Table of Contents:
- Ichimoku Cloud Trading Strategy Explained
- MACD Indicator: How to Use the MACD Indicator
- 5 Indicators that Foretold the 2008 Crash
- Understanding On Balance Volume (OBV) and How to Use It
- Volume Analysis: How to Analyze Trading Volume
- Relative Strength Index (RSI): How to Use It
- Coppock Curve: How to Use The Coppock Curve
- How to Use the Bollinger Bands
- Williams %R Indicator – How to Use It
- Stochastic Oscillator: How to Use Stochastic Oscillator Indicator
- Vortex Indicator: How to Use the Vortex Indicator
- Everything You Need to Know About Market Breadth Indicators
- Guide to the Average True Range (ATR) Indicator
- Put-Call Ratio: How to Use the Put-Call Ratio
- The Visual Guide to Bullish Reversal Patterns
- TRIX Indicator – Triple Exponential Average
- The Visual Guide to Bearish Reversal Patterns
- Arms Index (TRIN): How to Use Arms Index TRIN
- How to Use the Mass Index
- 10 Stock Market Indicators for Successful Investing
- Volatility Trading: Strategies to Trading the VIX Successfully
- Guide to the Average Directional Index (ADX) Indicator
- Force Index Indicator: How to Use the Force Index
Ichimoku Cloud – Ichimoku Cloud Trading Strategy Explained
The Ichimoku Cloud is an indicator designed to tell you everything you need to know about a price trend, including its direction, momentum, dynamic support and resistance levels, and even trade signals. The Japanese name—Ichimoku Kinko Hyo—means “one look (or glance) equilibrium chart.”
At first, the Ichimoku Cloud actually looks a little scary when applied to the chart, but once you know how to use it, it’s easy to understand and helpful, especially if you’re a newer trader and want potential support and resistance areas and trend direction highlighted for you.
What Is the Ichimoku Cloud?
Goichi Hosoda, a Japanese journalist, released this indicator in his 1969 book, which revealed about three decades worth of trading research.
Ichimoku Cloud includes five lines, each giving information about the price action. The distance between two of these is filled in, creating a cloud-like appearance. For many traders who use this indicator, the “cloud” is the dominant factor, and what they focus on.
Ichimoku Cloud can be used on various time frames or markets.
All charts courtesy of FreeStockCharts.com.
Ichimoku Cloud Components and Calculations
The following calculations are based on default indicator values, such as using nine periods for the Conversion Line. These defaults can be easily adjusted on a charting platform, such as FreeStockCharts.com or StockCharts.com, to suit an individual trader’s needs.
The red line in Figure 1 is Tenkan-Sen (Conversion Line). It’s the midpoint of the last nine price bars: [(9-period high + 9-period low)/2].
The white line is Kijun-sen (Base Line). It’s the midpoint of the last 26 price bars: [(26-period high + 26-period low)/2].
The yellow line is Senkou Span A (Leading Span A). It’s the midpoint of the above two lines: [(Conversion Line + Base Line)/2]. This value is plotted 26 periods into the future.
The blue line is Senkou Span B (Leading Span B). It’s the midpoint of the last 52 price bars: [(52-period high + 52-period low)/2]. This value is plotted 26 periods into the future.
The green line is the Chickou Span (Lagging Span), and will always lag behind the price; it’s the most recent price, plotted 26 periods back. This line is not used in the methods described below, and therefore has been removed in those associated figures to reduce chart clutter.
How is Ichimoku Cloud Used?
The cloud offers the most potential for traders, since it is easy to interpret and provides predictive support and resistance levels projected out 26 periods from the current period. Here are the ways the cloud is used to assess price action.
- Trend Confirmation: When the price is above the cloud it indicates an uptrend, when the price is below the cloud it indicates a downtrend.
Trend Strength or Weakness: When Span A (yellow) is moving up and away from Span B (blue) it indicates the uptrend is gaining momentum. When Span A is moving down and away from Span B it indicates the downtrend is accelerating. In other words, a thickening cloud helps confirm the current trend. A very thin cloud shows indecision, and a potentially weak or weakening trend.
Support and Resistance: The cloud is projected out 26 price bars to the right of the current price, providing an idea of where support and resistance may develop in the future. During an uptrend, the price will often bounce off the cloud during pullbacks and then resume the uptrend. During a downtrend, the price will often retrace to the cloud and then continue lower. Therefore, the cloud presents entry opportunities into the trend.
Crossover Signals: If the trend is up (price above cloud and Span A is above Span B), and the Conversion line falls below the Base line and then rallies back above it, it signals a long entry. If the trend is down (price below cloud and Span A is below Span B), and the Conversion line rallies above Base line and then drops back below it, it signals a short entry.
Another entry signal involves the price and the Base line (can also use Conversion line). If the trend is up and the price drops below the Base line, buy when the price rallies back above the Base line. If the trend is down and the price moves above the Base line, short sell when the price drops back through the Base line.
Notice how these tactics capitalize on the current trend. By understanding how the indicators confirm a trend, they can also be used to show when a trend is reversing.
Interpreting Ichimoku Cloud
Even on the choppy, yet trending, JCP daily chart in Figure 2, the Ichimoku Cloud indicator would have been useful.
At the far left the price is in a downtrend, but when the cloud fails to act as resistance, and price moves above it, that movement signaled a potential trend reversal. Now that the price is above the cloud, the cloud acts as support, and provides several trade signals to get into the emerging uptrend.
Figure 3 shows a very strong downtrend in TWTR as the price trades well below the cloud and the cloud is also quite thick throughout the significant declines. One short trade is provided by the price crossing above the Base (or Conversion) line and then dropping back below. As the price rises in June, the Cloud narrows, showing the downtrend is losing momentum. In late July the price breaks definitively above the cloud, indicating a trend reversal.
Ichimoku Cloud Limitations
Like most indicators, Ichimoku Cloud only gives information on the time periods being analyzed, even though the cloud is projected out into the future. This means there may be larger trends at work that the indicator doesn’t account for, and false trade signals or data may be generated. For example, the dominant trend may be down, but the price could rally above the cloud on a retracement, only to continue falling within the downtrend a short time later.
The cloud is also just essentially a pair of moving altered moving averages, which may or not provide support during an uptrend, or resistance in a downtrend.
All calculations are also based on historical data, which means trade signals may appear late or at inopportune times, because historical short-term tendencies (which the indicator captures) may not repeat in the future.
While entry signals are provided, traders will need to determine where to take profits (See: 3 Ways to Exit a Profitable Trade), and also how to control risk on each trade via a stop loss order (See: 4 Ways to Exit a Losing Trade).
The Bottom Line
The Ichimoku Cloud is a useful indicator, especially for new traders who want some help with gauging trend direction, momentum, spotting trend reversals and finding entry points. Traders will still need to control risk with a stop loss and also find a way to profitably exit trades. With all its lines, the Ichimoku Cloud can appear scary, but basically if the price is below the Cloud, the trend is down; look for short positions and avoid long positions. When the price is above the Cloud, the trend is up; look for long positions and avoid short positions.
Macd Indicator – MACD Indicator: How to Use the MACD Indicator
Technical analysis indicators condense price information, providing analytical insight and trading signals which may not be obvious on a stock’s price chart. The Moving-Average-Convergence-Divergence (MACD) indicator fluctuates above and below zero, highlighting both the momentum and trend direction of a stock. Utilizing the MACD effectively requires understanding how it works, its functions and applications, as well as its limitations.
What is the MACD Indicator?
Gerald Appel developed the MACD in the 1970s, and it is one of the most popular indicators in use today. Traders use the MACD for determining trend direction, momentum and potential reversals. It is used to confirm trades based on other strategies, but it also provides its own trade signals.
Figure 1 shows the MACD applied to a daily chart of Apple (AAPL) stock.
Two lines compose the MACD: the MACD line and Signal line. These lines move together, except the MACD moves faster as the Signal line is a moving average of the MACD line.
The MACD Histogram that oscillates above and below zero shows the extent to which the MACD line is above or below signal line. The histogram provides a short-term view on recent momentum and direction. When the histogram is above zero, recent movement has been higher; below zero and the recent momentum was down. The greater the histogram value the greater the momentum of the recent move.
The Histogram is not always shown as part of the MACD indicator as many traders prefer to focus on the how the two lines (MACD and Signal) are interacting. These two lines are the source of most MACD strategies and price analysis.
The MACD is calculated as follows:
MACD Line = 12day EMA – 26day EMA
Signal Line = 9day EMA of MACD Line
EMA stands for exponential moving average.
The MACD Histogram is the MACD Line – Signal Line
Trading with the MACD Indicator
There are three primary uses for the MACD indicator, each offering advantages and disadvantages. Combing all three functions will help eliminate some losing MACD trade signals, as will using the MACD in conjunction with other indicators and price analysis.
Moves across the zero line on the indicator represent times when the 12day EMA is crossing the 26day EMA. When the MACD crosses the zero line from below, a new uptrend may be emerging. When the MACD crosses the zero line from above a new downtrend may be emerging.
Figure 2 shows several zero line crossovers in International Business Machines (IBM).
The strategy is to buy when the MACD crosses above the zero line, and sell (or take short positions) when the MACD line (black) crosses below the zero line. During choppy conditions this results in losing trades, and is profitable when strong trends emerge.
Hold long trades until the MACD crosses back below the zero line. Hold short trades until the MACD crosses above the zero line. This strategy is very basic and doesn’t have a stop loss, which means risk is not controlled. To utilize this strategy, traders need to implement their own form of risk control (see next section)
Zero line crossovers also confirm trends. When the MACD line is above zero it helps confirm uptrends and other strategies that indicate taking long positions. Below zero, the MACD confirms downtrends and taking short trades based on other strategies.
Signal Line Crossovers
Signal line crossovers provide better timing, and are preferred by most traders to zero-line crossovers.
With this method, a buy signal occurs when the MACD line crosses above the Signal line.
A sell (short) signal occurs when the MACD line crosses below the Signal line. Figure 3 shows IBM again, this time using Signal line crossovers. The buy and sell signals occur earlier in the price move than zero-line crossovers, potentially providing better entry and exit prices.
Since the MACD is an indicator, and not a trading system, there is no stop loss. For buy signals a stop can be placed below a recent low, and for short signals a stop can be placed above the recent high.
There are no built in targets, so trades are held until a crossover in the opposite direction occurs. New trades can then be initiated in the new crossover direction.
The downfall of this strategy is that it can result in “whipsaw” trades, when the MACD and Signal lines cross back and forth in a short amount time.
One way to avoid some whipsaws is to only take trades in the direction of the long-term trend. If the trend is up, only take a buy signals, and exit when the MACD line crosses back below the Signal Line.
Bearish divergence is when the price is making new highs, but the MACD isn’t. It shows that momentum has slowed, and a reversal could be forthcoming.
Bullish divergence is when the price is making new lows, but the MACD isn’t. It shows selling pressure has slowed, and a reversal higher could be around the corner.
Until divergence is confirmed by an actual turnaround in price, don’t base trades simply on divergence. A stock can continue to rise (fall) for a long time even while bearish (bullish) divergence is occurring.
In Figure 4 the price tries to make a new low in late March, but the MACD is already making higher highs. This indicated the move lower would potentially fail and a rally would ensue.
In May the price makes a new high but the MACD is making a lower high. This warns buying pressure has slowed and that the move higher could fail.
Adjustment and Limitations
The MACD line is based on the difference between the 26-day and 12-day EMA (see calculation). The Signal line is a 9-period EMA of the of the MACD line. Increasing the number of periods for the Signal line will reduce the number of crossover signals, helping avoid false signals. The drawback is that trade signals will occur later in the price move than they would with a shorter Signal line EMA.
Figure 5 shows this in action. Two MACD indicators are shown; the top one uses a 9-period signal line and bottom one uses a 26-period signal line.
The top one has more crossovers, but gets you into the long trade soon. The bottom one gets you into the trade later, but there are no crossovers, letting you to profit more from the extended uptrend.
The MACD is a useful indicator but it isn’t perfect. The Indicator is prone to “false signals” – providing a trade signal just as the price is turning the other way. The MACD also doesn’t come with built in risk controls or profit targets – it is just an indicator, not a strategy. Traders need to therefore implement their own risk and profit management tactics.
Divergence is a useful tool and warns a trend has slowed down, but this doesn’t mean price will reverse. Even if the price does reverse, divergence doesn’t tell you when that will occur.
The Bottom Line
If the MACD is above zero it helps confirm an uptrend; below zero and it helps confirm a downtrend. Zero line and Signal line crossovers are used as trade signals to enter and exit trending trades. Losing trade signals occur when crossovers occur in rapid succession due to choppy price action. Divergence shows when momentum is slowing, but it doesn’t indicate when a reversal will occur (if it occurs).
Combing different elements of each strategy makes the indicator more useful, such as taking buy signals following a bullish divergence. Using price and trend analysis will aid in determining which signals to take, such as only taking buy signals when a long-term uptrend is in place.
Darvas Box – 5 Indicators that Foretold the 2008 Crash
Traders have access to countless tools designed to help predict future price movements, ranging from technical to economic indicators. While no individual indicator can definitively predict a market rally or decline, savvy traders can draw conclusions by looking at the story that multiple indicators are telling. The 2008 crash provides an excellent example of how certain readings can predict problems.
In this article, we will take a look at five indicators that foretold the 2008 crash and how savvy traders could have taken advantage of the knowledge. Traders should keep in mind, however, that every bear market is different and the same indicators may not apply during the next bear market that hits.
#5. Monthly Supply of Homes
A house is the single largest asset that most people own, accounting for a significant portion of their overall net worth. Demand for housing is typically driven by high levels of employment and rising wages, while a contraction in the economy leads to slower home sales and a glut of supply. In 2008, the collapse in U.S. housing prices was a crucial contributor to the subsequent global financial crisis.
See Also: Ten Commandments of Futures Trading
Data from the U.S. Federal Reserve suggests that housing supply may be an accurate predictor of pending U.S. recessions. In the 1970s, 1980s, and 1990s, a sharp rise in housing supply was immediately followed by a recession. The rise in supply could have been attributed to overconfidence on the part of homebuilders or simply a growing lack of demand among homebuyers as the market became overheated.
See Also: 4 Ways To Exit A Losing Trade
#4. Market Caps vs. GDP
Billionaire investor Warren Buffett has often said that the ratio of market capitalization to gross domestic product (“GDP”) is the single best measure of where valuations stand in the equity markets. When the metric stands at greater than 100% of GDP, the Oracle of Omaha believes that investors should be wary about holding common stocks, since they may be overdue for a correction.
