crossover would be drawing a trend line. This would offer additional support to a buy/sell signal. In order to draw a trend line, find the lowest low and draw the trend line up touching the last low before the last high. This is shown in the chart below:
At the right end of the chart, notice how price broke the trend line, yet closed above the MA. The next bar is the sell signal bar as price closed below the 20 MA. There was advance warning when price broke below the trend line! Conclusion There are hundreds of indicators in use today, with new indicators being created every week. Even with the introduction of hundreds of new indicators, only a select few really offer a different perspective and are worthy of attention. When choosing indicators to use, a trader needs to choose wisely and moderately. It is generally futile to use more than five indicators as the greater the number of indicators used, the higher the chance of those indicators giving conflicting signals. Instead, try to select two or three indicators and examine their intricacies inside out. It is also important to choose indicators that will complement one another, instead of those that move in unison. Email us @ research@nusinvest.com if you have any questions! We will do our best to answer your queries!
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