GET Financial Education Series - Stocks and CFDs
Technical Analysis: Technical Indicators
– Lesson 7
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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 stock
and CFD markets. 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.
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 historic price of a stock or CFD and plots a point on your chart.
As your stock or CFD 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 the direction in which the stock or CFD
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 behind current market data to an extent but they still provide
invaluable information.
Technical indicators are divided into the following categories:
- Trending Indicators
- Oscillating Indicators
- Volume Indicators
Trending Indicators
Trending indicators, as their name suggests, identify and follow the trend
of a stock or CFD. Stock and CFD traders make most of their money when stocks
and CFDs are on a trend. It is therefore crucial for you to be able to determine
when a stock or CFD is on a trend and when it is consolidating. If you can
enter your trades shortly after a trend begins and exit shortly after the
trend ends then you will be quite successful.
Let's take a look at the following indicators of trends:
Moving Averages
Moving averages are the most basic trending indicator. They show you
the direction in which a stock or CFD 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 signals
- Strengths of moving averages
How a Moving Average is Constructed
Moving averages are constructed by finding the average closing price
of a stock or CFD 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 stock or CFD (see Figure 2).
You can adjust the volatility of a moving average by adjusting the time-frame
which the indicator looks at to obtain an average price. Moving averages
that look at fewer time-frames to determine an average are more volatile.
Moving averages that look at more time-frames to determine an average
are less volatile.
Figure 2 - Moving Average
Moving Average Trading Signal
Moving averages provide useful trading signals for stocks or CFDs that
are on a trend.
Entry signal
- when an upward-trending stock or CFD bounces back up after hitting an
upward-tending- moving average, or when a downward-trending- stock or
CFD bounces back down after hitting a downward-trending- moving average.
Exit signal - when you invest on an upward-trending-
stock or CFD set a stop-loss below the moving average. As the moving average
rises, move your stop-loss up along with the moving average. If the stock
or CFD ever breaks far enough below the moving average, your stop-loss
will take you out of your investment.
When you enter a trade on a downward-trending- stock or CFD, 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 stock or CFD 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 behind the market because the data used to calculate
a moving average is historic, which doesn't necessarily reflect
what will happen in the future.
- They cannot identify trends, or levels of support or resistance,
during channelling markets.
|
Bollinger Bands
Bollinger bands are a on a trend indicator, created by John Bollinger,
that can show you not only what direction a stock or CFD is going but
also assess the volatility of the price movement of the stock or CFD.
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.
A standard deviation is a statistical term that measures how far various
closing prices diverge from the average closing price.
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.
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 stock or CFD, the wider the bands will be. The less volatile
the stock or CFD, the narrower the bands will be (see Figure 3).
Figure 3 - Bollinger Bands
Bollinger Band Trading Signal
Bollinger bands provide useful breakout signals for stocks or CFDs 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 invest 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 sell 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 behind the market because the data used to calculate
Bollinger bands is historic, which doesn't necessarily reflect
what will happen in the future.
- The bands do not, as is commonly believed, serve as support
(i.e. the lower band) and resistance (i.e. the upper band) levels.
|
Oscillating Indicators
Oscillating indicators, as their name suggests, are indicators that move
back and forth as stocks and CFDs rise and fall. Oscillating indicators
can help you determine how strong the current trend of a stock or CFD is,
as well as when that trend is in danger of losing momentum and turning around.
When an oscillating indicator moves too high, the stock or CFD is considered
to be overbought (i.e. too many people have bought the stock or CFD and
there are not enough buyers left in the market to push the stock or CFD
higher). This indicates the stock or CFD is at risk of losing momentum and
turning around to move lower or sideways.
When an oscillating indicator moves too low, the stock or CFD is considered
to be oversold (i.e. too many people have sold the stock or CFD air and
there are not enough sellers left in the market to push the stock or CFD
lower). This indicates the stock or CFD is at risk of losing momentum and
turning around to move higher or sideways.
We will now take a look at the following oscillating indicators:
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 stock or CFD and evaluate the strength of those sentiments. You
can see the volatility of a stock or CFD 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, telling traders in effect how volatile the price movements
have been.
If the average price of the stock or CFD is moving higher then the CCI
will also be moving higher. Just how quickly the CCI moves higher depends
on the volatility of the stock or CFD. 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 stock or CFD is moving lower, the CCI will
also be moving lower. Just how quickly the CCI moves lower depends on
the volatility of the stock or CFD. 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)
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 fluctuates
to cross above and below both 100 and -100.
Entry signal
- when the CCI initially rises above 100 and then falls below it, you
can sell the stock or CFD knowing that buyers have exhausted their momentum
and the stock or CFD is likely to decline soon.
When the CCI falls below -100 and then rises above it, you can buy the
stock or CFD knowing that sellers have exhausted their momentum and the
stock or CFD is likely to rise soon.
Exit signal
- when the CCI turns around and starts moving higher after you have sold
a stock or CFD, place your stop-loss just above the nearest level of resistance.
If the stock or CFD turns around and moves above resistance, your stop-loss
will sell your investment.
