GET Financial Education Series - Futures
Technical Analysis: Technical Indicators
– Lesson 8
You need at least Flash Player 7 to view this website.
Please go to:
http://www.adobe.com
to download the latest version.
Charts always have a story to tell. However, sometimes those charts may be speaking a language you do not understand and you may need some help from an interpreter. Technical indicators are the interpreters of the futures market. They look at price information and translate it into simple, easy-to-read signals that can help you determine when to buy and when to sell a futures contract.
Technical indicators are based on mathematical equations that produce a value that is then plotted on your chart. For example, a moving average calculates the average price of a futures contract in the past and plots a point on your chart. As your chart moves forward, the moving average plots new points based on the updated price information it has. Ultimately, the moving average gives you a smooth indication of which direction the futures contract is moving (see Figure 1).
Figure 1 - Technical Indicator: Moving Average
Each technical indicator provides unique information. You will find you will naturally gravitate toward specific technical indicators based on your trading personality, but it is important to become familiar with all of the technical indicators at your disposal.
You should also be aware of the one weakness associated with technical indicators. Because technical indicators look at historical price data, they do lag current market data to an extent, but they still provide excellent information.
Technical indicators are divided into the following categories:
- Trending Indicators
- Oscillating Indicators
Trending Indicators
Trending indicators, as their name suggests, identify and follow the trend of a futures contract. Futures traders make most of their money when futures are trending. It is therefore crucial for you to be able to determine when a futures contract is trending and when it is consolidating. If you can enter your trades shortly after a trend begins and exit shortly after the trend ends, you will be quite successful.
Let's take a look at the following trending indicators:
- Moving average
- Bollinger bands
Moving Average
Moving averages are the most basic trending indicator. They show you what direction a futures contract is going and where potential levels of support and resistance may be - moving averages themselves can serve as both support and resistance.
As we discuss moving averages, we will look at the following three topics:
- How moving averages are constructed
- Moving average trading signal
- Strengths of moving averages
How a Moving Average is Constructed
Moving averages are constructed by finding the average closing price of a futures contract at any given time and then plotting these points on a price chart. The result gives you a smooth line that follows the price movement of the futures contract (see Figure 2).
You can adjust the volatility of a moving average by adjusting the time frame the indicator looks at to obtain an average price. Moving averages that look at fewer time periods to determine an average are more volatile. Moving averages that look at more time periods to determine an average are less volatile.
Figure 2 - Moving Average
Moving Average Trading Signal
Moving averages provide useful trading signals for futures contracts that are trending.
Entry signal - when an up-trending futures contract bounces back up after hitting an up-trending moving average, or when a down-trending futures contract bounces back down after hitting a down-trending moving average.
Exit signal - when you enter a trade on an up-trending futures contract, set a stop loss below the moving average. As the moving average rises, move your stop loss up along with the moving average. If futures contract ever breaks far enough below the moving average, your stop loss will take you out of your trade.
When you enter a trade on a down-trending futures contract, set a stop loss above the moving average. As the moving average falls, move your stop loss down along with the moving average. If the futures contract ever breaks far enough above the moving average, your stop loss will take you out of your trade.
| Strengths of a Moving Average |
Moving averages enjoy the following strengths:
- They identify simple trends
- 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 weaknesses:
- They lag the market - the data used to calculate a moving average comes from the past, which doesn't necessarily reflect what will happen in the future.
- They cannot identify trends or levels of support or resistance during channeling markets.
|
Bollinger Bands
Bollinger bands are a trending indicator, created by John Bollinger, that can show you not only what direction a futures contract is going but also how volatile the price movement of the futures contract is. Bollinger bands consist of two bands - an upper band and a lower band - and a moving average and are generally plotted on top of the price movement of a chart.
As we discuss Bollinger bands, we will look at the following three topics:
- How Bollinger bands are constructed
- Bollinger band trading signal
- Strengths of Bollinger bands
How Bollinger Bands are Constructed
Bollinger bands are typically based on a 20-period moving average. This moving average runs through the middle of the two bands. The upper band is plotted two standard deviations above the 20-period moving average. The lower band is plotted two standard deviations below the 20-period moving average (see Figure 3).
A standard deviation is a statistical term that measures how far various closing prices diverge from the average closing price. Therefore 20-period Bollinger bands tell you how wide, or volatile, the range of closing prices has been during the past 20 periods. The more volatile the futures contract, the wider the bands will be. The less volatile the futures contract, the narrower the bands will be.
Figure 3 - Bollinger Bands
Bollinger Band Trading Signal
Bollinger bands provide useful breakout signals for futures contracts that have been consolidating.
Entry signal - when the bands widen and begin moving in opposite 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.