In 2007, as the housing bubble was bursting, the ratio of market capitalization to GDP stood at over 100%, suggesting that the market was significantly overvalued and due for a correction that ultimately took place the following year. Even before the 2008 crisis, the same metric could have been used to predict the dot-com bubble and many other market-crashes throughout U.S. history.
#3. Tobin’s Q
James Tobin is a well-known economist that developed the fundamental principles surrounding Keynesian economics and advocated for government intervention to stabilize output and avoid recessions. Ironically, one of his post popular indicators Tobin’s Q has become popular in Austrian economics circles as a way to predict market downturns by looking at the ratio between market and replacement values.
Tobin’s Q is calculated by dividing the value of the stock market by total corporate net worth. If the ratio is greater than the ~0.7 mean, the market may be topping as was apparent during the 2008 housing crisis and the 1999 tech bubble. Investors buying stock only during low-Tobin’s Q periods in the 1980s and 1990s would have enjoyed stronger returns than the market averages have produced.
#2. Historical P/E Ratios
The price-earnings (“P/E”) ratios is perhaps the most common metric used by investors to value publicly traded companies. While it does not account for growth rates by default, it represents a simple metric that can be compared over long periods of time. Lofty P/E multiples can predict market declines when growth starts to slow down, since investors can no longer justify the higher valuations.
In general, the S&P 500’s historical mean P/E ratio has been 15.51x with a median P/E ratio of 14.54×. These numbers are significantly lower than the greater than 60x P/E ratios seen during the 2008 market crash, as shown in Figure 4 above. In the past, similarly high P/E ratios relative to the long-term mean were seen during the 1999 and 2001 recessions when valuations soared higher.
#1. Jobless Claims
Employment indicators are among the most watched economic indicators, for a good reason: consumer spending, which is fueled by gainful employment and rising wages, drives the U.S. economy. Jobless claims represent a good proxy for determining the strength of the U.S. workforce, since it directly measures those filing for unemployment claims rather than relying on a survey.
In the years leading up to the 2008 crash, jobless claims hit a low and then began rapidly accelerating. Similar dynamics were seen before other market crashes in the 1990s and 2000s. While jobless claims tend to quickly drop after a recession, traders should keep in mind that other dynamics may be at play, including changes in discouraged workers and consumer spending trends.
The Bottom Line
There are many different indicators that foretold the 2008 crash, as well as similar crashes that happened throughout history. Traders should keep these indicators in mind, but should also realize they may not always apply to future crashes. For example, quantitative easing and other unconventional monetary policy may have changed the market’s dynamics when comparing the current situation to historical norms. Check out VTI for an ETF that tracks the total U.S. stock market.
On Balance Volume – Understanding On Balance Volume (OBV) and How to Use It
On Balance Volume (OBV) was developed by Joe Granville in the 1960s and somewhat revolutionized trading indicators. Not only did the indicator consider volume, but also whether volume was pushing prices up or down. The indicator therefore acts as a confirmation tool for price trends, and when OBV and price are moving in opposite directions, it indicates that a price trend reversal could soon develop. Being able to utilize OBV requires an understanding of how the indicator operates, how it can be used to aid trading decisions, and its limitations.
Pick a starting point based on historical data. If it was an up day (moved above prior close), note the volume for that day as a positive number, for example +1,200,000. If it was a down day (moved below prior close), note the volume as negative, for example -1,200,000.
If the next day is positive add the volume to the prior volume.
If the next day is negative then subtract the volume from the prior total.
Keep a running total, adding volume on up days, and subtracting volume on down days. If a stock (or other market) closes at the same level as the prior close, there is no change to OBV.
Be sure to see our guide to Analyzing Trading Volume.
OBV is simply a running total of volume, but it can provide insight because it is dependent on quantity of volume, and not only whether the price moves higher lower. For example, a down day with 1,000,000 volume is not as significant if the next up day has 5,000,000 in volume. The volume indicates buyers are very active in pushing the price up, and therefore OBV will move up over the two day period, even though one day was down and the other up.
The actual OBV value isn’t important, since the number can be huge, near zero, negative or positive. Therefore the right axis of the OBV indicator can be ignored; what matters is how OBV is acting, and its trajectory.
All charts courtesy of StockCharts.com.
OBV Uses and Strategies
OBV is primarily used as a confirmation tool for trends, but is also believed to foreshadow price reversals because changes in volume will often precede major price changes. Based on this assumption—please read the OBV Limitations section below for more on this topic—the OBV indicator is used in three primary ways: confirmation, divergence and breakouts.
Confirmation was already shown in Figure 1. OBV should rise when price is rising, and fall when price is falling. This helps confirm the current price direction is likely to continue. Since prices move in waves, OBV will also typically reflect this. Use trendlines to indicate the current direction in both the price and OBV.
See also Trend Trading 101.
Since OBV can confirm price trends, it can also warn when price is about to change direction. Divergence is a warning signal, and occurs when the price is trending higher but OBV is either flat or dropping overall, or when the price is falling but OBV is flat or rising overall.
If the price trend is up, and OBV is now dropping (bearish divergence), take a short position when the price breaks below its current trendline. Place a stop loss above the most recent swing higher in price. Hold the trade for as long as OBV confirms it, and the price is trending lower. Exit if the price breaks above its trendline.
If the price trend is down, and OBV is now rising (bullish divergence), take a long position when the price breaks above its current trendline. Place a stop loss below the most recent swing lower in price. Hold the trade for as long as OBV confirms it. Exit if the price breaks below its trendline.
As divergences show, OBV can act before price, also making it a useful tool for indicating in which direction a price breakout could occur.
In figure three OBV breaks below support, but price doesn’t … at least not initially. As OBV continues to decline, though, eventually the price breaks below support, following the direction of OBV, which acted first.
Be sure to also read our Ultimate Guide to the MACD Indicator.
Granville believed that a change in volume direction, reflected by the OBV, will always occur before the price changes direction. Unfortunately, it’s not that easy; while the OBV may help forecast many reversals, it often does so because it forecasts too many, providing a large number of false signals along with the valid ones.
Another limitation of the OBV indicator is that a massive volume spike day can throw off the indicator for months. An earnings announcement, index rebalancing or institutional block trade can cause the indicator to spike or plummet, but the volume spike may or may not be relevant information.
Note how in Figure 4 a massive volume spike in June causes the OBV to plummet. OBV does begin to rise again in August and September to confirm the price rally, but the massive drop in June still makes the indicator and stock appear rather weak, which could have led traders to avoid a very nice rally, or worse yet, short it based on a divergence.
The Bottom Line
OBV is a simple running total of up day (added) and down day (subtracted) volume. If OBV is moving with price it confirms the current trend. Divergences between OBV and price indicates the price may be due for a reversal. Using trendlines can aid in spotting divergences and trading opportunities. OBV can also help forecast breakout directions in price. OBV is not without its faults though. Volume spikes can skew the indicator, making objective analysis more difficult. Also, while it may appear that OBV often leads price, this is often simply a case of searching for evidence we wish to find. Therefore, OBV is a tool to be used in addition to price analysis, but shouldn’t be relied on solely.
Volume Trading Strategy – Volume Analysis: How to Analyze Trading Volume
Volume is representative of how many shares change hands in a stock, and as such, it indicates the interest in a security. Since each stock is different, and has a different amount of shares outstanding, volume can be compared to historical volume within a stock to spot changes, or compared to other stocks to find which are suitable for trading. Volume is also used to confirm price trends, breakouts, and spot potential reversals. Volume has also been implemented into indicators, which can aid in analyzing stocks (and other markets).
Volume is important because it shows the level of interest in a stock. Current volume in a stock, relative to prior volume, shows if interest is higher or lower in a stock than it was before. High volume, or relatively high volume (compared to prior volume), is more suitable for active traders. Very low volume typically indicates a lack of interest and usually little price movement.
Volume is also significant for screening stocks (See our 10 Best Stock Screeners). Average volume—the the typical volume seen in a day over a period time—helps greatly in this regard. Day traders need to be able to get in and out of a stock quickly and with ease, so they will want to trade stocks with high daily volume – typically 1 million shares at absolute minimum.
Swing traders and investors have a little more leeway and therefore may trade stocks with lower volume, around 500,000 and 100,000 shares or more per day, respectively. They still want stocks that have enough volume to get in and out when they need to, but the urgency is not quite as high as it is for short-term traders.
That’s the significance of volume as a defined number; here’s how to analyze it.
There are three primary ways we can use volume in conjunction with price analysis: confirming trends (or not), spotting potential price reversals, and confirming price breakouts (or not).
Confirm Price Trends
Volume is a secondary indicator to price; it provides more information about the price trend but doesn’t provide trade signals on its own. This is important to remember when considering these general volume guidelines for price trends: increasing volume in the direction of the trend helps confirm that trend direction.
Figure 1 shows this in action. Volume gradually increases as the price declines. If you are short, the rising volume helps confirm the downtrend and thus your position. If you are long, the rising volume on the price decline tells you the price could continue to drop and it may be time to look for an exit.
Be sure to also read about the 7 Psychological Traps Every Trader Must Face
- Declining volume during an uptrend indicates that interest is decreasing. Price can still continue to rise on declining volume though. Declining volume foreshadows an eventual reversal, but shouldn’t be acted upon until the price actually breaks the uptrend.
- Declining volume during a downtrend doesn’t tell us a lot, because a lack of interest can either indicate a lack of buying interest, which continues to the push the price lower, or a lack of selling interest, which could eventually push the price higher.
These guidelines are usable up to a point. Increasing volume helps confirm the trend, but when the volume spikes, often associated with a big price move, it usually indicates a price reversal is close at hand.
When volume spikes to an extreme, relative to typical volume, it indicates that buyers or sellers may be exhausted.
When the volume spike occurs after a run higher in price, it indicates buyers could soon be exhausted, and with no buyers left to push the price up, the price will drop.
When the volume spike occurs after a run lower in price, it indicates sellers could soon be exhausted, and with no sellers left to push the price down, the price will rise.
Figure 2 shows this in action. There are two price spikes, noticeable because they stick out compared to the other, more normal, volume bars around them. The first spike occurs in February. A big gap down in price on very high volume indicated potential exhaustion on the part of sellers. The price rebounded for a short period of time.
Another very significant volume spike occurs in May, where volume was more than five times what we normally see. This sort of capitulation selling indicated that a potential major turning point for the stock was close at hand, since most of the traders who wanted to sell did so on that very high volume day.
Volume only provides insight, not trade signals. Price ultimately needs to confirm what volume is saying. In Figure 2, the price needed to start to rise following the volume spikes to confirm the short-term bottom in price.
Following a volume spike, look to see how volume responds on the next price wave to provide more evidence of a price reversal.
When there is a major volume spike following a down move and then the price pops, watch volume on the next price decline. If the volume on the price decline is lower than it was on the volume spike there is a good chance the price will continue higher.
When there is a major volume spike following an up move and then the price drops, watch volume on the next price rally. If volume on the rally is lower than it was on the volume spike there is a good chance the price will continue lower.
When there are strong support and resistance levels, volume can help confirm a breakout. If the price has struggled to get above a certain price it is going to take conviction on the part of the buyers to push it through that level. Conviction is shown via volume.
- A break above resistance, or below support, on larger than average volume shows conviction and the breakout is more likely to be legitimate.
- A break above resistance, or below support, on low volume shows little conviction; the breakout is more likely to fail.
A common problem is buying an upside breakout, or selling a downside breakout, when volume doesn’t confirm it.
Figure 4 shows a small price range; had you bought near the top of this range, or sold near the bottom, it would have resulted in a losing trade. Volume didn’t increase as it approached resistance or support, which told us any breakout that occurred was more likely to fail.
If volume had increased as the price broke above resistance, or below support, we should be more inclined to trade in the direction of the breakout.
Using Volume Indicators
Volume and price are the purest indicators, yet because of this there can also be a lot of “noise.” Indicators help smooth out the data, make it more visually appealing, and may help you spot important changes in volume or price not easily seen on a basic chart.
There are a large number of volume based indicators, although many of them function in similar ways. Here are three popular volume indicators, and how to interpret them.
On Balance Volume (OBV)
On Balance Volume takes a running total of volume, adding the volume of a price bar when it closes higher than the prior, and subtracting the volume of price bars that close lower than the prior. It is a quick way to see if volume is increasing in the trending direction.
When the price is rising, OBV should also be rising. If the price is rising but OBV is falling it shows that uptrend may be in trouble. This is because down days are seeing more volume than up days, thus pushing the indicator lower.
Chaikin Money Flow (CMF)
This indicator includes both price and volume in its calculation. When prices are moving higher the indicator moves higher, but by how much is determined by volume. Large volume results in greater indicator increases, while low volume advances result in smaller indicator increases.
When price is moving lower, the indicator moves lower, but by how much is determined by volume.
Similar to OBV this indicator helps confirm the trend, or indicate that trouble may be afoot. CMF doesn’t necessarily need to move in the same direction as price; as long as the indicator is above zero it helps confirm the uptrend. For a downtrend to be confirmed, the indicator should be below zero.
When the indicator oscillates near zero it indicates there is little conviction on the part of buyers or sellers, and likely no price trend.
To learn more, check out our Ultimate Guide to Chaikin Money Flow.
VWAP and Moving VWAP
Volume Weighted Average Price (VWAP) is the average price, weighted by volume, over the course of trading day. It gives traders an idea of the “typical” price seen during the trading day. Each day VWAP starts over, only showing the volume weighted average price for that day.
Moving VWAP is an x-period average of the VWAP; therefore, it creates a continuous average from day to day. The Moving VWAP is similar to a simple moving average, except it also accounts for volume, and can be used in a similar fashion.
The Bottom Line
Volume is a significant tool because it shows the conviction of buyers and sellers. Increasing volume, as a general rule, helps confirm the current trend. When volume reaches extreme levels, multiple times average volume, it indicates a trend may be ending. Volume is also useful for confirming breakouts; volume should rise when the breakout occurs. Indicators such as OBV and CMF can also be used. The indicators include volume in their calculation, and can therefore be used to monitor the strength of a trend. VWAP and Moving VWAP show the typical price of a security, and Moving VWAP can be used in similar ways to a traditional moving average.