When the CCI turns around and starts moving lower after you have bought
a stock or CFD, place your stop-loss just below the nearest level of support.
If the stock or CFD turns around and moves below support, your stop-loss
will sell your investment.
| Strengths of the Commodity Channel Index (CCI) |
The commodity channel index (CCI)
enjoys the following strengths:
- It helps you identify volatility in a stock or CFD
- It helps you identify potential reversal points for a stock
or CFD
- 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 behind the market because the data used to calculate
the CCI is historic, which doesn't necessarily reflect what will
happen in the future.
- It cannot guarantee reversal points for a stock or CFD.
|
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 vice versa. The MACD can also show you
when traders are becoming over-extended, which usually results in a trend
reversal for the stock or CFD.
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 signals
- Strengths of the MACD
How the Moving Average Convergence/Divergence (MACD) is Constructed
The moving average convergence/divergence is based on a series of moving
averages and how they relate to one another. The standard MACD looks at
the relationship between a stock or CFD 12-period and 26-period exponential
moving averages. The MACD looks specifically at the distance between these
two moving averages. If the 12-period moving average is above the 26-period
moving average then the MACD line will be positive. If the 12-period moving
average is below the 26-period moving average then 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)
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 above and below the trigger line.
Entry signal
- when the MACD crosses above the trigger line you can buy the stock or
CFD knowing that momentum has shifted from being bearish to being bullish.
Commodity Channel Index (CCI) Trading Signal
Entry signal
- when the MACD crosses above the trigger line you can buy the stock or
CFD knowing that momentum has shifted from being bearish to being bullish.
When the MACD crosses below the trigger line you can sell the stock or
CFD knowing that momentum has shifted from being bullish to being bearish.
Exit signal
- when the MACD crosses back below the trigger line when you have bought
the stock or CFD you can sell the stock or CFD 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 stock or CFD you can buy the stock or CFD 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 stock or CFD changes
- It helps you confirm the strength of current trends
|
| Weaknesses of the Moving Average Convergence/Divergence
(MACD) |
The moving average convergence/divergence
(MACD) has the following weaknesses:
- It lags behind the market because the data used to calculate
the CCI is historic, which doesn't necessarily reflect what will
happen in the future.
- It can provide false signals.
|
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 vice versa. The slow stochastic can also show you when traders
are becoming over-extended, which usually results in a trend reversal
for the stock or CFD.
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 signals
- 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 based on where the current closing price of a stock or CFD is in
relation to the range of historic closing prices for that same stock or
CFD.
%D is a moving average of %K.
If the closing price of the stock or CFD is near the top of the range
of historic closing prices, the %K line (followed by the %D line) will
move higher.
If the closing price of the stock or CFD is near the bottom of the range
of historic closing prices, the %K line (followed by the %D line) will
move lower (see Figure 7).
For example, if the EUR/USD 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), then %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.
When %K is above 80, it shows the stock or CFD may be overbought and may
be reversing trend shortly.
The lower reversal zone is the area of the indicator that is below 20.
When %K is below 20, it shows the stock or CFD may be oversold and may
be reversing trend shortly.
Entry signal
- when %K crosses from above 80 to below 80 you can sell the stock
When %K crosses from below 20 to above 20 you can buy the stock or CFD
knowing that investor sentiment toward the stock or CFD has shifted from
being bearish to being bullish.
Exit signal
- when %K reverses direction after having crossed either above 20 or below
80, and then 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 stock
or CFD changes
- It helps you confirm the strength of current trends
|
| Weaknesses of the Slow Stochastic |
The slow stochastic has the following
weaknesses:
- It lags behind the market because the data used to calculate
the CCI is historic, which doesn't necessarily reflect what will
happen in the future.
- It can provide false signals.
|
Volume Indicators
Volume indicators provide incredible diversification to your technical
indicator portfolio because, instead of relying solely on the price movement
of a stock or CFD in their calculations, they take a completely different
piece of information into the equation: volume.
Price movement can tell you in which direction a stock or CFD is moving,
but volume can tell you what kind of support is behind that price movement.
For instance, if you see a stock or CFD moving higher on high volume, you
know that there are a lot of investors who believe the stock or CFD should
be moving higher. Seeing this support for the price movement should be encouraging
to you and should give you the increased confidence you need to buy the
stock or CFD yourself. On the other hand, if you see a stock of CFD moving
higher on low volume you will know that there are only a few investors who
believe the stock or CFD should be moving higher. Seeing this lack of support
for the price movement should be discouraging to you and should make you
stop and think twice before buying the stock or CFD yourself.
We should take a look at the following two volume indicators:
On Balance Volume
On balance volume is a volume indicator developed by Joe Granville that
shows positive and negative volume flow. On balance volume can also show
you when the stock price movement is not supported by increasing volume,
which usually results in a trend reversal for the stock or CFD.
On balance volume is usually plotted below the price movement on a chart.
