Technical Analysis Workshop Series Session Ten Semester 2 Week 4 Oscillators Part 1
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Agenda - Oscillator Characteristics - Comparison with moving averages (MA) - Usefulness - Underlying basis - Construction - Forecasting Principle Moving Average Convergence Divergence () - Construction - Interpretation (overbought/oversold) - Divergence - Histogram Summary INTRODUCTION
Oscillators and Momentum Principles momentum principles
Oscillator Characteristics Useful in non-trending markets where prices fluctuate in a horizontal price band (i.e. sideways consolidation/trading range) Enables trader to profit from periodic sideways and trendless market environments which occur 70% of the time Example of a sideways trend with horizontal peaks and troughs: A trendless market (no up or down trend present) momentum principles
Oscillator Characteristics Oscillators are used in conjunction with price charts during trending phases as well Alerts trader to short term market extremes: overboughtand oversoldconditions Overbought: A time to think about selling (liquidating a long position or shorting) market participants overly exuberant Oversold: A time to think about buying market participants overly negative momentum principles
Oscillator Momentum Indicator Can warn of changes in momentum beforesuch change is reflected in the price action (i.e. before turning points/reversals) Signal that a trend is nearing completion by displaying divergences Upward/Downward Momentum: The ball possesses strong momentum at the beginning before its speed starts to diminish before coming to a standstill The ball analogy is similar to the uptrend and downtrend situations in the market both trends cannot continue indefinitely and will eventually lose steam (change in momentum) momentum principles
Momentum Principle Important to use momentum analysis together with trendreversal signals (recall lesson 3) in the price action itself as confirmation Oscillators depends upon the time span which it has been calculated daily, weekly or monthly data Time period Type of trend Daily Weekly Monthly Short-term Intermediate Primary momentum principles
Comparison with Moving Averages (MA) Moving Averages (MA) - Trend-following indicator - Identify a change in trend only after it has taken place(price action precedes the MA) - Works well in trending markets Oscillators - Momentum indicators - Identify a change in trend even before it has taken place (Momentum precedes price action) - Works well in both trending and non-trending markets momentum principles
Usefulness common to all oscillators Warns that the price trend is overextendedwhen the oscillator reaches an overbought (upper extreme) or oversold (lower extreme) region Divergencebetween oscillator (already in overextended regions) and price action is another important warning Crossing (Oscillation) above and below the midpoint linegives important signals in the price trend direction (buy and sell signals) momentum principles
(ATR) is the average of true pricesover xperiods An indicator that shows the volatility of the market Does not provide any indication of price direction, only volatility True Range Defined as the greatest of the following: (1) Current high and current low (2) Current high and previous close (absolute value to ensure positive) (3) Current low and previous close (absolute value to ensure positive) Source: Stockcharts.com, Chart Schools
ATR Underlying Basis ATR calculation hence, a calculation of volatility is based mainly on gap upsand gap downs Gap down: Previous close is greater than the current high Gap up: Previous close is lower than the current low Situation A: Gap up true range equals the difference between current high and previous close Situation B: Gap down true range equals absolutedifference between current low and previous close Situation C: True range is smaller than the example in situation A (less volatile) Source: Stockcharts.com, Chart Schools
ATR Calculation and Construction Typically, ATR is based on 14 periodsand can be calculated on intraday, daily, weekly or monthly basis However, manual formulae-based calculation is unimportant ATR is on the indicator drop-down menu of most charting software
ATR Forecasting Principle The higherthe value of the indicator, the higher the probabilityof a trend change The lower the value of the indicator, the weaker the trend s movement Nota directional indicator unique volatility indicator that reflects market interest and disinterest Appears as a smoothed moving averageof true range values below the price action chart ATR reflects volatility as a positivenumber (above zero) and NOTas a percentage low-priced stocks will have lower ATR values than high-priced stocks
Bullish Reversal Signals Recall that bullish reversal signals occur at market bottoms only An increasein the ATR would show strong buying pressure and reinforce the reversal evident on price action In general, strong moves (bearish or bullish) are accompanied by large increases in ATRs Spike in ATR reinforces the possible bullish reversal evident on price chart
Bearish Reversal Signals Recall that bearish reversal signals occur at market tops only An increasein the ATR would show strong selling pressure and reinforce the reversal evident on price action In general, strong moves (bearish or bullish) are accompanied by large increases in ATRs Spike in ATR reinforces the possible bullish reversal evident on price chart Increased volatility Downtrend Spike in ATR reinforces the possible bearish reversal evident on price chart