Rsi Indicator – Relative Strength Index (RSI): How to Use It
The Relative Strength Index, or RSI, is an indicator that moves back and forth between 0 and 100, providing insight into the underlying strength or weakness of stock prices. It is used in various capacities, including confirming trends, providing trade signals and foreshadowing reversals. To use the RSI effectively we must understand how it works and its trading applications, as well as its strengths and limitations.
What is the Relative Strength Index (RSI)?
Developed by J. Welles Wilder—who also developed the Average True Range, Average Directional Index and, Parabolic SAR—the RSI is a very popular indicator.
The RSI moves higher when the average gains over a period, typically 14 days, are larger than the average losses. The indicator moves down when the averages losses are greater than average gains. Put another way, if the indicator is at 100, over the last 14 days it was all gains. If the indicator is at zero, all 14 periods were losses.
The indicator is calculated using the following formula, which requires a number of steps:
*RSI = 100 – [100/(1+RS)]
*Where RS = Smoothed Average Gain / Smoothed Average Loss
*Average Gain = Sum of gains over the last 14 periods/14
*Average Loss (expressed as a positive number) = Sum of losses over the last 14 periods/14
To create a smoothed RSI average, similar to a moving average, another step is added:
*Smoothed Average Gain = [(previous Average Gain) x 13 + current Gain]
*Smoothed Average Loss = [(previous Average Loss) x 13 + current Loss]
The indicator is typically used on daily charts with a period of 14, which equates to 14 days. Decrease the number of periods to make the indicator more sensitive to price changes. Increase the periods to make the indicator less sensitive.
Using the indicator on other timeframes also works. A 14-period RSI applied to an hourly chart will base calculations off the last 14 hours.
Figure 1 shows how the RSI looks on a chart, moving with price. All charts created using http://www.StockCharts.com
Trading with the Relative Strength Index (RSI)
The RSI is used in a number ways. Three popular functions are overbought/oversold levels, RSI ranges and divergence.
Via media and analysis it is frequent to hear phrases such as “The stock is overbought” or “WXYZ is oversold.” Often the speaker is referring to the stock’s RSI reading.
When the RSI is above 70 (or 80 is often used as well) it shows a strong run higher in price, which may not be sustainable, and therefore due for a correction.
When the indicator is below 30 (or 20) it shows a strong run lower which may not be sustainable, and the price may be due for a rally.
Unfortunately, it is not as easy as buying when the indicator moves below 30 or selling above 70, some confirmation of a change in direction is needed. Allow the price to cross below 30 and then rally back above it before buying. Let the price cross above 70 and then back below it before selling.
This approach can work well in ranging markets, when the price is swinging back and forth between overbought and oversold levels. As Figure 2 shows the price may not always reach 30 or 70; if the stock doesn’t quite reach the pre-defined levels, alternate levels can be used, such as 35 or 65.
When a buy is triggered a stop is placed below the recent swing low. A sell signal is used to exit long trades or initiate short positions, with a stop above the recent swing high.
During trends, the RSI will usually stay contained within certain readings. During an uptrend it typically bottoms above 30 and frequently reaches 80+. During a downtrend the indicator will typically top out before 70 and frequently reach 20 or below. This can be used to confirm trends, and provide entry signals during a trend.
During an uptrend, buy if the price drops below 35 (or 40) and then rallies back above it. Place a stop loss below the recent low. Sell when the price moves above 70 (or 80) and then drops back below.
One problem with this strategy is that the RSI may not provide an exit signal, in which case, a winning trade may turn into a loser. For such occasions, having a price target or another exit method is needed.
Each stock moves differently, and therefore may have a slightly different range. Adjust levels to suit the individual stocks movement, for example 40 may be the entry point instead of 35.
During a downtrend, short-sell if the price rallies above 65 and then drops back below. Place a stop above the recent high. Cover the short position when the stock drops below 30 (or 20) and rallies back above it.
The RSI is also used to spot divergence. Bearish divergence is when the price is rising, but the RSI falling. It warns the price could soon correct lower since buying momentum is slowing.
Divergence (bullish or bearish) is not a timing signal, as it can last a long time. Rather, divergence helps confirm other signals, and lets traders know when a trend may almost be over.
Bullish divergence is when the price is falling, but the RSI is rising. It warns the price could soon move higher since selling momentum is slowing.
Divergence on major trends warns of an overall change in direction, while divergence on a small scale, as shown on Figures 5 and 6 may only indicate a small correction or short-term change in direction.
Limitations of the RSI
The RSI has several limitations, as all indicators do. Since the indicator is showing momentum, as long as momentum remains strong (up or down) the indicator can stay in overbought or oversold territory for long periods of time. Therefore, price analysis or some other confirmation is still needed for reversals.
The same is true for divergence. While the RSI may be dropping and price rising, that doesn’t mean price will drop soon. The RSI is just showing that the price is moving higher at a slower pace than it was before. Confirmation of a reversal is still needed, such as lower swing highs and lower swing lows in price.
RSI ranges can help confirm trends, but each stock or market will have slightly different levels. One stock may repeatedly move to 38 on pullbacks, while another goes to 33. Therefore, some adjustment is often needed for each stock, since a one-size-fits-all approach may not work.
The Bottom Line
The RSI is popular because it has multiple uses. It is used to find entry exit signals based on overbought/oversold reading and trending ranges, and can help spot or confirm reversals via divergence. Like any technical analysis tool though, the RSI is prone to providing false signals. Price analysis is still need to determine if a trend is present, and then important RSI levels identified for that particular security.
Coppock Curve – Coppock Curve: How to Use The Coppock Curve
The Coppock Curve is a momentum indicator introduced by Edwin “Sedge” Coppock in an October 1965 issue of Barron’s. After being commissioned by the Episcopal Church to find long-term investment opportunities, the burgeoning economist reportedly asked bishops how long it took for people to get over the death of a loved one and developed a series of calculations based on the 11 and 14 month changes.
In this article, we’ll take a look at how to calculate and interpret the Coppock Curve as well as some examples of is usage and limitations to consider.
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Calculating the Coppock Curve
The Coppock Curve is calculated using a relatively simple formula based on the rate of change indicator (“ROC”). Specifically, the calculation is the 10-day weighted moving average (“WMA”) of the 14-period ROC plus the 11-period ROC. The WMA places more weight on recent data and less weight on older data by multiplying the first data point by 1, the second data point by 2, and so forth.
The Coppock Curve = WMA [ 10 ] of (ROC [ 14 ] + ROC [ 11 ])
Interpreting the Coppock Curve
The Coppock Curve is simply a smoothed momentum oscillator with long timeframes that have only generated a few signals throughout recent history. While the indicator generates signals in both directions, most technical analysts prefer to watch for sell signals rather than buy signals. In fact, the monthly indicator has successfully predicted the last two bear markets in 2000 and 2008.
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The Coppock Curve can also be adjusted in many different ways:
- Different Periods – Coppock Curves can be calculated using monthly, weekly, or even daily periods, although the indicator gets progressively more choppy as the duration of the periods shortens due to increased volatility.
- Changing Metrics – Coppock Curves are designed to be calculated with 11-day and 14-day ROCs, but traders can adjust these numbers as necessary in order to increase the accuracy of the indicator in certain cases.
- Multiple Curves – Multiple Coppock Curves can be utilized in order to identify crossovers and other events, similar to the way in which MACD and moving averages are interpreted when looking for buy or sell signals.
Examples of Coppock Curves
The Coppock Curve can be interpreted in many different ways, using many different timeframes and many different settings. In Figure 2 and Figure 3 below, we’ll look at two unconventional ways of using the indicator and what the charts may mean for traders, although it’s important to keep in mind that the indicator is best used in conjunction with other technical indicators rather than on its own.
Figure 3 shows a Coppock Curve based on the daily prices of the S&P 500 SPDR ETF (NYSE: SPY) between late-April 2014 and August 2014. While the traditional Coppock Curve is meant to be a monthly indicator rather than a daily indicator, the daily version provides some key insights including a buy and sell signal from crossing above and below zero, respectively, and the decelerating trend since June.
Figure 4 shows a weekly Coppock Curve and MACD indicator on the Dow Jones Industrial Average ETF (NYSE: DIA) between April 2012 and August 2014. In this case, the Coppock Curve and MACD both indicate a bearish divergence that could signal an upcoming correction, although the Coppock Curve hasn’t crossed below the zero line quite yet to generate a definitive sell signal.
Limitations of the Coppock Curve
The Coppock Curve has a number of limitations that traders should carefully consider before using the indicator in practice. To overcome these limitations, trader should use the indicator in conjunction with others to confirm price movements and changes in sentiment.
Some limitations to keep in mind include:
- False Signals. The Coppock Curve generates a lot of false signals, where the indicator crosses above or below the zero line during choppy trading, particularly when using shorter timeframes like daily or weekly bars.
- Curve Fitting. The Coppock Curve’s default settings are relatively arbitrary, which means that traders may be tempted to change them in order to curve fit a given index or equity and generate buy/sell signals.
The Bottom Line
The Coppock Curve is a momentum indicator introduced by Edwin “Sedge” Coppock in an October 1965 issue of Barron’s. The Coppock Curve is calculated by adding the 10-day weighted moving average (“WMA”) of the 14-period ROC to the 11-period ROC. The buy and sell signals are generated when the indicator crosses above and below the zero line, respectively. The Coppock Curve can be modified by changing the three variables involved in the calculation, as well as by using multiple timeframes or curves. Traders should be aware of the Coppock Curve’s limitations, which include false signals when using shorter timeframes.
– How to Use the Bollinger Bands
Bollinger Bands are applied directly to price charts, providing a gauge for how strong a trend is, and spotting potential bottoms and tops in stocks prices. Band width fluctuates based on volatility; the ability for Bands to adapt to changing market conditions makes it a popular indicator amongst traders. To use Bollinger Bands effectively, we must understand how they work, their trading applications, and pitfalls.
What are Bollinger Bands?
Bollinger Bands® are a volatility based indicator, developed by John Bollinger, which have a number of trading applications.
There are three lines that compose Bollinger Bands: A simple moving average (middle band) and an upper and lower band. These bands move with the price, widening or narrowing as volatility increases or decreases, respectively. The position of the bands and how the price acts in relation to the bands provides information about how strong the trend is and potential bottom or topping signals.
Bollinger Bands are used on all timeframes, such as daily, hourly or five-minute charts. Bollinger Bands have two adjustable settings: the Period and the Standard Deviation. The Period is how many price bars are included in the Bollinger Band calculation. The number of periods used is often 20, but is adjusted to suit various trading styles.
The Standard Deviation is typically set at 2.0, and determines the widths of the Bands. The higher the Standard Deviation, the harder it will be for the price to reach the upper or lower band. The lower the Standard Deviation the easier it is for price to “breakout” of the Bands.
Bollinger Bands denoted (20,2) means the Period and Standard Deviation are set to 20 and 2, respectively.
The indicator is calculated using the following formula. First calculate the Middle Band, then calculate the Upper and Lower Bands.
- Middle Band = 20-day simple moving average (SMA)
- Upper Band = 20-day SMA + (20-day standard deviation of price x 2)
- Lower Band = 20-day SMA – (20-day standard deviation of price x 2)
Where SMA = the sum of closing prices over n periods / by n.
Figure 1 shows how Bollinger Bands looks on a chart as they move and adapt with price.
Trading with Bollinger Bands
The first way to use Bollinger Bands is for analysis. Some common occurrences provide us with information on the direction and strength of the trend. This information can then be used to confirm trade signals from other indicators or strategies to make trades.
- If an uptrend is strong it will reach the upper band on a regular basis. Reaching the upper band shows the stock is pushing higher and buying activity remains strong.
- When the price pulls back, within the uptrend, if it stays above the middle band and then moves back to upper band it shows a lot of strength.
- During an uptrend the price shouldn’t break below the lower band; if it does it warns the uptrend has slowed and may be reversing.
The same principles apply to a downtrend.
- If a downtrend is strong it will reach the lower band on a regular basis. Reaching the lower band shows selling activity remains strong.
- When the price pulls back (higher), within the downtrend, if it stays below the middle band and then moves back to lower band it shows a lot of strength.
- During a downtrend the price shouldn’t break above the upper band; if it does it warns the uptrend has slowed and may be reversing.
These are general guidelines for trading with Bollinger Bands to help analyzed the trend. Adjusting the Bollinger Band settings may help avoid getting false signals from these guidelines.
Another way to use Bollinger Bands is for trading W-Bottoms and M-Tops.
A W-Bottom signals a reversal from a downtrend into an uptrend.
Initially there is a wave lower, which gets close to or moves below the lower band. The price then pulls back to the middle band or higher, and proceeds to create a lower price low than the prior wave, but doesn’t close below the lower Bollinger Band. When the price moves above the high of the prior pullback the W-Bottom is in place. A long trade is initiated and a stop is placed below the recent lows.
The W-Bottom is similar to a Double Bottom chart pattern. One potential profit target is to add the height of the W-bottom to the breakout price. In Figure 3 the W-Bottom is roughly $1.50 high, added to a breakout price near $33, this gives a target of $34.50. If a major uptrend unfolds, a trailing stop can be used to attempt to capture more profit from the rally.
An M-Top signals a reversal from an uptrend into a downtrend.
Initially there is a wave higher, which gets close to or moves above the upper band. The price then pulls back to the middle band or lower, and then proceeds to create a higher price high than the prior wave, but doesn’t close above the upper Bollinger Band. When the price moves below the low of the prior pullback the M-Top is in place. A short trade (and exit long positions) is initiated and a stop is placed above the recent highs.
The M-Top is similar to a Double Top chart pattern. One potential profit target is to subtract the height the M-Top from the breakout price. In Figure 4 the M-Top is roughly $9 high, subtracted from a breakout price near $31, this gives a target of $22. If a major downtrend unfolds, a trailing stop can be used to attempt to capture more profit from the short position.
Bollinger Band Limitations
Bollinger Bands are a helpful indicator, but they have a number of limitations. Bollinger Bands are derived from a simple moving average, which is the average price over a certain number of price bars. This means Bollinger Bands will always react to price moves, but won’t forecast them. Bollinger Bands are reactive, not predictive.
Standard settings won’t work for all traders. Active traders may want a small number of periods or lower standard deviation, while long-term traders may prefer a greater number of periods and a greater standard deviation, so few signals are presented. By adjusting the settings though it may be more difficult to gauge the trend based on the guidelines or spot W-Bottoms or M-Tops.
