Technical analysis II

Understanding Bollinger Bands.

What are they?

Introduced by John Bollinger in the 1980s, Bollinger Bands are a pair of trading bands representing an upper and lower trading range for a particular market price. A stock is expected to trade within this upper and lower limit as each band or line represents the predictable range on either side of the moving average. Generally, 80-85% of the price action happens within these bands. All trading softwares will have options to display Bollinger bands.

Bollinger Bands consist of a set of three lines drawn in relation to securities prices. The middle line is a measure of the intermediate-term trend, usually a simple moving average that serves as the base for the upper band and lower band. The interval between the upper and lower bands and the middle band is determined by volatility. The purpose of Bollinger Bands is to provide a relative definition of high and low. By definition, prices are high at the upper band and low at the lower band.

Why use them?

Finds support and resistance levels: The upper band usually indicates a resistance level while the lower band usually indicates a support level. If you take a close look at any  Bollinger band, you will find that the price usually bounce off the Bollinger band whenever it touches the upper or lower band. With this observation, you can use the upper and lower bands as support and resistance when planning your trade.

Helps to find where to Enter and Exit: Bollinger Bands can be very useful trading tools, particularly in determining when to enter and exit a market position. For example: entering a market position when the price is midway between the bands with no apparent trend, is not a good idea. Generally when a price touches one band, it switches direction and moves the whole way across to the price level on the opposing band. If a price breaks out of the trading bands, then generally the directional trend prevails and the bands will widen accordingly.

Gauges volatility: The Bollinger Band is an indicator that helps you to measure the volatility of the market. It can tell you the current situation of the market by using its upper and lower band. Whenever the market has low volatility, the bands will be narrow and whenever the market has high volatility, the bands will be wide.

Shows Breakouts—one of the lesser known uses of Bollinger bands is the prediction for breakouts or gaps. As the bands squeeze a share price, the price range grows very narrow. Some trading systems identify that this is a prime time for the price to breakout of this range. Usually a large price gap is the result. The difficulty is to know the direction of the price breakout.

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Understanding Average True Range.

The Average True Range (ATR) is an indicator that measures volatility. A stock’s ‘range’ is the difference between the high and low price on any given day. It reveals information about how volatile a stock is. Large ranges indicate high volatility and small ranges indicate low volatility.

Average true range is built on this principle of ‘range’. To understand ATR, you must first try the concept of ‘true range’.

What is True range?

True Range is the greatest of the following three values:
1.The difference in price between today’s high and today’s low of a stock.
2.The difference in price between yesterday’s close to today’s high.
3.The difference in price between yesterdays close to today’s low.

True range is always a positive number (negative numbers from the calculation above are to be ignored).

Average true range is simply an average of the true range- usually 14-days. Calculating the Average True Range Indicator is slightly complex, though it is possible with a spreadsheet. Fortunately, most of the trading screens provide the average true range indicator as a part of their service.

Care should be taken to use sufficient periods in the averaging process in order to obtain a suitable sample size, i.e. an average true range using only 3 days would not provide a large enough sample to give you an accurate indication of the true range of the security’s price movement. A more useful period to use for the average true range would be 14.

What does ATR indicate?

The value returned by the average true range is simply an indication as to how much a stock has moved either up or down on average over the defined period. High values indicate that prices are changing a large amount during the day. Low values indicate that prices are staying relatively constant.

The ATR (Average True Range) indicator also helps to determine the average size of the daily trading range. In other words, it tells how volatile the market is and how much does it move from one point to another during the trading day.

ATR is not a leading indicator – means it does not send signals about market direction or duration, but it gauges one of the most important market parameter – price volatility.

The logic behind ATR is that – over the last several days on average, if the stock price has moved ‘X’ points, we could safely assume that unless some shocking market news comes along, this range will remain relatively consistent.

In short, ATR indicator is a tool for short term traders.Since it shows the average price range of a share, traders also use it to place stop loss orders.


Understanding Williams %R

Williams %R is a simple momentum oscillator explained by Larry Williams for the first time in 1973.It shows the relationship of the close relative to the high-low range over a set period of time.

Typically, Williams %R is calculated using 14 periods and can be used on intraday, daily, weekly or monthly data. The time frame and number of periods will likely vary according to desired sensitivity and the characteristics of the individual security. The scale ranges from 0 to -100 with readings from 0 to -20 considered overbought, and readings from -80 to -100 considered oversold.

This momentum indicator is, in fact , the inverse of the Fast Stochastic Oscillator. The default setting for Williams %R, as said above, is 14 periods, which can be days, weeks, months or an intraday timeframe. A 14-period %R would use the most recent close, the highest high over the last 14 periods and the lowest low over the last 14 periods.

The indicator would appear below the price chart on your trading screen. An example of how Williams %R would look is given below.

