Technical analysis II

Types of indicators/Oscillators

Before moving on to the next lesson, here’s the summary of the last three lessons:

Technical indicators are tools that provide an indication about the condition or direction of the stock market. These indicators are generally used as additional information before one takes a decision to buy or sell a share. They provide unique perspective on the strength and direction of the market. Oscillators are a type of technical indicator. Most of the indicators work on the principle of averages.

For technical indicators, there is a trade-off between sensitivity and consistency. In an ideal world, we want an indicator that is sensitive to price movements, gives early signals and has few false signals (whipsaws).

Sensitiveness of an indicator/oscillator to price movements in the market would depend on the time interval for which the indicator is constructed. For example a 5 day RSI would be more sensitive than a 14 day RSI. The 5 period RSI would have more overbought and oversold readings. It is up to each investor to select a time frame that suits his or her trading style and objectives. The shorter the period selected, the more sensitive the indicator becomes.

If we increase the sensitivity by reducing the number of periods, an indicator will provide early signals, but the number of false signals will increase. If we decrease sensitivity by increasing the number of periods, then the number of false signals will decrease, but the signals will lag and this will skew the risk reward ratio.

From here on, for ease of understanding, we will discuss the prominent types of technical indicators/oscillators from the point of view of what exactly it measures. Whether it is leading or lagging and whether it’s signals are crossovers or not would be discussed at appropriate places.

Prominent indicators/oscillators.

Indicators that show the trend

  • Moving average
  • MACD (Moving average convergence/ divergence)
  • Average directional index.

Indicators that show momentum

  • RSI (relative strength index)
  • Stochastic oscillator
  • Williams %R

Indicators that measures volatility

  • Average true range
  • Bollinger bands

Before moving further, I would also like to explain in brief about the difference between trend, momentum and volatility.

Momentum- It measures the degree of acceleration in a stock price. It is a short term measurement. In other words, Momentum measures the speed of price change and provides a leading indicator of changes in trend. When momentum slows, this is taken to mean that there might be a change in direction. Momentum is significant because it signals  the strength of price trends

Trend – A trend can be defined as the general direction in which the market is moving in. A trend can be either upwards (bullish trend) or downwards (bearish trend) or sideways (lack of direction).

Volatility – The relative rate at which the price  of a stock moves up and down  If the price of a stock moves up and down rapidly over short time periods,  it has high volatility. If the price almost never changes, it has low volatility. In other words, Volatility refers to the amount of uncertainty about the swings in price of a stock. A higher volatility means that a stock’s value can potentially be spread out over a larger range of values. This means that the price of the security can change dramatically over a short time period in either direction. A lower volatility means that a security’s value does not fluctuate dramatically, but changes in value at a steady pace over a period of time.

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Oscillators

What are oscillators?

Oscillators are technical indicators that measure a stock’s momentum as it oscillates between an overbought and an oversold zone and then give a buy/sell signal. Oscillators have recently caught the fancy of most traders. Oscillators give out ‘crossover’ model signals to indicate a change in trend.
Oscillators are typically plotted in two ways.

  1. Banded oscillators: Plotted within a range between 0 and 100, in this method, the zone between 0 and 30 is considered the ‘oversold’ zone while the zone between 70 and 100 is considered ‘overbought’. When the oscillator reaches an extreme value in any end, either up or down, the implication is that price has moved too fast and too far. This would warn investor to be ready to face a sudden reversal or a period of consolidation or sideways movement. Investors should typically buy when oscillators feature in the lower end of the range and sell when the oscillator line reaches the upper end of the range.
  2. Centered oscillators: The other way to plot oscillators is on either side of a zero line and the oscillator moves between positive and negative values. Called ‘centered oscillators’, they fluctuate above and below a central point or line. These oscillators are good for identifying the strength or weakness, or direction, of momentum behind a security’s move. In its purest form, momentum is positive (bullish) when a centered oscillator is trading above its center line and negative (bearish) when the oscillator is trading below its center line. MACD (discussed later) is an example of a centered oscillator that fluctuates above and below zero.

What are ‘oversold’ and ‘overbought’ conditions?

  • Oversold is a condition where it appears that a stock has declined to the point where the selling is over and buyers will likely step in and push the stock higher.
  • Over bought is a condition where it appears that a stock has reached a price peak and is now likely to turn down.
  • However, overbought is not meant to act as a sell signal, and oversold is not meant to act as a buy signal. Overbought and oversold situations serve as an alert that conditions are reaching extreme levels and close attention should be paid to the price action and other indicators.

An example of relative strength index (RSI) , one of the most commonly used oscillators is given below.

oscillators

The blue line on the picture above is the stock’s RSI which moves within a band of 30 -70. When ever the RSI breaches the 30 mark it signals an oversold situation and the stock bounces back. The zone above 70 is considered as overbought. Note that the stock price has shown a drop in price after it breaches the upper limit of the band at 70.

A few words of caution

Too Many indicators and oscillators!

The best technical indicators are those that have in the past been tried, tested and proven successful. Nowadays, every other technical analyst develops a new technical indicator or oscillator regularly. There are hundreds of oscillators available. In fact, you ‘will be confused as to which one would give you good signals. Our advice to you is to follow the tried and tested indicators. Also, keep in mind the following points:

  • Do not attempt to master all technical indicators and oscillators. Just pick up knowledge in about three of them.
  • Do not analyse stock’s price by applying just one indicator – use about 2 or 3 complementary indicators, as using just one indicator may give you a false signal. Using 2–3 indicators can confirm the signals given by one indicator, but if you get a different signal from another complementary indicator then you must not rush into the trade.
  • Take your time to study. With time you will develop the art of judging profitable trades using technical indicators. Do not expect to morph into an expert on day one and carry out trades based on a knee-jerk assessment. First put your new found knowledge to test and begin trading only if you’re proven correct most of the time.