M-Tops and W-Bottoms may not actually end up not being reversals, but rather just consolidations where the price continues to head in the trending direction after a false breakout. A false breakout is when the price passes through the entry point, initiating a trade, but then quickly moves back in the other direction resulting in a loss. This is why stop losses are used.
The Bottom Line
Bollinger Bands are comprised of a middle band (SMA), and upper and lower bands based on standard deviation which contract and widen with volatility. The Bands are a useful tool for analyzing trend strength and monitoring when a reversal may be occurring. Combining Bollinger Bands with M and W price patterns aids in spotting major reversal signals. Bollinger Bands are not predictive though. They are always based on historical information and therefore react to price changes, but don’t anticipate price changes. Like other indicators, Bollinger Bands are best used in conjunction with other indicators, price analysis and risk management as part of an overall trading plan.
Williams %R – Williams %R Indicator – How to Use It
The Williams %R, or just %R for short, is an indicator that moves between 0 and -100, providing insight into the weakness or strength of a stock. It’s used in various capacities including overbought/oversold levels, momentum confirmations and providing trade signals. To use the Williams %R effectively we must understand how it works, its trading applications, as well as its strengths and limitations.
What is the Williams %R?
The %R is very similar to the Stochastic Oscillator. The only difference between the two indicators is how they’re scaled. The %R fluctuates between 0 and -100, while the Stochastic moves between 0 and 100. The Stochastic also has a moving average applied to it so it can be used for “crossover” signals. The Williams %R only has one line by default, although a moving average can be applied to it to give all the functionality of the Stochastic.
See also our Ultimate Guide to the Relative Strength Index
The indicator was developed by Larry Williams, and shows how the current price compares to the highest price over the look back period. Typically the look back is 14 periods; on a weekly chart that is 14 weeks, on an hourly chart 14 hours.
When the indicator is near zero is shows the price is trading near or above the highest high during the look back period. If indicator is near -100, the price is trading near or below the lowest low during the look back period. Above -50 and the price is trading within the upper portion of the 14 period range; below -50 and the price is trading in the lower portion of the 14 period range.
All charts created using http://www.StockCharts.com
Williams %R Calculation
Here’s the calculation for the %R:
%R = (Highest High – Close) / (Highest High – Lowest Low) X -100
Where Highest-High is the highest price over the look back period and Lowest-Low is the lowest price over the look back period.
Calculating the indicator is no longer required, as charting platforms and trading software do it for us. Although knowing how the indicator is calculated will help you better understand the indicator and its strengths and weaknesses.
The Williams %R is available on most trading platforms, such as ThinkorSwim and MetaTrader. The indicator is also available on many free online charting sites, such as FreeStockCharts.com, StockCharts.com and Yahoo! Finance.
How the Williams %R Is Useful
The most common use for the Williams %R is for “overbought” and “oversold” readings and momentum confirmations and failures.
A security is overbought when the indicator is above -20, and the security is oversold if the indicator is below -80.
The labels are misleading, overbought doesn’t necessarily mean the price is going to drop soon, and oversold doesn’t mean the price is due for a rally. Prices always reverse at some point, but the overbought and oversold don’t tell us when this will occur. Overbought simply means the price is trading near the top of the 14 day range. Oversold means the price is trading near the bottom of the 14 range. If the price continues to rally or decline, overbought and oversold conditions (respectively) can last a long time.
Traders do use overbought and oversold levels to monitor reversals though. If the indicator is overbought (above -20) and then falls below -50, traders take this as a sign that the price is moving lower. If the price was oversold (below -80) and rallies above -50 traders take this is a sign the price is moving higher.
False signals or late signals occur frequently if these signals are traded unfiltered. Use the price trend to filter the signals.
During a price downtrend, enter short when the indicator was overbought and then drops below the -50 level. During an uptrend, buy when the price was oversold then rallies above the -50 level. The trigger level doesn’t need to be -50, although is the common trigger level used.
Figure 2 shows this approach applied to a stock in an overall uptrend. Only the long trades are taken as the %R moves from oversold to above -50. Since the indicator does not provide a stop loss, one can be placed below the recent low that formed just before the signal (just above recent high for short sale signals).
The same method can be applied to exiting profitable trades. Wait for the price to reach overbought levels (for long trades) then exit when the price falls below -50 (or -20 or -30 to get out a bit earlier). For short trades, let the price move to oversold levels, then exit when the price rallies above -50 (or -80 or -70 to get out a bit earlier).
Momentum Confirmations and Failures
During an uptrend, if the %R continually moves above -20 (overbought) that shows strength and confirms the trend. The price is closing in the upper portion of its 14 period range. It follows that if during an uptrend the %R can’t reach -20, momentum may be failing. If during an uptrend the price falls into oversold territory and then can’t rally back above -20, this shows upside momentum has stalled and potentially reversed.
A downtrend is strong when the %R consistently reaches -80 or below. If it fails to reach -80, momentum is slowing; if it reaches overbought and then fails to drop back below -80, the downtrend could be reversing.
Figure 3 shows how the %R can be used to confirm trends and show failures in momentum. Initially (left side of chart) the price continually reaches above -20, showing very strong momentum. There are barely any pullbacks and they typically stay above -80. If the %R does pullback into oversold territory, it quickly recovers above -20 showing upside momentum is still there.
At the start of March the %R drops and can’t rally back above -20. That is a momentum failure and signals the uptrend is likely over. The %R continually reaching -80 or lower confirms this, and shows the downtrend is strong. Not until late May when the %R moves above -20 is the downtrend drawn into question.
Williams %R Limitations
Just using %R for entries will produce a large number of false signals; false signals are when the indicator signals that the trend is turning, but in fact it doesn’t. Only taking signals in the same direction as the trend can help in this regard.
Exits are also an issue. At times the traditional exit will get you out of the trend too early. The third trade (from the left) in Figure 2 is an example of this. After the entry the price moves into overbought territory and then drop below -50 signaling an exit, yet the price continued to move higher for three more months.
The trend can also help in this regard. As long as the price is making overall higher swing highs and higher swing lows, maintain your long positions (ignore exit signals). When the price stops making higher highs or higher lows, then get out the next time the %R drops below -50.
Figure 4 shows the significant difference this can make during a strong trend, such as the trend that was originally shown in Figure 2.
The same principle is applied to downtrends. Hold short positions as long as the price is making lower swing lows and lower swing highs (ignore exit signals). When the price stops doing this, get out the next the price moves above -50.
The Williams %R is a trading tool, not a complete strategy. Placing stop losses and coming up with your own exit strategy, such as the one described above, is required.
Proponents of the Williams %R Indicator
The creator of the indicator is Larry Williams, a commodities trader born in 1942, and author of 11 books. In 1987 he won the (real money) World Cup Championships for Futures Trading with an 11,376% return in 12 months—the highest return ever in the competition . His daughter, Michelle Williams (who is also an actress), won the competition in 1997 with a return of 1,000%. Whether the Williams %R played a pivotal role in helping them accomplish these returns is unknown.
The Bottom Line
The %R is used in various capacities, including overbought/oversold levels and momentum failures. It can also be used to provide trade signals and let you quickly know where the price is in the context of the look back period. It moves between 0 and -100 and is very similar to the Stochastic which moves between 0 and 100. Since the indicator moves and forth between “overbought” and “oversold” it is prone to providing false signals. Using the indicator in conjunction with other indicators or price and trend analysis will help filter out some of the false signals.
Stochastic Oscillator – Stochastic Oscillator: How to Use Stochastic Oscillator Indicator
The Stochastic Oscillator is a technical indicator that moves back and forth between 0 and 100, providing a gauge of stock momentum. Developed by George C. Lane in the 1950s the main uses for the Stochastic Oscillator include divergences which can foreshadow reversals, overbought/oversold readings, bull/bear trade setups and crossovers which help pinpoint trade entries.
What Is the Stochastic Oscillator?
The Stochastic Oscillator is a two-line indicator that fluctuates between 0 and 100.
The indicator shows how the current price compares to the highest and lowest price over the look back period. Typically the look back is 14 periods; on a weekly chart that is 14 weeks, on an hourly chart 14 hours.
When the indicator is near zero it shows the price is trading near or below the lowest low during the look back period. If the indicator is near 100, the price is trading near or above the highest high during the look back period. Above 50 and the price is trading within the upper portion of the 14 period range; below 50 and the price is trading in the lower portion of the 14 period range.
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Stochastic Oscillator Calculation
Since the indicator has two lines-labelled %K and %D-there are two steps to calculating the Stochastic Oscillator values.
%K = (Current Close – Lowest Low) / (Highest High – Lowest Low) x 100
%D = 3-day SMA of %K
Lowest Low = lowest low for the look-back period (typically 14 periods)
Highest High = highest high for the look-back period (typically 14 periods)
SMA = Simple Moving Average
The above formula is for a “Fast Stochastic,” but there is also a “Slow Stochastic” version. It is the same as above except the Slow %K is averaged over 3 periods.
Slow %K = 3-period SMA of Fast %K
Slow %D = 3-period SMA of Slow %K
Since the Slow Stochastic is less choppy, many traders prefer it over the Fast Stochastic.
The Stochastic Oscillator is available on most trading platforms, such as ThinkorSwim, and on many free online charting sites, such as FreeStockCharts.com, StockCharts.com and Yahoo! Finance.
How It Is Useful
Uses for the Stochastic Oscillator include overbought/oversold readings, divergences. bull/bear trade setups and crossovers.
Overbought and Oversold
A security is overbought when the Stochastic is above 80, and the security is oversold if the indicator is below 20.
The labels are misleading though; overbought doesn’t necessarily mean the price will drop immediately, and oversold doesn’t mean the price will rally immediately. Overbought and oversold simply mean the price is trading near the top or bottom of the 14 day range, respectively. These conditions can last for a long time.
Traders do use overbought and oversold levels to monitor reversals though. If the indicator is overbought (above 80) and then falls below 50, it indicates the price is moving lower. If the price was oversold (below 20) and rallies above 50 it indicates the price is moving higher.
False or late signals occur frequently if these signals are traded unfiltered. Use the price trend to filter the signals.
During a price downtrend, enter short when the indicator was overbought and then drops below 50. During an uptrend, buy when the price was oversold then rallies above 50. The 50 level is commonly used, but can be adjusted based on personal trading strategies.
In Figure 2 this approach is applied to a stock trending higher. Only the long trades are initiated as the Stochastic moves above 50 after being oversold. Place a stop loss below the recent low that formed just before the signal (just above recent high for short sale signals).
Apply the same method to getting out of a profitable trade. Wait for the price to reach overbought levels (for long trades) then exit when the price falls below 50 (or 70 or 60 to get out a bit earlier). For short trades, let the price move to oversold levels, then exit when the price rallies above 50 (or 30 or 40 to get out a bit earlier).
Bearish divergence is when the price is making new highs, but the Stochastic isn’t. It shows that momentum has slowed, and a reversal could be forthcoming.
Bullish divergence is when the price is making new lows, but the Stochastic isn’t. It shows selling pressure has slowed, and a reversal higher could be around the corner.
Until divergence is confirmed by an actual turnaround in price, don’t base trades simply on divergence. A stock can continue to rise (or fall) for a long time even while bearish (or bullish) divergence is occurring.
See also our Ultimate Guide to the MACD Indicators
In April, Macy’s makes a higher high in price, but the Stochastic doesn’t, warning of a potential move lower.
In May, the price makes a lower low than it did in April, but the Stochastic makes a higher low, warning the move lower had lost momentum and an upside rally could ensue.
Bull and Bear Trade Setups
A bull trade setup is when the stochastic makes a higher high, but the price makes a lower high. The Stochastic is indicating that momentum is building and the price could rally following a pullback.
This is a setup that can be used with any number of entry signals. Here is one way to use it:
Once the bull setup has occurred the price will typically pullback and then rally, presenting a trade opportunity. Following the bull trade setup, buy after a pullback (the Stochastic must drop below 50 on the pullback) when the Stochastic rallies back above 50 (or 40 or 30).
A bear trade setup is when the stochastic makes a lower low, but the price makes a higher low. The Stochastic is indicating that selling pressure is building and the price could drop following a pullback higher.
In Figure 5, another type of entry signal is needed to enter a short position following the pullback higher. The Stochastic did not get back above 50, so it could drop back below, to provide the trade signal. The bear trade setup still provided warning about the forthcoming decline though.
In this case, the %K line (black) crossing back below the %D (red) following the bear trade setup provides a potential short entry. This crossover strategy can be used for the overbought and oversold strategy as well. For a downtrend the stop loss is placed above a recent high. For an uptrend signal the stop loss is placed below a recent low.
Stochastic Oscillator Limitations
The main drawback of the Stochastic is false signals. This is when an entry signal occurs on the indicator, but the price doesn’t follow through, resulting in a losing trade. During choppy market conditions this can happen frequently. One way to help with this is to use the trend as a filter—only take trade signals in the direction of the trend.
Bull and bear trade setups are prone to the same false signals, especially when the price lacks any clear direction. Trading in stocks with a clear direction and only taking trades in the same direction as that trend will help in this regard.
Divergence on the Stochastic is a warning signal, but isn’t a timing or trade signal. The price can continue to trend for a long time in the face of divergence. So while divergence works sometimes, it needs to be combined with other forms of analysis or a trade signal to make it an effective trading tool.
Proponents of the Stochastic Oscillator
The man attributed to devising the Stochastic Oscillator is George C. Lane (1921 – 2004). He was a trader, technical analyst, author, speaker and President of Investment Educators Inc. The Stochastic concept was based on the idea that momentum must always change before price.
The indicator is one of the most popular in use today, used by countless traders and included in many technical analysis newsletters. Despite the drawbacks highlighted, it continues to have a wide following mainly because of the numerous ways it can be used for both analyzing and trading all types of markets.
The Bottom Line
The Stochastic Oscillator is used in various capacities, including overbought/oversold levels, divergences and bull/bear trade setups. It can also be used to provide trade signals and let you quickly know where the price is in the context of the look back period. It moves between 0 and 100 and is prone to providing false signals. Using the indicator in conjunction with other indicators or price and trend analysis helps filter out some of the false signals.
Vortex Indicator – Vortex Indicator: How to Use the Vortex Indicator
The Vortex Indicator is a volatility-adjusted trending indicator that helps traders determine the short-term trend, spot trading opportunities, and isolate when a trend is not present. It is composed of two lines, and has a relatively straight forward application. Before using the vortex indicator for trading purposes traders should understand how the indicator works, its uses, strategies, and limitations.