Exit signal - at some point after the breakout occurs, the bands will
begin to move back toward each other (see Point B on Figure 4).
When this happens, set a trailing stop loss to take you out of the trade 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:
- They help you identify the trend
- They identify current market volatility
|
|
| Weaknesses of Bollinger Bands |
Bollinger bands have the following weaknesses:
- They lag the market - the data used to calculate Bollinger bands comes from the past, which doesn't necessarily reflect what will happen in the future.
- The bands do not, as is commonly believed, serve as support (lower band) and resistance (upper band) levels.
|
Oscillating Indicators
Oscillating indicators, as their name suggests, are indicators that move back and forth as futures contracts rise and fall. Oscillating indicators can help you determine how strong the current trend of a futures contract is and when that trend is in danger of losing momentum and turning around.
When an oscillating indicator moves too high, the futures contract is considered to be overbought (too many people have bought the futures contract and there are not enough buyers left in the market to push the futures contract higher). This indicates the futures contract is at risk of losing momentum and turning around to move lower or sideways.
When an oscillating indicator moves too low, the futures contract is considered to be oversold (too many people have sold the futures contract air and there are not enough sellers left in the market to push the futures contract lower). This indicates the futures contract is at risk of losing momentum and turning around to move higher or sideways.
Let's take a look at the following oscillating indicators:
- Commodity channel index (CCI)
- Moving average convergence divergence (MACD)
- Slow stochastic
- Relative strength index (RSI)
Commodity Channel Index (CCI)
The commodity channel index (CCI) is an oscillating indicator developed by Donald Lambert that can show you how bullish or bearish traders are toward a futures contract and how dramatic those sentiments are. You can see the volatility of a futures contract with the CCI, much like you can with Bollinger bands.
The CCI is usually plotted below the price movement on a chart.
As we discuss the CCI, we will look at the following three topics:
- How the CCI is constructed
- CCI trading signal
- Strengths of the CCI
How the Commodity Channel Index (CCI) is Constructed
The commodity channel index (CCI) is based on both the average value of past price movements and how far those price movements have strayed from the average - how volatile the price movements have been.
If the average price of the futures contract is moving higher, the CCI will also be moving higher. Just how quickly the CCI moves higher depends on how volatile the futures contract is. If it is more volatile, the CCI will move higher faster. If it is less volatile, the CCI will move higher slower.
If the average price of the futures contract is moving lower, the CCI will also be moving lower. Just how quickly the CCI moves lower depends on how volatile the futures contract is. If it is more volatile, the CCI will move lower faster. If it is less volatile, the CCI will move lower slower.
The CCI moves back and forth, crossing 100, zero and -100 as it cycles through its progression (see Figure 5).
Figure 5 - Commodity Channel Index (CCI)
Cut Outs
The equation for calculating the commodity channel index (CCI) is as follows:
CCI = ( Typical Price - SMATP ) / ( .015 x Mean Deviation )
- Typical Price = average of the high, low and close prices of the most recent period
- SMATP = simple moving average of the typical prices of previous n periods
Commodity Channel Index (CCI) Trading Signal
The commodity channel index (CCI) produces trading signals as it crosses back and forth above and below both 100 and -100.
Entry signal - when the CCI rises above 100 and then turns around and crosses back below 100, you can sell the futures contract knowing that buyers have exhausted their momentum and the futures contract is likely to decline in the near future.
When the CCI falls below -100 and then turns around and crosses back above -100, you can buy the futures contract knowing that sellers have exhausted their momentum and the futures contract is likely to rise in the near future.
Exit signal - when the CCI turns around and starts moving higher after you have sold a futures contract, place your stop loss just above the nearest level of resistance. If the futures contract turns around and moves above resistance, your stop loss will take you out of the trade.
when the CCI turns around and starts moving higher after you have sold a futures contract, place your stop loss just above the nearest level of resistance. If the futures contract turns around and moves above resistance, your stop loss will take you out of the trade.
| Strengths of the Commodity Channel Index (CCI) |
The commodity channel index (CCI) enjoys the following strengths:
- It helps you identify volatility in a futures contract
- It helps you identify potential reversal points for a futures contract
- It helps you confirm the strength of current trends
|
|
| Weaknesses of the Commodity Channel Index (CCI) |
The commodity channel index (CCI) has the following weaknesses:
- It lags the market - the data used to calculate the CCI comes from the past, which doesn't necessarily reflect what will happen in the future.
- It cannot guarantee reversal points for a futures contract.
|
Moving Average Convergence/Divergence (MACD)
The moving average convergence/divergence (MACD) is an oscillating indicator developed by Gerald Appel that can show you when trading momentum changes from being bullish to bearish and from being bearish to bullish. The MACD can also show you when traders are becoming over-extended, which usually results in a trend reversal for the futures contract.
