November… What comes to your mind around this time of the year?
For me, there are three themes for the month:
- Year-end catching up with friends
- Bullish stock market
For the most part of the year, with the changing COVID situation… Catching up with friends in groups have been perpetually postponed, or relegated to individual meetups. (Hopefully the recent updates which took effect this week will give a boost to our reopening plans.) Travels are a bigger question mark despite the vaccinated travel lanes given the surging prices, atypical atmosphere and “what ifs”.
Well, let’s see if the bullish stock market proves to be the steadier theme of the three!
So far it seems that there have been encountering a little pullback along the way, so it pays to remain nimble and alert to market changes.
On that note, this article in our Beginner’s Guide continues the topic of Technical Analysis (TA). Specifically, I’ll introduce the categories of leading and lagging indicators, and then look at two of the four common types of indicators.
You may notice that a bit of it will already overlap with the earlier part in the overview of Fundamental Analysis (FA) vs TA. That is all good.
After all, mastery comes with repetition, right?
Categories of indicators: Leading vs lagging
While you may be eager to jump into the individual indicators, let’s first take a quick step back and look at the big picture.
When it comes to indicators, they are either leading or lagging in nature.
Leading indicators provide clues as to when a trend is about to start. They attempt to predict where prices are headed.
Lagging indicators, on the other hand, reveal clues only after the price action has occurred. The trend or reversal has already begun, and these are often used to confirm a trend.
Why it is important to differentiate the two, is because indicators are best used in combination.
Yet at the same time, it is not a case of having “the more the merrier”. There will be different signals given off, and attempting to combine a myriad of indicators might result in confusion – and thus paralysis.
Remember, indicators are supposed to help you time your entries and exits, not prevent you from taking action.
To get a better idea of what and how to use technical indicators, let’s get into the types of indicators and the most commonly used ones.
Types of indicators: #1 Trend indicators
If there is ONE universal law in which all traders can agree with, it would be this: The trend is your friend.
This is especially so as we realize how powerless we are, unable to influence the market in any way. What we’re trying to do is navigate our way in the stock market, ride the waves and stay afloat. If you have ever tried swimming against the ocean’s current, you would know how difficult that is.
In the case of profiting in the stock market, such contrarian moves are uncalled for as well.
So, trend indicators help you determine the direction and strength of the trend. These typically involve using some form of price averaging in order to have a baseline.
When the price is above that baseline, that makes a bullish trend. Conversely if it is below the baseline, then that would be a bearish trend.
Of course, your timeframe matters here as well. Trends can be short-term, medium-term, and long-term. Depending on your timeframe, the baseline would change accordingly.
Now let’s take a look at 3 of the commonly used trend indicators.
Moving averages (MA)
I’ve mentioned this in the previous part as well, and I have to say it again – simple doesn’t mean that it’s not powerful. On the contrary, it could be because it is so widely used that contributes to its strength and relevance.
Moving averages, as the name suggests, takes the average of the prices to plot a moving average line. Depending on your timeframe, you could use a combination of two (or more) moving averages to see changes in the trend. Moving averages often show areas of support and resistance as well.
For instance, you could plot both the 20-MA and 40-MA. When the gap between the two lines closes, that signals a weakening trend. If the 20-MA eventually crosses beneath the 40-MA, that would signal a reversal in the short-term trend.
Taking the example of Facebook’s chart, can you see that the 20-MA lags the price action, and only crosses beneath the 40-MA towards the end of September?
Do you also notice the gap between the 20-MA and 40-MA narrowing very much, almost as if the 20-MA might cross over the 40-MA at mid-November? Seeing that this is a lagging indicator, it is best used for what it does – providing confirmation as to directions and strength of the trend.
When it comes to support and resistance, do you also see that prices had bounced off the 40-MA support in July and August before rallying higher subsequently?
If you are an investor, these short-term averages would not have as much meaning to you. Instead, go for the longer-term 150-MA or 200-MA than to concern yourself with short-term price actions.
Parabolic stop and reverse (Parabolic SAR)
Unlike moving averages which are lagging and established as prices move, the parabolic SAR is a leading indicator which attempts to show where prices might be headed to.
This indicator appears as a series of dots on the chart, either above or below the price. When the dots are below the price, it indicates a bullish momentum. Which means if the dots are above the price, it is showing a bearish momentum.
When the dots flip, say, from being at the top to being at the bottom, this indicates that a potential reversal in trend is occurring from bearish to bullish.
Let’s take a look at this using the same Facebook chart:
If you had religiously followed the reversal signals, would you have profited or lost money?
Notably, parabolic SAR does not serve a trader well if the stock is trending sideways. We see this on the chart in June where the dots had flipped around for a fair bit, and subsequently again in July as well.
Moving average convergence divergence (MACD)
The MACD actually serves both as a trend indicator as well as a momentum indicator.
In setting its parameters, the typical values would be 26, 12 and 9. These values refer to subtracting the 26-period exponential moving average (EMA) from the 12-period EMA to form the MACD line. A 9-day EMA known as the signal line is then plotted on top of this MACD line. For further reading into the details, head over to this Investopedia article.
What we are interested to know next is how to work this indicator in our trades.
Technical signals are triggered when the MACD line crosses the line. Crossing above indicates a buy signal and crossing below indicates a sell. This is also reflected in histogram form, whether it crosses above or below the base line. That is, when the MACD line crossed above the signal line, the histogram would also cross above the base line.
Again, let’s see how this plays out in Facebook’s chart:
Similar to the parabolic SAR, there is a certain degree of profitability if a trader was to sell whenever the MACD crossed below the signal line, and buy if it crossed above.
Here, we also see one of the limitations of MACD, which is the “false positive”. While the signal may show a possible reversal, the reversal in price did not actually occur. This is more evident when prices trend sideways, such as in mid-June.