How to Use the Vortex Indicator
The Vortex Indicator was created by Douglas Siepman and Etienne Botes and is composed of two lines, +VI and -VI. +VI represents up trending momentum and -VI represents down trending momentum.
The two indicator lines fluctuate above and below 1.0, spreading further apart during very strong trends and moving close together during weak trends or sideways markets.
When the +VI crosses above -VI, it signals a potential uptrend, and as long as +VI stays above -VI it helps confirm the uptrend.
When -VI crosses above +VI it signals a potential downtrend, and as long as -VI stays above +VI it helps confirm the downtrend.
When +VI and -VI are very close together and hovering near the 1.0 mark, it indicates a short-term lack of trend, and a potential consolidation phase in the stock price.
All charts created with StockCharts.com.
Vortex Indicator Calculation
The Vortex Indicator calculation requires five steps:
1. Calculate upward movement and downward movement for the last two periods, using the current and previous one.
- downward movement (-VM) is current low minus previous high (absolute value)
- upward movement (+VM) is current high minus previous low (absolute value).
2. Calculate for periods desired, for example 25 periods.
- -VM25 = 25-period sum of -VM
- +VM25 = 25-period sum of +VM
3. Calculate the True Range (TR). TR is the greatest of the current high less the current low, current high less the previous close, or the current low less the previous close. All must be absolute values.
4. Calculate for the periods desired, for example 25 periods.
- TR25 = 25-period sum of TR
5. Calculate for -VI and +VI.
- -VI25 = -VM25 / TR25
- +VI25 = +VM25 / TR25
A different number of periods could be used in the calculation. Increasing the number of periods, for example to 40, will decrease the sensitivity of the indicator and may be more useful to long-term traders. Decreasing the number periods, for example to 10, will increase the sensitivity of the indicator; very short-term traders may prefer this.
Periods can be days, hourly price bars or 1-minute price bars, or any other period of time.
How to calculate the indicator by hand is good to know, but it’s not required. Many platforms such as Thinkorswim, as well free charting applications such as Stockcharts.com and FreeStockCharts.com, provide the indicator.
Vortex Indicator Strategies
The most basic vortex indicator strategy is to use the crossovers as trade signals: when +VI crosses above -VI, go long; when -VI crosses above +VI, go short. Exit when a crossover occurs in the opposite direction.
Trading this basic strategy without filtering any of the signals can result in whipsaws. A whipsaw is when there is a crossover in one direction, followed shortly after by a crossover in the other direction. Whipsaws can result in a number of losing trades in a short period of time.
To help avoid this, only take +VI crossovers (above
VI) when the overall trend is up. A 100 or 200-day moving average can help establish the trend.
When the overall trend is down, only take -VI crossovers (above +VI).
In either case, use a crossover in the opposite direction as an exit signal. A manual stop loss should also be placed to control risk. For a long trade, place a stop just below a recent swing low, and for a short trade place a stop just above a recent swing high.
Be sure to also read Trend Trading 101
Looking at the Vortex Indicator combined with the trending price in figure two, notice how the large uptrending waves are associated with +VI moving above 1.10 on the indicator, and at no point during this uptrend does -VI move above 1.10. Also note that during the uptrend +VI does not move below 0.90.
Therefore, indicator levels can provide insight into the trend, and provide an additional strategy. This strategy can be combined with the crossover strategy above, or used in isolation.
During an uptrend (price above moving average or making higher swing highs and higher swing lows), either buy on a +VI crossover (above -VI) or when the +VI crosses above 1.10 showing a strong trending move is in place. Hold the trade as long as +VI stays above 0.90 and -VI stays below 1.10. If the +VI crosses below 0.90, or the -VI crosses above 1.10, exit the long trade.
This strategy will result in longer term trades, and will often keep the trader in the position for the majority of the uptrend, and through a number of pullbacks.
During a downtrend (price below moving average or making low swing highs and lower swing lows), either short on a -VI crossover (above +VI) or when the -VI crosses above 1.10 showing a strong trending move is in place. Hold the trade as long as -VI stays above 0.90 and +VI stays below 1.10. If the -VI crosses below 0.90, or +VI crosses above 1.10, exit the short trade as this shows the downtrend has lost momentum.
Figure 3 shows how this strategy would have worked in the same stock. The entry occurs as the price moves above 1.10 signaling the start of a potential trend. This also aligns with the price moving above the 100-day moving average. The long trade stays open as long as the +VI stays above 0.90 and -VI stays below 1.10.
Signals occur less frequently with this method and can capture a larger chunk of the overall trend. It is only useful if a strong trend develops following the entry though
A manual stop loss should also be utilized with this strategy to help control risk in the case of a large adverse price move. After the entry occurs, place a stop loss below a recent swing low for long positions, or above a recent swing high for short positions.
Vortex Indicator Limitations
The greatest flaw of the Vortex Indicator is its susceptibility to “whipsaws.” This can be somewhat offset by using more periods in the indicator calculation, although this will also make the indicator slower to react to trend changes.
The Bottom Line
The Vortex Indicator is an oscillating momentum indicator that helps define the short-term trend. Increase or decrease the number periods used in the calculation to get more or fewer trading signals. When +VI is above -VI it helps identify the uptrend, and when -VI is above +VI it helps identify the downtrend. Using indicator levels, such as 1.10 or 0.90, show when a trend is gaining momentum or losing it. Price analysis should still be used in conjunction with the indicator, as the indicator is prone to providing false trading signals (whipsaws); price analysis can help you determine the overall and longer-term trend and trading direction. A moving average may also be of use in determining trend direction.
Market Breadth Indicators – Everything You Need to Know About Market Breadth Indicators
Traders have literally thousands of different tools available to help them discern market momentum and predict future price movements, ranging from simple moving averages to complex neural networks. While any individual indicator provides limited insight, traders should consider multiple indicators in their analysis in order to get the complete picture of price action.
In addition to stock-specific tools, traders should consider market-wide tools like the so-called market breadth indicators. These indicators can provide key insights into the movements of the overall market, which are important in ensuring that traders are on the right side of a trade. In this article, we’ll take a look at market breadth and three popular indicators used to gauge it.
Be sure to also read A Trader’s Guide to Understanding Business Cycles
What Is Market Breadth?
Market breadth is a technical analysis technique that compares the number of advancing securities within an index or market to the number of declining securities. Positive market breadth occurs when there are a greater number of advancers relative to decliners, while negative market breadth occurs when there are a greater number of decliners relative to advancers in a market.
Generally, a greater number of advancing issues is an indicator of bullish sentiment and used to confirm market uptrends and vice-versa for a greater number of declining issues. There are also many derivations of market breadth calculations, such as the analysis of new 52-week highs and lows. Traders often use this information in conjunction with other technical indicators to confirm trends.
Advance-Decline Index Explained
The most basic market breadth indicator is the advance-decline index, seen in Figure 1 below, which is also known as the AD Line. By calculating the difference between the number of advancing and declining securities, the index can be very useful in confirming whether or not trends are likely to continue. Bullish markets with a negative AD Line, for instance, may be ready for a change in direction.
All charts created using StockCharts.com
In Figure 1, the stock chart shows the cumulative AD Line rather than the individual daily line since the latter can be difficult to discern any trends. The cumulative AD Line is calculated by subtracting the number of advancing stocks from the number of declining stocks within an index and then adding the previous period’s AD Line value in order to show trends in a more readable fashion.
Looking at the divergence between the actual index and the AD Line generates the most reliable buy and sell signals. Bullish divergence occurs when the actual index is moving lower and the AD Line is moving higher, signaling potential pent-up demand, while bearish divergence occurs when the actual index is moving higher and the AD Line is moving lower, signaling early selling pressure on the index.
Be sure to also read Trend Reversals: How to Spot and How to Trade
Bullish Percent Index Explained
The Bullish Percent Index (“BPI”) was developed by Abe Cohen in the mid-1950s to measure the number of stocks generating Point & Figure buy signals in a given index. Since Point & Figure charts generate a clear buy or sell signal, there is no ambiguity in calculating the BPI, although Earl Blumenthal and Mike Burke refined the process itself in the 1970s and 1980s, respectively.
For those new to P&F charts, the X’s represent upward moves and the O’s represent downward moves without any regard for time. New columns are added when a price change is great enough to indicate a reversal, with only either X’s or O’s occupying any given column. Traders use these types of charts to remove the “noise” of daily price activity in order to remove any ambiguity in reading price trends.
The BPI is calculated by dividing the number of stocks in an index generating P&F buy signals by the total number of stocks in an index. Basic P&F buy signals occur when one column of X’s exceeds the prior column of X’s, while a basic P&F sell signal happens in reverse. Traders should watch for a BPI below 30% followed by a buy signal (bull) or a reading above 70% followed by a sell signal (bear).
New Highs-Lows Index Explained
The High-Low Index (“HLI”) is a market breadth indicator designed to measure new 52-week highs relative to new 52-week lows. By dividing new highs by new highs plus new lows and then multiplying that figure by 100, traders can calculate the record high percent that can then be smoothed using a 10-day moving average to create the High-Low Index and provide key market insights.
Traders can interpret the HLI in many different ways. In general, readings below 50% suggest a greater number of new 52-week lows relative to 52-week highs and could be the early signs of a bear market. By comparing the HLI with a moving average of the HLI, such as the 20-day moving average, traders can gain insights into when new 52-week highs are slowing down and a top may be nearing.
Most traders use the HLI indicator for confirmation purposes, since 52-week highs and lows tend to be a lagging indicator. Traders may also want to compare the HLI indicators for various industries or sectors to see what areas of the market are outperforming at any given time, as well as gauge when certain markets may be overextended from excessive optimism and buying.
The Bottom Line
Market breadth indicators provide valuable insights into the movements of larger indexes to assist in analyzing individual component securities. There are several different market breadth indicators to consider, but each of them have their own set of advantages and disadvantages. Traders should use market breadth indicators as a single part of a broader technical analysis approach in order to realize the most benefit.
Atr Indicator – Guide to the Average True Range (ATR) Indicator
Traders have loads of indicators to look at when it comes to identifying setups, patterns, trends and reversals. These are all viewed in relation to a price chart, which is arguably the most important piece of information a trader can have. Average True Range looks at the distance the price is traveling each day and plots it on a graph. The ATR reading can then be used by traders to determine when markets are most likely to range, when there is a high interest in a trend, or when extreme levels are being reached indicating a reversal.
What Is the Average True Range (ATR)?
ATR is a volatility indicator developed by J. Welles Wilder, who also created the RSI and Parabolic SAR, among other popular indicators.
Be sure to read our Ultimate Guide to the Relative Strength Index
The “true” range aspect separates the indicator from other volatility measures, such as measuring the difference between the daily high and low to assess how much a stock or commodity is moving each day.
When holding positions overnight, traders must also factor in price gaps. Average true range factors in gaps, when required, to provide a truer sense of day to day volatility and movement.
ATR does not account for price direction. The job of the trader is to use the price chart to determine direction, and use the ATR indicator to help analyze the price movement.
All charts created using StockCharts.com
Figure 1 shows the indicator applied to a daily chart of Apple, which has a current ATR reading of 1.607. This means that, on average, the price is moving about $1.60 from day to day. This gives traders an indication of how much volatility or movement they can expect each day. As the chart shows, this ATR value (volatility) fluctuates over time.
For day traders, the average difference between the high and low each day may provide a better gauge of volatility for the style of trading, since all trades occur during the day and no positions are held overnight. That said, ATR is still a popular indicator even among day traders for intraday trading and monitoring overall volatility.
To find the True Range, take the greatest of the following:
- Current High minus current Low
- Current High less previous Close (absolute value)
- Current Low less previous Close (absolute value)
Absolute value is a positive number.
The TR value is noted each day. The ATR is then constructed using the following formula:
Current ATR = [(Prior ATR x 13) + Current TR] / 14
Thankfully the ATR is available on most trading platforms—so calculating by hand isn’t required—such as ThinkorSwim, and a number of free online charting sites including FreeStockCharts.com and StockCharts.com.
The ATR can be calculated for, and applied to, any chart timeframe, including 1-minute charts, hourly charts or weekly charts. When using intra-day charts, such as a 5-minute chart, there may be big swings in the ATR near the open if there was a gap in price over night. As the day progresses the ATR will settle down and reflect the movement for just that trading day.
How ATR Is Useful
ATR is not necessarily a trade signal, although it can be used to help confirm entry points.
Since many investors look to buy stocks (and not short-sell them), when a price is declining and then breaks above its trendline, it is a potential buy signal. When the ATR also breaks above its own resistance it confirms the price break higher, since it shows strong movement in the upward direction.
Figure 2 shows this on the AAPL daily chart. The price breaks aggressively above a downward trendline. ATR was dropping prior to this, showing that the downtrend was lacking momentum. When the price breaks higher, the ATR also breaks higher confirming the price rise.
The same method can also be used to confirm downside breakouts for those wishing to enter short positions.
The above example show how the ATR can help confirm trades by looking for a jump in ATR as the price breaks resistance or support. For these trades, traders can look to exit profitable trades using a predefined target, trailing stop or other technical analysis method (see 3 Ways to Exit a Profitable Trade).
A stop should also be placed on each trade to control risk. Typically a stop is placed below a recent low when taking a long position, or above a recent high when taking a short position (see also 4 Ways to Exit a Losing Trade).
After big price moves, like those seen in Figures 2 and 3, that can sometimes mean very big stops.
As an alternative to traditional stops and profit taking methods, ATR can be used as both a stop and trailing stop. This controls risk, profits from a trend, and then gets you out when the trend may be reversing.
Traders use a multiple of ATR, usually 2, 2.5, or 3 to set an initial stop, and then continue to trail that multiple of the ATR behind the price as it moves in their favor.
Assume you enter short in Twitter on the break to a new low at $39.67 in April. ATR at that time is 2.32. If using a multiple of 2, a stop is placed $4.64 above the entry price (2 x ATR), which is $44.31.
As the trade progresses, ATR will change. Calculate 2 x the daily closing ATR and add it to the closing price (for short positions) to get the new stop level. If the price is moving lower this process will act as a trailing stop.
Never move a stop higher than a prior stop. If short, the stop can only drop. If the stop should be higher than the prior stop, keep the stop where it is. This will allow the trade to eventually be stopped out when a reversal occurs.
Figure 4 shows some sample readings and highlights when the trade is eventually stopped out on a price reversal by hitting the 2 x ATR stop.