As we discuss on balance volume, we will look at the following four topics:
- How on balance volume is constructed
- On balance volume confirmations
- Strengths of on balance volume
- Weaknesses of on balance volume
How On Balance Volume is Constructed
On balance volume is created by adding or subtracting (depending on whether
the stock price moved higher or lower, respectively) today's volume from
the previous trading day's on-balance-volume level and then plotting this
point below the price chart. For example if the stock price closes higher
today than it closed yesterday then you would add today's volume amount
to yesterday's on-balance-volume level. Conversely, if the stock price
closes lower today than it closed yesterday then you would subtract today's
volume amount from yesterday's on-balance-volume level. Connecting each
on-balance-volume data point gives you a smooth line that illustrates
how volume has, or has not, been supporting the price movement of the
stock (see Figure 8).
Figure 8 - On Balance Volume
On Balance Volume Confirmations
Traders are always eager to know whether a trend, or a reversal, has
the momentum to continue moving in the same direction. On balance volume
can help you determine if there is enough momentum behind a price movement
to continue pushing it along.
Positive confirmation - on balance volume can provide
positive confirmations of both upward trends and downward trends. If the
on-balance-volume line is on a upward trend while the stock price is also
on a upward trend, you know there is strong buying support underpinning
the upward trend. If the on-balance-volume line is on a downward trend
while the stock price is also on a downward trend, you know there is strong
selling support underpinning the downward trend.
Negative confirmation - on balance volume can provide
negative confirmations of both upward trends and downward trends. If the
on-balance-volume line is on a downward trend while the stock price is
on a upward trend, you know there is weak buying support underpinning
the upward trend. If the on-balance-volume line is on a upward trend while
the stock price is on a downward trend, you know there is weak selling
support underpinning the downward trend.
| Strengths of On Balance Volume |
On balance volume enjoys the following
strengths:
- It does not rely on price alone in its calculation
- It helps you confirm the strength of current trends
|
| Weaknesses of On Balance Volume |
On balance volume has the following
weaknesses:
- It lags behind the market because the data used to calculate
on balance volume is historic, which doesn't necessarily reflect
what will happen in the future.
- It can give false confirmations of some trends.
|
Accumulation/Distribution
The accumulation/distribution line is a volume indicator developed by
Marc Chaikin that shows the cumulative flow of money both into and out
of a stock. The accumulation/distribution line can also show you when
the stock price movement is not supported by increasing volume, which
usually results in a trend reversal for the stock or CFD.
The accumulation/distribution line is usually plotted below the price
movement on a chart.
As we discuss the accumulation/distribution line, we will look at the
following four topics:
- How the accumulation/distribution line is constructed
- Accumulation/Distribution line confirmations
- Strengths of the accumulation/distribution line
- Weaknesses of the accumulation/distribution line
How the Accumulation/Distribution Line is Constructed
The accumulation/distribution line is similar to the on-balance-volume
line, but its calculation has one distinct difference: it does not look
at the current trading period's price movement in relation to the previous
period's price movement. Whereas the on-balance volume line is calculated
based on where the stock price closed in the current period compared to
where it closed in the previous period, the accumulation/distribution
line is constructed by determining where the stock price closed in relation
to the midpoint of that period's price movement.
If the stock price closes above the midpoint you add a value between
0 and 1 to the cumulative value of the accumulation/distribution line.
If the stock price closes below the midpoint you subtract a value between
0 and -1 from the cumulative value of the accumulation/distribution line.
For example if the stock price closed at the high of that trading period
you would add 1 to the cumulative value of the accumulation/distribution
line. Conversely if the stock price closed at the low of that trading
period you would subtract 1 from the cumulative value of the accumulation/distribution
line. Connecting each accumulation/distribution data point gives you a
smooth line that illustrates how volume has, or has not, been supporting
the price movement of the stock (see Figure 9).
Figure 9 - Accumulation/Distribution
Accumulation/Distribution Line Confirmations
Traders are always eager to know whether a trend or a reversal, has the
momentum to continue moving in the same direction. The accumulation/distribution
line can help you to determine if there is enough momentum behind a price
movement to continue pushing it along.
Positive confirmation - the accumulation/distribution
line can provide positive confirmations of both upward trends and downward
trends. If the accumulation/distribution line is on a upward trend while
the stock price is also on a upward trend, you know there is strong buying
support underpinning the upward trend. If the accumulation/distribution
line is on a downward trend while the stock price is also on a downward
trend, you know there is strong selling support underpinning the downward
trend.
Negative confirmation - the accumulation/distribution
line can provide negative confirmations of both upward trends and downward
trends. If the accumulation/distribution line is on a downward trend while
the stock price is on a upward trend, you know there is weak buying support
underpinning the upward trend. If the accumulation/distribution line is
on a upward trend while the stock price is on a downward trend, you know
there is weak selling support underpinning the downward trend.
| Strengths of the Accumulation/Distribution Line |
The accumulation/distribution line
volume enjoys the following strengths:
- It does not rely on price alone in its calculation
- It helps you confirm the strength of current trends
|
| Weaknesses of the Accumulation/Distribution Line |
The accumulation/distribution line
has the following weaknesses:
- It lags behind the market because the data used to calculate
the accumulation/distribution line is historic, which doesn't
necessarily reflect what will happen in the future.
- It can give false confirmations of some trends.
|
Moving Averages