Range Trading Sideways Trend Low ATR values would normally correspond to a horizontal range trading High values, as seen previously, may indicate trend breakout Although prices were trading sideways, traders could also profit from the shorttermvariation in prices within the trading range as evident by relatively high ATR values
Moving Average Convergence Divergence ()
Moving Average Convergence Divergence () The is a combination of both oscillator principlesand the dual moving average crossover approach Recalldouble crossover method in moving averages (MA) a buy signal is produced when the shorter MA crosses above the longer Sell signal produced when the shorter MA crosses below the longer Shorter MA crosses below the longer MA signaling downtrend (sell signal)
Moving Average Convergence Divergence () indicator consists of 2 lines: line faster line difference between 2 exponentially smoothed moving averages (EMA) of closing prices (i.e. usually the difference between a 12-period EMA and a 26-period EMA) Zero line Signal line slower line usually a 9-period EMA of the line
and Momentum The oscillation of the line (i.e. usually the difference between a 12-period EMA and a 26-period EMA) above and below the zero line determines price momentum Source: Stockcharts.com, Chart Schools
+/-Momentum Positive momentum: 12- day EMA above 26-day EMA 12-day EMA diverges further from 26-day EMA Upside momentum is increasing (above zero line) Negative momentum: 12- day EMA below 26-day EMA Source: Stockcharts.com, Chart Schools 12-day EMA diverges further below from 26-day EMA Downside momentum is increasing (below zero line)
-Parameters Short period shorter EMA used for line calculation Long period longer EMA used for line calculation Signal period period of the EMA used for signal line
Momentum However, momentum cannot increase indefinitely Momentum will decrease up till a turning point which may signify trend reversal
-Interpretation Buy signal: Crossing of faster line above slower signal line Sell signal: Crossing of faster line below slower signal line Sell signals given by the red arrows correspond with the line crossing below the signal line Buy signals given by the green arrows correspond with the line crossing above the signal line
-Interpretation Overbought (sell signals): -signal crossovers are too far abovethe zero line Oversold (buy signals): -signal crossovers are too far belowthe zero line The buy and sell signals correspond well with the actual price actions The indicator fluctuates around the zero line, giving it the quality of an oscillator
Bullish Divergence Bullish/positive divergence (buy signal): When (1) lines are moving well above the zero line with (2) prices continuing to fall Signs of bullish divergence Price action exhibits downtrend as characterized by lower peaks and troughs The lines exhibit uptrend as characterized by higher troughs line crosses abovesignal line for added confirmation Source: Stockcharts.com, Chart Schools Upside breakoutin price action
Bullish Divergence Bullish/positive divergence (buy signal): Shape of bullish divergence in fact resembles a convergence of two trend lines to the right Price action: Downtrend lower lows/troughs Oscillator trend: Uptrend higher lows/troughs
Bearish Divergence Bearish/negative divergence (short signal/liquidate longs): When (1) lines are moving well below the zero line with (2) prices continuing to rise Signs of bearish divergence Price action exhibits uptrend as characterized by higher peaks and troughs The lines exhibit downtrend as characterized by lower peaks/highs line crosses belowsignal line for added confirmation Source: Stockcharts.com, Chart Schools Downside breakoutin price action
Bearish Divergence Bearish/negative divergence:shape of bearish divergence in fact resembles a divergence of two trend lines to the right Price action: Uptrend higher highs/peaks Oscillator trend: Downtrend lower highs/peaks
3 Confirmation Points Has the lines entered the overbought or oversold regions? Has the faster line crossed above or below the slower signal line? Is there any bearish or bullish divergence present from the oscillator trend?
Histogram histogram is constructed by plotting the differences between the line and signal line Crossings by the histogram above and below the zero line coincidewith actual crossover buy and sell signals histogram abovezero line positive uptrend gain in momentum histogram belowzero line negative downtrend gain in momentum
Histogram Possible turning point Uptrend is gaining momentum Uptrend is weakening Downtrend is weakening
Histogram -Usefulness Turns in the histogram back towardsthe zero line tend to precedeactual crossover signals Early turns provide earlier warnings that current trend is losing momentum and tend to signal market tops or bottoms Price action reversal Actual crossover Histogram reaches zero line before actual crossover
Summary Oscillators are useful in determining near-termoverbought and oversold conditions Alert traders to possible divergences Never ignorethe basic trend on price charts before applying divergence analysis Buy when market is oversold in an uptrend(primary trend) Sell short when market is overbought in a downtrend (primary trend) Always trade in the direction of the major trend
Relative Strength Index (RSI) Momentum Stochastic Next Week