The first stop is placed at $44.31, as it can only move lower. Each day the ATR is multiplied by 2 and added to the closing price. If it provides a lower figure than the last, then the stop is moved to this lower level.
At the start of May there is sharp sell-off and the price closes at a $30.66 with an ATR of 2.835. This moves the stop to $36.33 [(2 × 2.835) + 30.66].
The price continues to drop through May, but so does the ATR. On May 27 the price closes at $30.51 and ATR is 1.37. The new stop is $33.25 [(2 × 1.37) + 30.51]. This stop is hit shortly after, closing out the position.
The same process applies to uptrends. After entry, multiply the ATR by 2 and subtract it from the closing price. Do this each day and adjust the stop accordingly. The stop can only move higher and never move lower, as that would increase your risk.
Other ATR Tendencies
Historically low ATR readings are typically followed by increasing ATR readings as volatility can’t stay low forever. This is why watching for resistance breaks on the ATR can be beneficial. It alerts traders to the potential of a strong move potentially occurring.
Similarly, a market can’t stay volatile forever. When ATR is reaching extremely high levels relative to a multi-year history, then the price may be extended (either up or down). Watch for signs of a price reversal and for ATR to break below support, indicating a price climax has potentially been reached.
Both of these tendencies can be traded in the ways described above.
Interpreting ATR is subjective. There is no level that indicates a stock is about to reverse, or that a trend will continue. Rather, current ATR readings must always be compared to prior readings to get a “sense” of trend strength or weakness.
ATR also doesn’t factor direction, only volatility. This can sometimes result in confusing signals at market turning points. A spike in the ATR following a big counter-trend move may make traders think the ATR is expanding to confirm the old trend. This is not the case, though. The new price information reveals a big price reversal, so ATR is confirming that, not the old trend (see figures 2 and 3).
When using a multiple of ATR as a stop and trailing stop, the potential profit is unknown. This makes establishing a risk/reward for the trade impossible. The benefit is that if a large trend develops profits can be very large. If trading during a volatile time though, the ATR can be very big, and thus multiplying it by two may make a trade infeasible since the risk would be too large.
Day traders will likely find an average of the high minus low provides a better gauge of what a stock does intra-day than ATR. Day traders only trade during the day, so their only real concern is how much movement they can expect between the open and close, or high and low, each day.
The Bottom Line
Average True Range is a versatile volatility indicator that accounts for price gaps. It can be used to confirm entries as well as act as a stop and/or trailing stop. ATR doesn’t look at direction; it is up to the trader to determine whether expanding or contracting ATR values confirm recent price moves. ATR may be useful for day traders for general stock or market analysis, although an average high minus low indicator will provide a truer picture of what is occurring just within the trading day (doesn’t account for gaps). Use ATR to determine when volatility is increasing and when it is contracting; this can help determine the best times to trade.
Scalping Strategies – Put-Call Ratio: How to Use the Put-Call Ratio
The Put/Call Ratio is a sentiment indicator used to assess whether stock market buying or selling is at an extreme. The ratio is based on put and call option volume, the former bets on a decline in stock or index prices, and the latter is used to bet on a rise in stock or index prices. By looking for extremes in the put/call ratio, traders isolate periods where a reversal could occur. Therefore, this ratio is typically used as a contrarian indicator.
What Is the Put/Call Ratio?
Traders and hedge funds use options to make speculative bets, as well as hedge other positions. A call option is used if a trader expects an equity price to rise, or can be used to hedge a short stock position. A put option is used if a trader expects an equity price to rise, or can be used to hedge a long stock position.
Individual traders usually are more active in the options of individual stocks, while hedge funds (and the like) are more inclined to trade index options.
For this reason there are three dominant put/call ratios that are used, with data provided by the Chicago Board Options Exchange (CBOE).
All charts courtesy of StockCharts.com
- CBOE Equity Put/Call Ratio looks at puts relative to calls in individual stock options. Since most individual traders are looking to profit from rising prices, this ratio tends to hover below 1; more calls than puts.
- CBOE Index Put/Call Ratio looks at puts relative to calls in index options. Major funds and even individual traders will often use index options to hedge other equity positions. Given the long-term upward bias in the stock market, and the tendency for uptrends to last longer than downtrends, this ratio tends to hover just above 1; slightly more puts than calls, because puts are used as a hedge against long equity positions.
- CBOE Total Put/Call Ratio combines the above ratios into one. This helps eliminate the biases inherent in each ratio, and provides a broader picture of how all market participants feel about the stock market. Unless you are very experienced at reading put/call ratios, this is the ratio to focus on as it tends to hover closer to 1, and therefore extremes (deviations from 1) are easier to spot.
How Is the Put/Call Ratio Calculated?
The Equity Put/Call ratio is calculated by taking total put volume and dividing it by total call volume traded on equity options on the CBOE.
The Index Put/Call ratio is calculated by taking total put volume divided by total call volume traded on index options on the CBOE.
The Total Put/Call ratios is both equity and index put volume divided by equity and index call volume on the CBOE.
If the ratio rises, there are an increasing number of puts relative to calls. If the ratio falls there are fewer puts relative to calls.
Be sure to also see Everything You Need to Know About Market Breadth Indicators
What Is the Put/Call Ratio Used For?
The Put/Call Ratio is used as a contrarian indicator. An extremely high number of puts indicates that traders may be too bearish, and if all the “bears” have already taken positions then there is no one left to push prices lower. A very high Put/Call Ratio is therefore potentially short-term bullish for stocks/stock indexes.
An extremely low number of puts (high number of calls) indicates that traders may be too bullish, and if all the “bulls” have already taken positions then there is no one left to push prices higher. A very low Put/Call Ratio is therefore potentially short-term bearish for stocks/stock indexes.
Traders watch for extreme levels in the Put/Call Ratio to signal periods where stock and index prices could reverse. These levels will vary based on which ratio is used (discussed above), as well as market conditions. A long-term up or downtrend in the stock market may alter the exact levels used to indicate extreme bullishness or bearishness. Viewing the long-term Total Put/Call Ratio will show which levels are acting as extremes.
How to Interpret the Put/Call Ratio
Figure 3 shows the Total Put/Call Ratio over two and a half years. Below the ratio there is an S&P 500 chart showing the overall uptrend in the index over that time. Notice that as the price rises, the Put/Call ratio is actually trending lower, as more puts are accumulated to hedge against an eventual decline. This highlights how the levels the Ratio fluctuates between can change over time.
When the Total Put/Call Ratio moved above 130 it often signaled a short-term bottom and prices rose shortly after.
Due to the strong uptrend, sell/short signals, where the ratio dipped below 0.65, were not quite as timely, although prices did fall after two of the signals.
The Put/Call Ratio is extremely choppy and can result in a lot of trade signals that aren’t ideal, as shown above. Therefore, it’s possible to average out the Put/Call Ratio. This gives the indicator a smoother and easier to read appearance. It will also decrease the number of trade signals as the Put/Call ratio will only reach an extreme level if there is some persistence to the extreme bearishness or bullishness.
On StockCharts.com, apply a 10-period simple moving average to the Total Put/Call Ratio ($CPC), and change the chart type to “Invisible.” This means you’ll only see the moving average of the Put/Call Ratio, and not the crazy gyrations as shown in previous figures.
Figure 4 shows how this looks. The chart is much less choppy, although since an average is being used, the extreme levels need to be reduced. Over this period, when the Total Put/Call 10-period average exceeded 1.05, and then dropped back below it, it was a good buy signal.
There was also only one sell/short signal generated by this average over the entire 2.5 year period, which captured a decline in early 2014.
Extremes can last for some time; this is why traders typically wait for the average to drop back through the bearish extreme level (green horizontal line) before initiating a long, or waiting for the average to rally back above the bullish extreme level (red horizontal line) before initiating a short position.
Limitations of the Put/Call Ratio
A non-averaged Put/Call Ratio can be very volatile, providing lots of a false signals or ill-timed signals. Using an averaged Put/Call Ratio can help filter out some of these signals, the drawback to averaging though is that trade signals occur later in the move. In Figure 4 the buy signals occurred after the price had already begun to move higher, missing out on a large chunk of the move in some cases.
The extreme levels are never fixed either. Traders need to look at the Put/Call chart and pick out which extreme levels caused reversals in the past and then trust that that level will produce the same result in the future. It may or it may not.
Using the Total Put/Call Ratio will be simplest for many traders, but if using the Equity or Index Put/Call Ratio on their own, traders need to be aware of inherent biases and adjust their extreme levels accordingly.
The Bottom Line
The Put/Call Ratio can be used to assess bullishness or bearishness in stocks, indexes or both (Total). The Total Put/Call Ratio should satisfy most traders’ needs. The ratio can be choppy, but when it reaches a bullish or bearish extreme level, it can provide timely reversal signals. Applying an average to the Put/Call Ratio will reduce the choppiness and provide fewer signals, but those signals will occur later and thus possibly reduce profit potential. The Put/Call Ratio extremes are not fixed, and will require the trader to assess what levels have worked recently and form a strategy around those levels when they are approached again.
Bullish Reversal – The Visual Guide to Bullish Reversal Patterns
Most traders fall into one of two categories: Those following the trend and those trying to predict a change in the trend. When trying to pinpoint a change in the trend, traders often use candlestick patterns to make high probability predictions. These candlestick patterns are visual representations of sorts for the market’s psychology at a given point in time and can be invaluable in predicting reversals.
In this article, we’ll take a look at some popular bullish reversal patterns and how traders can use them to identify profitable trend changes.
A bullish engulfing is a reversal pattern characterized by a small daily candlestick body followed by a day whose candlestick body completely “engulfs” the previous day’s candlestick body. The shadows or tails of the smaller candlestick are also completely “engulfed” by the larger candlestick in order for the pattern to be considered completely valid by market technicians.
The bullish engulfing pattern represents the bulls taking control of the market in a given security from the bears. After the pattern occurs, traders should watch for a rebound in the security’s price as a confirmation of the reversal.
Learn more about Trend Reversals: How to Spot and How to Trade.
A bullish harami is a reversal pattern characterized by a large candlestick followed by a smaller candlestick whose body lies within the scope of the larger candlestick body. As with the bullish engulfing, the shadows or tails of the smaller candlestick must also be within the scope of the larger candlestick in order for the candlestick pattern to be considered completely valid by market technicians.
The three-candlestick pattern suggests that the bears are ceding control to the bulls, as evidenced by their inability to maintain a strong downward trend. After the pattern occurs, traders should watch for a rebound as confirmation of a reversal.
A bullish hammer is characterized by a hammer-shaped candlestick consisting of a small body at the top of a longer shadow or tail. During the period, the security experiences a significant sell-off that creates a long shadow or tail, followed by a rally that causes the security’s price to closer near its opening price. The shadow or tail should be at least twice the length of the candlestick’s body.
In terms of market psychology, the bullish hammer pattern suggests that bears attempted to take the stock lower throughout the period, but failed to hold the security down from a late rally to close near its opening price.
Bullish Morning Star
A bullish morning star is characterized by a large bearish candlestick body followed by a small-bodied candlestick that closes below the first candlestick followed by a large bullish candlestick body that opens above the middle candlestick and closes near the center of the first candlestick’s body. The pattern usually indicates that a downtrend is likely to experience a near-term reversal.
Be sure to check out the 25 Stocks Day Traders Love.
In essence, the bullish morning star pattern involves bears taking control of a security and pushing it down, followed by a day of relative uncertainty, which is then followed by a strong move higher controlled by the bulls.
How to Trade Bullish Reversals
Bullish reversal patterns provide traders with an early indication of a potential change in a security’s underlying trend. Depending on the timeframe being analyzed, these candlestick patterns can represent short-term or long-term changes in prevailing trends. Traders should consider several factors, however, rather than blindly following these bullish reversal patterns.
Here are a few tips to keep in mind:
- Multiple Timeframes – Always look at an opportunity in multiple timeframes to confirm whether the reversal in the short-term goes with or against longer-term trends in a security’s price over time.
- Seek Confirmation – Always look to see if there are any other technical indicators that may provide confirmation of a trend change. For instance, a crossover in the MACD indicator could provide such a confirmation.
- Look for Volume – The greater the volume, the more significant the candlestick pattern, all else equal. Traders should look for reversals that occur on high volume as bulls and bears fight for control.
The Bottom Line
Bullish reversal patterns can provide a great early indication of a potential change in price trend, but traders should seek confirmations before acting upon them. By looking at multiple timeframes, seeking confirmation, and considering volume, traders can maximize the odds of finding winning trades.
– TRIX Indicator – Triple Exponential Average
Investors can use the TRIX indicator to provide trade signals, help confirm trends and spot potential price reversals. TRIX is a fairly simple looking indicator that helps smooth out price fluctuations and shows the direction of dominant momentum (or lack thereof) in a stock or other asset. Before using the indicator, be sure you understand how to interpret TRIX, its strategies, as well as its limitations.
The TRIX Indicator
The TRIX indicator smooths price data and then looks at the daily (or whatever time frame is being used) percentage movement of that smoothed price data. This filters out much of the price noise that’s seen on the price chart. TRIX will rise on sustained moves higher in price, and will fall on sustained moves lower in price.
Since TRIX is smoothed (see calculation below) it takes time to react to changes in price direction. This can be beneficial, because not every little pullback means a trade should be exited or that the trend is going to reverse.
0.0 (zero) on the indicator is used a baseline. When the TRIX is below 0.0, and especially when it’s moving lower, the trend is considered down. When the TRIX is above 0.0, and especially when it’s moving higher, the trend is considered up.
All charts created using FreeStockCharts.com.
TRIX helps confirm trends, indicates when a trend reversal may be underway, and can also be used to generate trade signals.
Divergences are another useful aspect of the indicator. Bullish divergence is when the price makes a lower low but the TRIX doesn’t. It indicates selling momentum is not as great as it was on prior price drop. Weak selling momentum could lead to an eventual reversal.
Bearish divergence is when the price makes a higher high, but the TRIX doesn’t. It signals weakening buying momentum, which could result in an eventual reversal.
Divergences offer analytical insight and can be used to help confirm the strategies discussed in the TRIX Strategies section below. On their own, however, divergences are not high quality trade signals.
Divergences can occur for extended periods of time, resulting in:
- Missed opportunities because of not trading with a strong trend when there was a divergence.
- Traders taking losing trades because a divergence convinces them the price trend will reverse, but it doesn’t.
How TRIX is Calculated
It is a four step process to calculate TRIX. The indicator is “triple smoothed,” which means we are taking a moving average of a moving average of a moving average.
