Technical analysis II

Understanding RSI (Relative strength Index)

Introduction

The name “Relative Strength Index” is slightly misleading as the Relative Strength Index does not compare the relative strength of two securities, but rather the internal strength of a single security.  Relative Strength Index (RSI) is a very popular momentum indicator.

What does it measure?

RSI measures the speed and change of price movements. RSI oscillates between zero and 100. When the RSI line moves higher, it is understood that price is enjoying increased strength and as the RSI line moves lower, it is understood that the price is suffering from a lack of strength. However, technical analysts believe that a value of 30 or below indicates an oversold condition and that a value of 70 or above indicates an over bought condition.

When Wilder introduced the Relative Strength Index in 1978, he recommended using a 14-day Relative Strength Index.  Since then, the 9-day and 25-day Relative Strength Indexes have also gained popularity. The most popular is the 14 day RSI. Shown below is an example of how the RSI would be displayed below your stock prices chart

Tips for Using the RSI Indicator

  • As with all technical indicators, RSI is a way of measuring odds – it’s not a full-blown, fool-proof ‘system’ to gauge price trends. It is usually best used in conduction with other indicators.
  • Though considered an oscillator, the relative strength index has qualities of momentum indicators, and can be used in that capacity. For instance, some investors interpret a cross of the 50 level (the mid-point of the scale) as a signal of momentum – bullish or bearish – in itself.
  • If the stock has been trending up, but the relative strength indicator starts to trend down, there is a divergence and you would prepare to enter a bearish trade (down direction). It’s the vice versa for bullish trades.
  • Once the stock becomes overbought (RSI reaches the point 70) or oversold (RSI at 30), or has price divergence you should always wait for some type of confirmation that a price reversal has indeed occurred.
  • RSI should not be used in isolation. It must be used in combination with other indicators to help build a clear picture.
  • The RSI oscillator should not be confused with another trading tool – unfortunately called – the ‘Relative strength’. The other tool compares a stock’s or index’s performance to other stocks or indices in a group, and ranks that stock or index, assigning a ‘relative strength’ score. The other tool is powerful too, but is unrelated to the RSI indicator discussed here.

RSI is a versatile momentum oscillator that has stood the test of time. Hope you have got information about RSI and how it can be used to take decisions.

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Understanding Average Directional Index (ADX)

Introduction:

Average directional index evaluates the strength of the current trend, be it up or down. The ADX is an oscillator that fluctuates between 0 and 100. The indicator does not grade the trend as bullish or bearish, but merely assesses the strength of the current trend. A reading above 40 indicates that the trend is strong and a reading below 20 indicates that the trend is weak. An extremely strong trend is indicated by readings above 50.

What does it measure?

ADX does not indicate trend direction, only trend strength. It is a lagging indicator; that is, a trend must have established itself before the ADX will generate a signal that a trend is underway.

ADX can also be used to identify potential changes in a market from trending to non-trending. When ADX begins to strengthen from below 20 and moves above 20, it is a sign that the trading range is ending and a trend is developing.

The ADX indicator does not provide buy or sell signals for investors. It does, however, give you some perspective on where the stock is in the trend. Low readings and you have a trading range or the beginning of a trend. Extremely high readings tell you that the trend will likely come to an end.

Overall, what is important to understand is that this indicator measures strong or weak trends. This can be either a strong uptrend or a strong downtrend. It does not tell you if the trend is up or down, it just tell you how strong the current trend is.

Construction of ADX.

We will not go into the formulas for the Indicator here. However what we need to know is that:

  • ADX is derived from two other indicators
  • The first one is called the positive directional indicator(sometimes written +DI) and the second indicator is called the negative directional indicator(-DI)
  • The +DI Line shows how strong or weak the uptrend in the market is.
  • The -DI line shows how strong or weak the downtrend in the market is.
  • ADX is the average of the above two lines and hence, it shows the strength of the current movement.
  • On screen, the ADX appears below the stock price chart. The +DI (normally a green line) and –DI lines (red line) would accompany the ADX (Black line). So you see three lines as shown in the figure below.

More tips:

  • When the ADX starts rising from a low level it signals the beginning of a trend.
  • The trend is confirmed when the ADX has risen above the 20-25 value and the +DMI line has crossed the –DMI line (in case of an uptrend).
  • The ADX signal generally does not move above 60 or 70. ADX above these levels are considered to be ‘over bought’ levels. When the ADX has reached an overbought level and starts consolidating it can signal the end of the current trend.
  • The decline of the ADX signals the consolidation or indecision of the market.
  • When the ADX drops below 10, the current trend is virtually dead. Be ready for the beginning of a new trend – bullish or bearish. Don’t assume that since your current position has given you an ADX reading of 10 (or lower) implying that your trend is over and that the subsequent ADX move above 20 will take you in the opposite direction. That’s a terribly wrong assumption.
  • An ADX reading above 20 implies the “beginning” of a new trend; whereas; a rise above 25 implies a “trending” market; even a bearish market. So, know this – it is possible to have a reading of 35 and the market can be falling like a rock. An upward moving ADX does not specify market direction – only market trend. This is a very important point to note.