Types of indicators: #2 Momentum indicators
Momentum indicators identify the speed of price movements by comparing prices over time, such as comparing the current closing price to previous closing prices. These are also known as oscillators as the momentum oscillates around 100. Leading in nature, they measure the rate of change in prices, thus showing the strength or weakness in prices.
Importantly, these momentum indicators help to identify overbought and oversold conditions, which help a trader better time entries and exits in and out of the market. Here are three commonly used ones.
The stochastic oscillator compares the closing price to a range of its prices, over a specified period of time. Depending on its parameters, its sensitivity to market movements can be adjusted by means of the timeframe. This results in signals as to overbought and oversold conditions in the market, with values bounded in a range of 0-100%. For further reading into the details, head over to this Investopedia article.
Again, what we are interested in lies with application.
A reading over 80% is considered overbought, whereas below 20% would indicate oversold conditions. However, it is noteworthy that in strong trends, overbought and oversold regions do not necessarily indicate that a reversal would occur. Instead, the stock could remain well overbought or oversold for extended periods of time.
Applying this on the same Facebook chart, here’s what we get:
If one had simply entered a position whenever the stochastic oscillator had sank to the 20% region and sold whenever it had rose to the 80%, would he have profited? We see both yes and no answers in this case.
Buying in mid-July and selling about a week later proved profitable. Next, entering around 20th September and exiting around 18th October would have been a losing trade. Going back in at late October and exiting on 8th November also proved profitable.
How does it fare against the other momentum indicators though?
Relative strength index (RSI)
While the RSI also evaluates overbought and oversold conditions, it does so in a different method from the stochastic oscillator. Although it is also range-bound from 0-100, it measures the magnitude of recent price changes. For further reading, trusty Investopedia articles are here for us.
In terms of application, an RSI reading of 70% indicates overbought conditions, and 30% for oversold. The concept is the same as stochastic oscillator’s 80%-20% rationale.
Now let’s see compare the application results against the stochastic oscillator:
Unlike the stochastic oscillator, the RSI did not reach oversold levels as frequently. When it did in late September, and if a trader had entered a trade then – the price would be at about a breakeven level, although the RSI has yet to reach overbought levels.
That said, market technician Constance Brown has also “promoted the idea” that in an uptrend, the oversold reading is likely higher than 30%. Likewise, in a downtrend, overbought regions are likely much lower than the supposed reading of 70%. This would explain why the RSI did not actually reach the 30% reading although the stochastic oscillator did.
As you might gather by now, it is important to know how to work the respective tools in your trades.
Commodity channel index (CCI)
Last but not least, the CCI. I hope you are already acquainted with it by now. As you may have noticed, it was already featured in the earlier chart when showcasing MAs. This is because the MA-CCI combination is what we use when it comes to identifying swing trade set-ups.
So, what is the CCI anyway?
On the big picture, it measures the difference between the current price and historical average price. As with the stochastic oscillator and RSI, the calculations for CCI differ, but still provides signals as to overbought and oversold levels. Another difference is that CCI is not range-bound. For your further reading pleasure, head over to this article.
This means that instead of looking out for the 80-20 or 70-30 crossing, now we are looking at levels of above 100 for overbought, and below 0 for oversold readings. When it is above 0, price is above the historic average and if below, price is below the historic average.
Now on to application, let’s revisit the chart with the MA-CCI set-up:
One of the key conditions of a swing trade set-up, is that CCI should be below 0. Here, the parameters are a little different compared to the examples of stochastic oscillator and RSI. Do you see that the CCI is more reactive here, reaching overbought and oversold levels much more frequently?
Just looking at an entry when CCI is below 0 and an exit above 100… There would be some profitable trades here too, though it should be noted that this should not be the only condition when determining when to enter the trade.
Using trend & momentum indicators together
After looking at these six indicators and the charts, I’m sure you’ll be wanting to know which is the golden indicator to use and the parameters for it.
Well, my biasness leans towards MAs. Firstly because it is simple to understand, easy to use, and more importantly… It works really well.
To further bring out the “magic” of MAs, I normally pair it with a momentum indicator to help identify those overbought and oversold regions.
A simple execution of a swing trade would be during an uptrend, you see that the MAs are sloping up, both on the short and longer term. (You could be 20-MA and 40-MA for short term, or 50-MA and 150-MA for longer term.)
Then, when price has pulled back to the support on the MA, check that say the CCI is also below 0 so that it is indeed in the oversold region. This gives you a higher probability of prices bouncing back up on the uptrend pattern.
Having said that, do note that there isn’t a one-size-fits-all strategy.
Better still, do some back-testing on the indicators. Compare the results (similar to what I did above) and find the one which suits you best. By that, I mean suits your timeframe, strategy and personality.
And please, don’t use all six of them together, will you?
We’ve still got more indicators to look at in the next part. I can’t imagine the mess on your charts and how you might want to interpret the signals if you’ve got all of them happening at the same time.
It’s been quite a lengthy one, so let’s just do a quick recap.
Indicators are either leading or lagging. The two types of indicators covered are trend indicators and momentum indicators.
A basic method of having a set-up in place, is to use trend and momentum indicators together.
While calculations vary, we are more interested in application and the results it generates. Do test them out on your stock counters – the easiest pattern to spot would be whether it consistently bounces off the MA to climb even higher, heading from an oversold towards overbought region.
If you’ve gotten this down, congratulations! I hope you’re excited at seeing some results. (I know I was when I first started trading.)
The next part will be the icing on the cake, so stay tuned for it.
Can anybody start trading and investing on their own? If you’ve read up to this point, the answer is a resounding yes. Stay tuned to the next parts of the series as we adopt a systematic approach in generating a step-by-step beginner’s guide.
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