- 15-period exponential moving average (EMA) using closing prices.
- 15-period EMA of result from step 1.
- 15-period EMA of result from step 2.
- 1-period percent change of step 3.
Step 4 is the TRIX, which will fluctuate from period to period.
A different number of periods could be used in the calculation. Increasing the number of periods, for example to 40, will decrease the sensitivity of the indicator and may be more useful to long-term traders. Decreasing the number periods, for example to 10, will increase the sensitivity of the indicator; very short-term traders may prefer this.
Understanding how the indicator is calculated is important for really understanding the indicator, but calculating by hand is not required. Many platforms including TradeStation and Thinkorswim, as well free charting applications such as Stockcharts.com and FreeStockCharts.com, provide the indicator.
As an additional step, a moving average (which is visible) can be applied to the TRIX indicator. This is useful for providing crossover trade signals. The moving average is typically of shorter length than the number of periods used in the TRIX calculation. For example, if using a 15-period TRIX, a 9-period moving average could be applied to it.
A popular TRIX strategy is to watch for price reversal signals, such a trendline break, which is confirmed by a TRIX zero line crossover.
For long trades, buy when the TRIX crosses above 0.0 if there is some evidence that the price has started to reverse higher (trendline break, higher swing high or higher swing low).
For short trades, sell/short when the TRIX crosses below 0.0 if there is some evidence that the price has started to reverse lower (trendline break, lower swing high or lower swing low).
This strategy is simple and is mainly useful for entries. Unfortunately, the entry point has little regard for an appropriate place to put a stop loss. To control risk, a stop loss must be implemented, preferably just above a recent high if taking a short position, or just below a recent low if taking a long position.
Waiting for the price to move back across the zero line to exit the trade can mean giving back a lot of profit. For this reason, many traders prefer a signal line crossover strategy instead.
By adding a moving average (MA) to the TRIX indicator, traders buy when the TRIX crosses above the slower moving MA (called the signal line), and sell when the TRIX crosses below the MA (signal line). This method generally provides more timely trading signals, which means the entry point is often closest to a logical stop loss area, and a crossover in the opposite direction can be used as an exit point.
If there is an overall uptrend in effect, only use the long trade signals, and use bearish signal line crossovers as exit points. If there is an overall downtrend, only use the short trade signals, and use bullish signal line crossovers as exit points.
For a long entry, put the stop just below a recent low. For a short entry, place the stop just above a recent high. This will help control risk on the trade. If a stop level is a long way away, as in the second trade for Figure six below, you may opt to avoid the trade.
The TRIX doesn’t always reflect what is happening in the stock price. The price may be trending higher while TRIX is trending lower. This is a divergence which signals a potential end to the trend, but a trend can persist for a very long time even on weakening momentum. Using the TRIX in this situation can be deceiving, and can result in missing out on some great upside potential in the price.
False crossovers are another common issue. A false crossover is when the TRIX crosses above or below the zero line, only to snap back the other way, resulting in a losing trade. A false signal line crossover is when the TRIX crosses the signal line, only to cross back the other way shortly after.
False signals can result in numerous losses within a short period of time. Use longer-term trend analysis to help avoid some of these false signals. Ideally, only take buy signals when an overall uptrend is underway, and sell signals when an overall downtrend is underway.
The indicator also has no regard for setting a stop loss. A stop loss must be placed manually above a recent high (shorts) or below a recent low (longs). If there is no respective high or low near the entry point, consider avoiding the trade.
The Bottom Line
TRIX is a momentum indicator that is used to confirm trends, potentially spot reversals, and provide signals. Trade signals occur when the indicator crosses above (buy) or below (sell) zero, indicating a trend change is underway. Crossover signals occur when the TRIX crosses above (buy) or below (sell) the signal line. Both types of crossovers are prone to “false” moves; ideally trade in the direction of a longer-term trend to minimize these occurrences. Divergences are also used to analyze price, but they shouldn’t be acted on alone; however, divergences can be useful for providing some confirmation for other trading signals.
Bearish Reversal – The Visual Guide to Bearish Reversal Patterns
Candlestick patterns provide great insights into market psychology without the subjectivity associated with many forms of technical analysis. In particular, candlestick patterns excel at predicting short- and long-term tops and bottoms without having to look beyond a few price bars. Candlestick patterns are best used in conjunction with other forms of technical analysis that confirm long-term trends.
In this article, we’ll take a look at some common bearish reversal patterns and how they can be used in everyday trading to increase the odds of success.
Be sure to also see our Visual Guide to Bullish Reversal Patterns.
The bearish engulfing occurs when a small white candlestick with short shadows (or tails) is followed by a large black candlestick that completely “engulfs” it. Often times, the pattern occurs after a bullish move higher and predicts a bearish move lower and change in the prevailing trend. The pattern has a tendency to correctly predict downturns, but the breakdowns can be somewhat short-lived in nature.
Be sure to read more about Trend Reversals: How to Spot and How to Trade.
The bearish harami occurs when a large candlestick is followed by a much smaller candlestick with a body located within the vertical range of the larger body. Often times, the pattern occurs when a previously bullish trend is drawing to a close and a bearish trend may be ready to take its place. The pattern isn’t as reliable as the bearish engulfing but is still worth analyzing in context.
Bearish Evening Star
The bearish evening star is a three-candlestick pattern that occurs when there’s a large bullish candlestick, followed by a small candlestick that closes above the first candlestick’s bar, followed by a large bearish candlestick that opens below the middle candlestick and completely or nearly erases the first candlestick’s gains. In general, the pattern tends to be a good predictor of bearish reversals.
Bearish Shooting Star
The bearish shooting star looks exactly the same as an inverted hammer candlestick, with a small lower body, little or no downward tail, and a long upward tail. Unlike the inverted hammer, the candlestick pattern occurs in an uptrend rather than a downtrend, predicting a bearish reversal. A longer tail indicates a greater potential for reversal, although traders should seek confirmation with the pattern.
Bearish reversal patterns can provide great insights for traders, but it’s important to remember their shortcomings. While they are great for predicting quick reversals, traders should use other forms of technical analysis to confirm the overall long-term trends before using them. For example, looking at multiple timeframes can help determine the short-term and long-term trends for a given security.
For example, suppose that a trader identifies a stock in a long-term uptrend that appears to be topping out. He or she may use Relative Strength Index to determine that the trend is losing steam, while confirming the bearish sentiment with a Moving Average Convergence/Divergence crossover. In this case, a bearish engulfing may provide a specific trigger for a short sale.
The Bottom Line
Candlestick patterns provide a great way for traders to determine potential trend reversals. In particular, bearish engulfings and bearish evening stars provide high-probability trend reversal indicators, although bearish shooting stars and bearish harami may also provide some useful insights. Traders should keep in mind, however, that these tools are best used in conjunction with other forms of technical analysis in order to improve the likelihood of a successful trade.
Trin – Arms Index (TRIN): How to Use Arms Index TRIN
Created by Richard Arms in the ’60s, TRIN stands for TRading INdex, but is also known as the Arms Index. It is a breadth indicator, helping highlight overbought and oversold levels in major indexes by looking at the number of advancing and declining stocks, as well as volume. The indicator is also used for trading individual stocks, showing whether the broader market is strong or weak, which could impact the stock price.
What Is the Arms Index (TRIN)?
The indicator fluctuates above and below 1.0 and gives an indication of short-term overbought and oversold levels in the index’s price.
It combines how many stocks are advancing and declining, as well as the volume of these stocks to provide a short-term gauge of market health.
All charts created using StockCharts.com
TRIN gives data on the NYSE and TRINQ gives data on the Nasdaq. Both are used depending on which exchange is most applicable to the stocks being traded. If trading a financial stock then TRIN would be a better indicator. If trading a technology stock, following TRINQ and the Nasdaq Composite Index is likely more applicable.
TRIN often appears to move inversely to the price action of the index it is being applied to.
How TRIN Is Calculated
The indicator can be calculated for any index or exchange for which there is adequate data. It is often used to gauge the NYSE or Nasdaq.
TRIN = (Advancing Issues / Declining Issues) / (Advancing Volume / Declining Volume)
Advancing Issues is the number of stocks that closed higher on the day and Declining Issues is the number of stocks that closed lower on the day. Advancing Volume is the summed volume of all Advancing Issues; Declining Volume is the summed volume of all Declining Issues.
The first part of the equation is known as the AD Ratio, or Advance/Decline Ratio. The second part of the equation is known as the AD Volume Ratio.
Calculating the TRIN index can be a daunting task, especially on short time frames such a one-minute chart. It is available on many charting and trading applications—no manual calculation required—as an indicator, or it can be viewed as a symbol ($TRIN on StockCharts.com and FreeStockCharts.com).
How to Read the TRIN
A reading of 1.0 is a neutral point, and the indicator moves above and below it. A strong up day for an index will push the TRIN down, and a strong down day for the index will push the TRIN up. Very high or low readings in the TRIN indicator signal that the price may be oversold or overbought, respectively, and due for a reversal. Reversals don’t need to be assumed; the TRIN tips us off and then we wait for price to confirm before acting.
Be sure to also read Trend Reversals: How to Spot and How to Trade
Specific overbought and oversold levels may vary slightly by index. For the NYSE Index between August 2013 and August 2014, a reading of 2.0 or higher typically indicated a short-term bottom was close at hand, and the price was due for at least a bit of upside movement.
When the Indicator is above 1.0 but below 2.0 it indicates selling pressure, and a short-term downtrend may be in effect. During such times, short-term short trades are preferable to long trades.
When the indicator is below 1.0 it indicates buying pressure and a short-term uptrend may be in effect. During such times, short-term long trades are preferable to short positions. Given that there is so much “noise” around 1.0, price analysis must also be used to determine direction and filter out false signals in the TRIN.
Notice that the spikes lower are not as pronounced as the spikes higher on TRIN. This can make it difficult to pinpoint an exact overbought level. Usually a reading below 0.5 indicates a short-term top in price may be in place or close at hand.
When the TRIN is right around 1.0 it doesn’t provide much information. Look at the longer-term price action to determine trend direction and in which direction trades should be made; TRIN is most useful when it is above or below 1.0 by two-tenths or more.
See also Trend Trading 101
TRIN Uses & Strategies
Use oversold levels on the TRIN to confirm entry points during an overall uptrend. Define the uptrend using a 100- or 200-day moving average. Look for the TRIN to reach 2.0 or higher to signal an oversold level in the price. Enter long as soon as the price starts to show strength again and the TRIN reverses back below 2.0.
The same approach is applied to a downtrend. Wait for rallies in price where the TRIN reaches 0.5 or below. Once the price begins to move higher, and/or the TRIN moves above 0.5, look to enter a short position with a stop loss just above the recent high.
Since this trending approach attempts to capture the next wave of the trend, there isn’t a specific price target. Trailing stops, profits targets or indicators can be used to aid in exiting a profitable trade (see 3 Ways to Exit a Profitable Trade).
TRIN can also be used to confirm breakouts in stocks that are typically correlated with the broader market. Ideally, when the price breaks higher, the TRIN should be below 1.0 to show there is buying pressure (but not below 0.5, as that would indicate the price may be overbought). Buy when the price breaks above the pattern.
Figure 5 shows the price breaking above a descending triangle pattern. Just prior to the breakout the TRIN was below 1.0 showing buying pressure, and at the point of breakout the TRIN is right near 1.0. This provided enough confirmation of the buying pressure to trade the breakout.
On the right of the chart another small range develops. There is a strong up bar that corresponds with a TRIN value well below 1.0. This confirmation could have been used to enter a long position. Notice these breakouts both occur in the direction of the overall trend, which adds confidence to the trade setup.
The same concept applies to downside breakouts. TRIN is above 1.0 just prior to or at the time of breakout, and ideally the breakout is in the direction of an overall trend.
Overbought and oversold levels are not exact levels. The TRIN can move well beyond these extremes before a price reversal occurs. Also, just because an overbought or oversold level is reached doesn’t mean the price will reverse.
The TRIN, as described here, is predominantly a short-term indicator, used by day traders and swing traders. It can be used as a longer term indicator if the data is smoothed and averaged, say over 4, 21 or 55 periods. This can be done by applying a moving average to the indicator, and then focusing on the moving average reading. Spikes will be smoothed out over a number of days and only the strongest overbought and oversold will appear using the TRIN moving average.
Given that it is naturally a short-term indicator, it is best to use the indicator in conjunction with overall trend analysis. Isolating the broader trend is up to the trader, but using a 200- or 100-day moving average can aid in finding the trend direction.
The indicator can have erratic movements and therefore may not be an ideal indicator to use for exiting profitable positions. The strategies above focus on getting you into a trending move; once that trend move has begun another method must be employed to exit the position with a profit.
Be sure to also read 4 Ways to Exit a Losing Trade
The Bottom Line
TRIN is a market breadth indicator that looks at advancing and declining stocks on major indexes as well as the volume associated with those stocks. Extremely high values indicate the index may be near a bottom, while extremely low values indicate the index may be near a top. These levels are not exact though and reversals may not occur just because an overbought or oversold level is reached.
The indicator is also helpful with confirming price breakouts, but finding a price target or profitable exit will be up to the trader. TRIN can be erratic and therefore may not be ideal for exiting trades. Utilize a stop loss, and ideally trade in the direction of a longer-term trend, using TRIN to aid in trade selection and timing.
Mass Index Indicator – How to Use the Mass Index
The Mass Index is a measure of volatility that can be extremely helpful in identifying reversal patterns. While it does not predict the direction of a reversal, the indicator has proven to be quite accurate in analyzing trading ranges to determine when a reversal is likely to occur, particularly over long periods of time. As a result, the indicator should be an instrumental part of any traders toolbox.
In this article, we’ll take a closer look at the Mass Index, interpreting its readings, and some limitations for traders to consider.
What Is the Mass Index?
The Mass Index is a volatility indicator developed by Donald Dorsey and discussed in the June 1992 issue of Technical Analysis of Stocks & Commodities. By analyzing the narrowing and widening of trading ranges, the indicator identifies potential reversals based on market patterns that aren’t often considered by technical analysts largely focused on singular price and volume movements.
See also our Guide to the Average True Range (ATR) Indicator
Since the signals do not provide insight into the direction of the reversals, technical analysts should combine the indicator’s readings with directional indicators like the AD Line that specialize in predicting those types of things.
The Mass Index is calculated by taking the sum of multiple ratios of single and double exponential moving averages (“EMAs”) over time, as illustrated in Figure 1.