That completes our lesson on ADX. More about indicators in our next lesson.

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Understanding MACD

Developed by Gerald Appel in the late seventies, Moving Average Convergence-Divergence (MACD) is one of the simplest and most effective indicators available.

The two components of MACD.

The MACD indicator is comprised of two exponential moving averages (EMA), covering two different time periods, which help to measure momentum in the security. The two exponential moving averages are the 12 period EMA and the 26 period EMA.  The MACD is the difference between these two moving averages. A 9-day EMA of MACD is plotted along side to act as a ‘signal line’ to identify turns in the indicator. MACD is all about the convergence and divergence of the above said two moving averages.

Histogram

Another aspect to the MACD indicator that is often found on charts is the MACD histogram. Thomas Aspray added a histogram to the MACD in 1986. The MACD-Histogram represents the difference between MACD and its 9-day EMA, the signal line. The histogram is positive when MACD is above its 9-day EMA and negative when MACD is below its 9-day EMA.
What’s said above would be clearer if you follow the MACD signal given below. The idea behind this momentum indicator is to measure short-term momentum compared to long-term momentum to help determine the future direction of the asset. Note that the red line is the 9 day average of the MACD (and not of the stock price).

MACD signal is available on any standard online trading screen. Your online trading screen will have the option to select the MACD signal from the choices of technical indicators. The exact location of this operation varies between trading screens, but will almost always be titled “technicals” ,”indicators,” “studies,” “oscillators” or “analysis.” It may be a button on the chart, an option available by right-clicking on a chart or a menu above the chart. MACD signal will be displayed below the stock price chart.

It generates three meaningful signals for the investor: They are

  1. Crossover signal 1- MACD line crosses the signal line.
  2. Crossover signal 2- MACD Line crosses the line ‘Zero’(center line)
  3. Divergence signal- MACD line ( or histogram)  and the price of the stock (as seen on the price graph) diverge (i.e. moves in the opposite direction)

You must also read: How to read the signals generated by MACD to get a firm grip on the subject.

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Understanding Moving average

An average that moves!
As its name implies, a moving average is an average that moves. They do not predict price direction, but rather show the current direction with a lag. Moving averages are based on past prices, which mean they will lag behind current prices. It will be presented in graphical form on your online stock trading terminal. Moving averages form the building blocks for many other technical indicators and overlays, such as Bollinger bands and MACD (explained later in this section). Most analysts use the 50 day, 100 day and the 200 day moving averages.

The 200-day moving average is the important moving average.

Example: To begin calculating a 200-day moving average of Infosys, the closing prices of Infosys over the last 200 days would be added together, and then divided by 200. That provides the average price at which Infosys was sold over the last 200 days. That point would be marked on the chart today. To make the average move, each subsequent day the same process is repeated, and the new point is added to the chart. After a few weeks you have the 200-day moving average moving along the chart where its relationship to Infosys’s price each day can be seen. Note that in calculating the moving average each day, the oldest of the 200 closes is dropped and the new day’s close is added (Only the prices over the most recent 200 days are added together and divided by 200 each day).

So, the 200-day moving average is simply a share’s average closing price over the last 200 days. The 200-day moving average is perceived to be the dividing line between a stock that is technically healthy and one that is not. Furthermore, the percentage of stocks above their 200-day moving average helps determine the overall health of the market. Many market traders also use moving averages to determine profitable entry and exit points into specific securities.

Purpose of moving averages:

Primary function of a moving average is to identify trends and reversals, measure the strength of an asset’s momentum and determine potential areas where an asset will find support or resistance.

Moving averages are easier to see and analyse on a chart. There are different types of moving averages-simple moving average (explained above) and exponential moving average. The Exponential Moving Average differs from a Simple Moving Average both by calculation method and in the way that prices are weighted. The Exponential Moving Average (shortened to the initials EMA) is effectively a weighted moving average. With the EMA, the weighting is such that the recent days’ prices are given more weight than older prices. The theory behind this is that more recent prices are considered to be more important than older prices, particularly as a long-term simple average (for example a 200 day) places equal weight on price data that is over 6 months old and could be thought of as slightly out-of-date.

A moving average can be a great risk management tool because of its ability to identify strategic areas to stop losses.

What is the right moving average?

Moving averages come in various forms, but their underlying purpose remains the same: to help technical traders track the trend of financial assets by smoothing out the day-to-day price fluctuations. There is nothing called ‘right moving average’. A 50-day moving average should be right for the intermediate term and 150 or 200-day moving average should work well for a long term investor.

You must also read :  8 points to keep in mind while using moving average.

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