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How does a technical indicator work ?

How does a technical indicator work?

Technical indicators are derived from technical charts – which are graphical or pictorial representations of the market activity in terms of upward or downward movements in stock prices over a period of time. Mathematically, a technical chart is a plot of a set of price data (on the vertical axis) as a function of time (on the horizontal axis). The price data can include a stock’s opening price, closing price, day’s high or low price, average price, or a combination of these. The plotted data points on the chart can show as individual points or as small bars.

When all the data points on the chart are joined, a wave-like pattern is obtained. This pattern is then subjected to technical analysis by experts, who apply standard mathematical formulae to these price movements in order to arrive at technical indicators, from which they can predict the future market price of a stock or its market trend (upward/downward movement).

Types of signals- Crossovers and Divergence

The indicators show the signals in one of the two ways- through ‘crossovers’ or ‘divergence’. ‘Crossover’ indicators are constructed with an upper limit and a lower limit. When the limits set are breached, it signals that the trend in the indicator is shifting and that this trend shift will lead to a certain movement in the price of the underlying security.

Divergence means the direction of the price trend and the direction of the indicator trend moves in the opposite direction. This signals that the direction of the price trend may be weakening as the underlying momentum is changing. Divergence is a key concept.  Divergences can serve as a warning that the trend is about to change.

There are two types of divergences: positive and negative. In its most basic form, a positive divergence occurs when the indicator advances and the underlying security declines. A negative divergence occurs when an indicator declines and the underlying security advances.

The concepts of ‘crossovers’ and ‘Divergence’ would become clear to you once you learn more about indicators and oscillators.

How do technical indicators help the investor/trader?

If you have watched the stock market action on a computer screen, you would have noticed that stock prices keep fluctuating almost every second and it is impossible to make head or tail of the pattern if all the price movements are planted on a chart. So, to smooth out the data, technical analysts plot any one of the high/low/open/close/average prices on the charts. This also helps in understanding the movements of an extremely volatile stock and then predicting its future price movement. Technical indicators also help an investor in the following.

  1. They determine support and resistance levels. Even an amateur technical chartist can determine important technical levels, which when breached will take a stock’s price lower (support levels) or higher (resistance levels).
  2. Some indicators can help determine the future price of a share.
  3. Technical indicators help in establishing trends (upward or downward), which are critical for both traders and investors.
  4. Technical indicators always alert a technical analyst of any major price action/volatility is about to occur in a stock’s price. Even you will be able to interpret the alerts once you are through all the articles featured in this topic.

Next we need to look at something called ‘oscillators’. more about that in our next lesson.

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Introduction to technical indicators

What is a technical indicator?

In stock market analysis, a technical indicator is nothing but a tool that provides an indication about the condition or direction of the economy. Indicators take the form of calculations based on the price and the volume of a security and measures factors such as volatility and momentum. They are also used as a basis for trading as they can form buy-and-sell signals. Indicators provide an extremely useful source of additional information.

Technical analysis is broken into two main categories:-

  1. Chart patterns (discussed in technical analysis part 1)
  2. Indicators and oscillators  ( discussed below)

What does it offer?

Some technical indicators, such as moving averages are derived from simple formulas and the mechanics are relatively easy to understand. Others, such as stochastic, have complex formulas and require more study to fully understand and appreciate. Regardless of the complexity of the formula, technical indicators can provide unique perspective on the strength and direction of the underlying price action.

Types of indicators:

There are basically two types of indicators based on what they show users:

  1. Leading indicators
  2. Lagging indicators.

Leading indicators, as their name implies, are designed to ‘lead’ price movements. That is-the indicators move first and price action follows. Some of the more popular leading indicators are commodity channel index, Momentum, relative strength index, stochastic oscillators and Williams %R.

The advantage of using leading indicators is that the signals act as warning against a potential strength or weakness. Leading indicators are more ‘sensitive’ to price fluctuations.

Lagging indicators as their name implies, follow the price action and are commonly referred to as trend-following indicators. It has less predictive qualities. The usefulness of lagging indicators tends to be lower during non-trending periods but highly useful during trending periods. This is due to the fact that lagging indicators tend to focus more on the ‘trend’ and produce fewer buy-and-sell signals. This allows the trader to capture more of the trend instead of being forced out of their position based on the volatile or sensitive nature of the leading indicators. Moving averages and Bollinger bands are examples of lagging indicators.

Where to find these indicators?

Most of the common indicators and oscillators are available readily on your online trading platform screen.

Know it:

  • Always remember- Technical Indicators are sources of additional information.
  • The purpose of indicators is to ‘indicate’. This may sound very straightforward, but sometimes investors ignore the price action of a security and focus solely on an indicator. Indicators filter price action with formulas. As such, they are derivatives and not direct reflections of the price action. This should be taken into consideration when applying analysis. Any analysis of an indicator should be taken with the price action in mind. What is the indicator saying about the price action of a security? Is the price action getting stronger? Weaker?
  • Indicators should be studied in context of other technical analysis tools. An indicator may show a buy signal but the chart pattern and fundamentals may be weak.
  • There are two types of indicators – leading (one that leads the price change) and lagging indicators(one that follows the price action)

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