Reading W %R signals.

Here’s a collection of pointers you should be following in order to interpret William %R signals correctly.

  • Williams %R moves between 0 and -100, which makes -50 the midpoint. A Williams %R cross above -50 signals that prices are trading in the upper half of their high-low range for the given look-back period. Conversely, a cross below -50 means prices are trading in the bottom half of the given look-back period
  • Low readings (below -80) indicate that price is near its low for the given time period. High readings (above -20) indicate that price is near its high for the given time period.
  • Williams %R makes it easy to identify overbought and oversold levels. Readings from 0 to -20 considered overbought, and readings from -80 to -100 considered oversold. However,  It is important to remember that overbought does not necessarily imply time to sell, and oversold does not necessarily imply time to buy. A security can be in a downtrend, become oversold and remain oversold as the price continues to trend lower. Once a security becomes overbought or oversold, traders should wait for a signal that a price reversal has occurred
  • %R can be used to gauge the six month trend for a security. 125-day %R covers around 6 months. Prices are above their 6-month average when %R is above -50, which is consistent with an uptrend. Readings below -50 are consistent with a downtrend. In this regard, %R can be used to help define the bigger trend (six months).
  • Like all technical indicators, it is important to use the Williams %R in conjunction with other technical analysis tools.


Understanding Stochastic oscillators.

Stochastic indicator:

The Stochastic oscillator is a technical indicator that shows the momentum. It is designed to oscillate between 0 and 100. Low levels mark oversold markets, and high levels mark overbought markets. Overbought means prices are too high, ready to turn down. Oversold means prices are too low, ready to turn up. Technical analysts believe that a value of 20 or below indicates an oversold condition and that a value of 80 or above indicates an over bought condition. This indicator was popularized by George lane decades ago and is now included in most software packages.

What does it measure?

The Stochastic oscillator measures the capacity of bulls to close prices near the top of the recent trading range and the capacity of bears to close them near the bottom. Bulls may push prices higher during the day, or bears may push them lower, but the stochastic oscillator measures their performance at closing time—the crucial money-counting time in the markets. If bulls lift prices during the day but cannot close them near the high of the recent range, the stochastic oscillator turns down, identifying weakness and giving a sell signal. If bears push prices down during the day but cannot close them near the lows, the stochastic oscillator turns up, identifying strength and giving a buy signal. An example of how Stochastics appears below the stock price chart is shown below:

Fast & Slow Stochastics:

There are 2 main types of setting, the Fast Stochastic and the Slow stochastic.
Fast Stochastics: use shorter Time Periods, and Shorter Averages – this creates more fluctuations but conversely also more false alarms
Slow Stochastics: use longer time periods and longer average periods – this creates a smoother flow and gives the ability to see trends clearer, the drawback is the Indicator lags price and is less responsive.

How is the indicator plotted?

The term stochastic refers to the location of a current price in relation to its price range over a period of time. The stochastic is plotted as two lines %K, a fast line normally represented by a blue line and %D, a slow line, normally red. These two lines have the following characteristics:
The default setting for the Stochastic Oscillator is 14 periods, which can be days, weeks, months or an intraday time frame. The %K line is basically a representation of where the market has closed for each period in relation to the trading range for the 14 periods used in the indicator.
The %D line is a 5 period moving average of %K.
Sounds very complicated, isn’t it? Don’t worry. You don’t need to learn about how combustion engine works to drive a car. What you need to do is to follow these simple rules.
Rule 1- Use the stochastic oscillator just like RSI to identify overbought and oversold levels in the market. When the lines that make up the indicator are above 80, it represents a market that is potentially overbought and when they are below 20, it represents a market that is potentially oversold. The developer of the indicator George Lane recommended waiting for the %K line to trade back below or above the 80 or 20 lines as this gives a better signal that the momentum in the market is reversing.

Rule 2- Watch for a crossover of the %K line and the %D line. When %D is below the 20 mark and the faster %K line crosses the slower %D line, it is a sign that the market may be heading up and when %D is above the 80 mark and the %K line crosses below the %D line this is a sign that the market may be heading down.

Rule 3- The third rule is to watch for divergences where the Stochastic trends in the opposite direction of price. As with the RSI this is an indication that the momentum in the market is waning and a reversal may be in the making. For further confirmation many traders will wait for the cross below the 80 or above the 20 line before entering a trade on divergence.

Rule 4- Never rely solely on Stochastics or any other technical indicator for that matter. Always use technical indicators as additional tools. Stochastics uses the Price Open, High, Low and Close for the period, so it can be used well in conjunction with RSI, which uses only Close Price as the input.

That completes our lesson on Stochastics. The nicest thing about the stochastic is that it can keep up with fast moving, volatile or even trading range markets.