The MACD is usually plotted below the price movement on a chart.
As we discuss the MACD, we will look at the following three topics:
- How the MACD is constructed
- MACD trading signal
- Strengths of the MACD
How the Moving Average Convergence/Divergence (MACD) is Constructed
The moving average convergence/divergence is constructed based on a series of moving averages and how they relate to one another. The standard MACD looks at the relationship between a futures contract's 12-period and 26-period exponential moving average. Specifically, the MACD looks at the distance between these two moving averages. If 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 is accompanied by a trigger line. This line is a 9-period exponential moving average of the MACD line.
Figure 6 - Moving Average Convergence/Divergence (MACD)
Cut Outs
You can also plot the MACD as a histogram below the chart. When the histogram is above the 9-period signal line (illustrated by a horizontal line on the histogram), it is signaling 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 is signaling 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 (MACD) Histogram
Moving Average Convergence/Divergence (MACD) Trading Signal
The moving average convergence/divergence (MACD) produces trading signals as it crosses back and forth above and below the trigger line.
Entry signal - when the MACD crosses above the trigger line, you can buy the futures contract knowing that momentum has shifted from being bearish to being bullish.
When the MACD crosses below the trigger line, you can sell the futures contract knowing that momentum has shifted from being bullish to being beari
Exit signal - when the MACD crosses back below the trigger line when you have bought the futures contract, you can sell the futures contract back knowing that momentum has shifted back from being bullish to being bearish.
When the MACD crosses back above the trigger line when you have sold the futures contract, you can buy the futures contract back knowing that momentum has shifted back from being bearish to being bullish.
| Strengths of the Moving Average Convergence/Divergence (MACD) |
The moving average convergence/divergence (MACD) enjoys the following strengths:
- It helps you identify when the momentum of a futures contract changes
- It helps you confirm the strength of current trends
|
|
| Weaknesses of the Moving Average Convergence/Divergence (MACD) |
The moving average convergence/divergence (MACD) enjoys the following strengths:
- It helps you identify when the momentum of a futures contract changes
- It helps you confirm the strength of current trends
|
Slow Stochastic
The slow stochastic is an oscillating indicator developed by George Lane that can show you when investor sentiment changes from being bullish to bearish and from being bearish to bullish. The slow stochastic can also show you when traders are becoming over-extended, which usually results in a trend reversal for the futures contract.
The slow stochastic is usually plotted below the price movement on a chart.
As we discuss the slow stochastic, we will look at the following three topics:
- How the slow stochastic is constructed
- Slow stochastic trading signal
- Strengths of the slow stochastic
How the Slow Stochastic is Constructed
The slow stochastic consists of two lines - %K and %D - that oscillate in a range between 0 and 100. %K is constructed based on where the current closing price of a futures contract is in relation to the range of closing prices for that same futures contract in the past. %D is a moving average of %K.
If the closing price of the futures contract is near the top of the range of past closing prices, the %K line (followed by the %D line) will move higher.
If the closing price of the futures contract is near the bottom of the range of past closing prices, the %K line (followed by the %D line) will move lower (see Figure 7).
For example, if the Euro FX futures contract has closed in between 1.4200 and 1.4300 on each of the past 14 trading periods and it closes at 1.4295 (near the high of the range), %K will move toward the top of the indicator's range.
Figure 7 - Slow Stochastic
Slow Stochastic Trading Signal
The slow stochastic produces trading signals as it crosses in and out of its upper and lower reversal zones. The upper reversal zone is the area of the indicator that is above 80. The lower reversal zone is the area of the indicator that is below 20. When %K is above 80, it shows the futures contract may be overbought and may be reversing trend shortly. When %K is below 20, it shows the futures contract may be oversold and may be reversing trend shortly.
Entry signal - when %K crosses from above 80 to below 80, you can sell the futures contract knowing that investor sentiment toward the futures contract has shifted from being bullish to being bearish.
When %K crosses from below 20 to above 20, you can buy the futures contract knowing that investor sentiment toward the futures contract has shifted from being bearish to being bullish.
Exit signal - when %K reverses direction after having crossed either above 20 or below 80 and crosses over %D, you can exit your trade knowing that investor sentiment is changing direction again.
| Strengths of the Slow Stochastic |
The slow stochastic enjoys the following strengths:
- It helps you identify when investor sentiment toward a futures contract changes
- It helps you confirm the strength of current trends
|
|
| Weaknesses of the Slow Stochastic |
The slow stochastic has the following weaknesses:
- It lags the market - the data used to calculate the CCI comes from the past, which doesn't necessarily reflect what will happen in the future.
- It can provide false signals.
|
Moving Average