The four steps to completing the calculation, including:
- Calculate a 9-day EMA of the difference between the high and low prices.
- Calculate a 9-day EMA of the moving average calculated in Step 1.
- Divide the EMA calculated in Step 1 by the EMA calculated in Step 2.
- Total the values in Step 3 for the desired number of periods.
Interpreting the Mass Index
The Mass Index highlights potential reversals in the form of “reversal bulges”, according to Donald Dorsey. These “reversal bulges” are characterized by the indicator’s move above the 27.00 level and then back below the 26.50 level (in order to confirm the move). Of course, these levels and the Mass Index’s other settings can be modified in order to increase the number of signals or enhance accuracy.
Be sure to also read A Trader’s Guide to Understanding Business Cycles
Let’s take a look at a quick example:
In Figure 2, Microsoft Corporation’s (NASDAQ: MSFT) Mass Index “reversal bulge” indicates an upcoming change in direction. The AD Line shows that the trend reversal will likely be bullish in nature since traders have been starting to accumulate the stock. After a brief retracement, the long-term bullish uptrend begins to show by September 2014 and continues through August 2014.
In Figure 3, Groupon Inc.’s (NASDAQ: GRPN) Mass Index “reversal bulge” indicates an upcoming change in direction. The bearish MACD crossover suggested an upcoming downtrend and the stock price subsequently fell from about 12.50 to below 6.00 when the Mass Index crossed below 26.50. Traders that considered the sell signal could have either exited a long position or entered a short position.
Limitations of the Mass Index
The Mass Index suffers from the same limitations as many other reversal indicators – false signals. Traders can mitigate the effects of false signals by using the indicator in conjunction with other technical indicators designed to confirm reversals. For example, a relative strength index reading above 70.0 and a bearish MACD divergence may confirm a Mass Index prediction of an upcoming reversal.
Another limitation to consider is the lack of a directional prediction, as discussed in the previous section. The best way to determine the direction of the reversal, traders should use outside indicators like the AD Line seen in Figure 2 or other tools like the TRIX indicator, which serves as a smoothed MACD of sorts. The TRIX can be especially helpful in reducing the noise when generating trading signals.
The Bottom Line
The Mass Index is a volatility indicator developed by Donald Dorsey that analyzes the narrowing and widening of trading ranges. It is calculated by taking the sum of multiple ratios of single and double exponential moving averages (“EMAs”) over time. Mass Index “reversal bulges” are characterized by the indicator’s move above the 27.00 level and then back below the 26.50 level. The Mass Index has many important limitations that traders should understand before using it, including the risk of false signals.
Market Indicators – 10 Stock Market Indicators for Successful Investing
Traders use a variety of different ratios and indicators to evaluate individual securities or the market as a whole. Fundamental indicators can help determine the long-term direction of the market, while technical indicators can provide short-term insights into price movements. In general, traders should use both types of tools in order to draw the most accurate conclusions about the market.
In this article, we’ll take a look at the 10 ratios and indicators that traders watch most closely to predict future price movements.
Be sure to also read about the 5 Indicators that Foretold the 2008 Crash
Price-earnings (“P/E”) ratios are perhaps the most commonly cited fundamental ratios in the equity markets. By dividing the price per share by earnings per share, traders can get a general idea of how under- or over-valued an equity is relative to the market as a whole. For example, a stock trading with a P/E ratio of 50x compared to an industry average of 20x might be deemed overdue for a correction.
Traders also watch the average P/E ratio of the S&P 500 and other major U.S. indexes to get an idea of the overall market’s valuation. By comparing the current multiple with the historic mean and median, traders can get a good idea of whether the market is top heavy or bottoming out. The ratio provides no detailed timing information, but the fundamental bias remains important to know.
Price-sales (“P/S”) ratios are perhaps the second most commonly watched fundamental ratio in the equity markets. By dividing the price per share by sales per share, the metric provides insights into how a company is valued relative to its top-line revenue. The metric is especially useful for unprofitable companies, since P/E ratios cannot be calculated for those companies.
Just like the P/E ratio, traders also watch the overall P/S multiple for large indexes like the S&P 500. Movements above or below the historical mean or median could suggest that the market is top-heavy or bottoming out. Again, the ratio doesn’t provide much information about timing, but it can be very useful in determining where prices are headed over the long-term in terms of a fundamental bias.
Debt-equity ratios are commonly used to assess the default risk associated with individual equities. In general, companies with debt-equity ratios of more than 1.0x are considered to be risky since their debt levels exceed their equity capitalization. These ratios can be sustainable depending on the level of debt service and the company’s ability to grow equity to close the gap.
Some industries have naturally high debt-equity ratios, such as the commercial shipping industry, since it involves high capital costs. In these cases, traders should take into account the debt-equity ratio relative to industry peers rather than on an absolute basis. Traders should also keep an eye on interest rates, since rising interest rates increase required payments, and could cause financial trouble.
Price-cash (“P/C”) ratios are a useful measure of a company’s liquidity in terms of cash and short-term securities. In general, companies with a P/C ratio of less than 1.0x are considered to be attractive since their cash position exceeds their market value. These depressed valuations are considered to be unsustainable over the long-term, since a buyer would likely emerge for such a company.
Unlike P/E or P/S ratios, traders tend to use P/C ratios on individual equities rather than comparisons between equities or over various timeframes. Traders should carefully consider potential reasons for depressed P/C ratios of less than 1.0x, since the undervaluation may be justified. For example, companies with persistent net losses may trade below cash value in some cases.
Price-earnings to growth (“PEG”) ratios are a useful metric that compares a company’s P/E ratio to its growth rate. In general, companies with higher growth rates should be valued higher than companies with slower growth rates. The PEG ratio attempts to determine a fair valuation for these rapidly growing companies by dividing the P/E ratio by long-term growth rates.
Traders should watch for PEG ratios below 1.0x to indicate situations where a company might be undervalued relative to its growth. For example, a company trading with a P/E ratio of 10x and growing at a 20% annual rate would yield a PEG ratio of 0.5×. Traders might consider the company undervalued relative to its growth rate and consider the stock to have an upwards bias.
Moving averages are great technical indicators that provide a smoother picture of a stock’s price movements by taking an average over time. For example, a 20-day moving average takes the average of the last 20 days and uses that as a current price point. The most highly watched moving averages include the 20-, 50-, and 200-day moving averages, although they may vary from stock to stock.
Traders often watch for different moving average dynamics, such as crossovers between different moving averages, as technical signals. For instance, the moving average convergence divergence (“MACD”) indicator has become a popular measure of price trends by tracking the difference between two different moving averages over time in terms of absolute and relative positions.
Relative Strength Index
The Relative Strength Index measures the strength of a given trend by comparing the average gains and losses over a set period of time. In general, RSI values over 70 are considered overbought and values below 30 are considered oversold. The most common timeframe measured by the RSI indicator is the 14-day average gains and losses, which provide the right amount of volatility.
Traders use the RSI to determine the momentum associated with both individual stocks and market indexes. For instance, an S&P 500 RSI reading of 75 may suggest that equities are overdue for a correction and lead traders to have a bearish bias when looking for individual opportunities. An individual stock trading with a RSI reading of 20 may also suggest a rebound is likely ahead.
The numbers of advances and declines is a useful indicator of a broad market index’s underlying momentum. Often times, an individual stock can significantly influence the direction of a broad market index and obscure the true underlying movements of the index. Advance/decline lines can help show the true picture by telling the net movements of component stocks.
The advance/decline volume line can also be extremely useful for traders looking at an index’s dynamics. For instance, the S&P 500 may have a high net advance/decline index reading indicating a lot of stocks moving higher, but slowing overall volume may indicate that the index is topping. Traders often watch both of these indicators together to get a true picture of where major indexes are heading.
The put-to-call ratio provides traders with an excellent idea of where the market may be heading in the future. Rather than analyzing current price movements, the put-to-call ratio looks at where option trades are predicting future moves to occur. In general, a high put-to-call ratio is seen as a bearish indicator while a lower put-to-call ratio is seen as a bullish indicator for major stocks or indexes.
Traders often watch for changes in the ratio as a sign that the market may be ready to turn in the near future. For example, the S&P 500 may be rising and reaching new highs, but a growing put-to-call ratio may suggest that traders are positioning themselves for a decline by purchasing more puts than calls. Put options, in these cases, are presumably protective puts designed to hedge against downside risk.
The Chicago Board Options Exchange Market Volatility Index (“VIX”) is a popular measure of S&P 500 index options’ implied volatility. By measuring options rather than equity, the index predicts future volatility over the next 30-day period rather than the current volatility within the index. Many financial professionals refer to the index as the “fear index” or “fear gauge” as a result.
Traders can use the VIX in several different ways, ranging from guiding equity trades to positioning options trades. For example, a rising VIX could be a sign that the market is expecting a reversal after a large rise or fall. Traders may also be interested in exiting options positions that could deteriorate with volatility given the expectation in the broad market index that could trickle down.
The Bottom Line
Traders have access to a number of different fundamental and technical indicators that can help improve their risk-adjusted returns. Just like multiple timeframe analysis looks at more than one timeframe, traders should use multiple fundamental and technical indicators to come up with the best trade ideas.
Price Action Market Trap – Volatility Trading: Strategies to Trading the VIX Successfully
Volatility is simply how far a price moves, referred to as variance, over time. By comparing the volatility of one asset to another, we can see which ones potentially pose more risk. In trading, risk is typically associated with downside moves, so volatility when stocks (or other assets) decline is of greater concern to investors than prices spiking wildly higher. Multiple products have been created that appreciate as downside volatility increases. The VIX index is a great gauge of volatility, and multiple products can be traded based on the VIX, which provides traders with a hedge against volatility and additional ways to potentially make money.
What Is Volatility?
How far prices move over time affects investors. If a $50 stock moves on average $1 per day, it is moving about 2% per day. A $50 stock that sees $10 fluctuations in a day is moving 20% per day. The former is likely to be viewed as safer, or at least less risky, than the second stock.
Keep in mind that if a stock is trading at $50 and jumps to $60 in one day, most investors won’t mind, but if the stock drops from $50 to $40 this makes investors very nervous. So when it comes to how volatility is assessed in terms of securities, a price move lower is the volatility investors are generally more concerned about.
Since most investors buy stocks, and don’t short them, if stock prices rise they are happy. But if stocks prices fall, this is interpreted as “bad” volatility and they may wish to utilize a product that helps protect them against those moves lower – downside volatility.
Be sure to read about the Best Investments of All Time
What Is the Volatility Index (VIX)?
The CBOE Volatility Index was introduced in 1993. VIX futures began trading in 2004 and VIX options became available in 2006.
Escalating volatility, at least the downside volatility that scares investors, is often a sign of market turmoil, unrest in the markets, falling stock prices and/or lack of investor confidence. The VIX reflects this; when stock prices fall the VIX rises, acting as a “fear gauge”. It gives a reading of how much uneasiness there is in the market.
When stock prices are rising, fear is low and investor confidence relatively high, so the VIX will usually be at low levels or declining.
The VIX is based on real-time options prices. Options prices, which have a volatility aspect included in their price, tend to increase during periods of market declines. As option prices rise, so does the VIX. When there is little to worry about in terms of volatility (stock prices are rising), option prices on the whole tend to decline, and so will the VIX.
Trading the VIX with Options
Aside from the trading the VIX directly with a VIX futures contract, traders can also trade options on the underlying VIX futures. VIX options (and futures) are offered by the CBOE and can be traded by anyone with a brokerage account approved for options trading.
VIX options expire on the third Wednesday of each month. Quotes (delayed) are available on the CBOE website:
The quotes table lists what the option is called, as well as last sale, current pricing and volume information.
There are options available with expiries up to six months out from the current date. This gives traders some flexibility in choosing a maturity.
VIX1416G10-E (top of the list) means it is based on the VIX futures, expiry in 2014, on the 16th of the month, in month G and has a strike price of $10. Month G is equal to July. H is equal to August and so on. Names for Puts are structured in the same way, except that different letters are used for the expiry, for example S is for July, and T for August.
Strategies with VIX options range from the very simple to the complex. If you believe that stocks may see a significant decline over the next couple months, buy a VIX call option with an expiry a few months out. If stocks do in fact decline, the VIX will rise, hopefully by enough to make your VIX call worth some money. This approach can also be used as a short-term hedge against market declines when holding a portfolio of stocks.
If your view is the opposite—you believe stocks will rise and the VIX will fall – purchasing a VIX put option will give you the potential to profit if this scenario plays out.
Another approach it to look for historical extremes in the VIX index, and attempt to profit when these extremes occur. In Figure 2, between 2007 and 2014 a reading above 40 marked an extreme high in the VIX. Buying puts on the VIX when the price began to decline from these extremes could have been one way to potentially profit as the VIX returned to more normal levels. The downside is that these extremes can last longer, or extend further, than we think, as seen in 2008.
Options expire, so VIX options traders not only need to pick the right direction, but also make their trade at the right times. CBOE VIX options are also typically European style, meaning they can only be exercised on the expiration date, unlike equity options, which can typically be exercised at any time before expiry.
Be sure to read Options 101: American vs. European vs. Exotic
The S&P 500 and the VIX also don’t move in a perfect inverse relationship. From 2000 to 2012 the two indexes moved opposite each other about 80% of the time, according to the CBOE. Therefore, a decline in the S&P 500 doesn’t always equate to the rise in VIX, or vice versa. Although sustained rises or falls in the S&P 500 will cause an overall inverse move in the VIX.
Trading the VIX with ETFs
Trading the VIX is relatively straightforward for stock traders with the advent of exchange traded products (ETPs). These are instruments that are offered on NYSEARCA stock exchange, trade in a similar fashion to stocks and can be bought and sold actively.
Top VIX-Related ETPs Based on Average Daily Volume as of July 9, 2014:
|VXX||iPath S&P 500 VIX Short Term Futures ETN|
|TVIX||VelocityShares Daily 2x VIX Short Term ETN|
|XIV||VelocityShares Daily Inverse VIX Short Term ETN|
|UVXY||ProShares Ultra VIX Short-Term Futures ETF|
|VXZ||iPath S&P 500 VIX Mid-Term Futures ETN|
- VXX is the most actively traded VIX-related ETP. It has an ETN structure, was established in 2009 and has a 0.89% expense ratio. It will typically move inversely to the S&P 500.
- TVIX is a leveraged product, and will therefore move approximately twice as much as VXX. It has an ETN structure, was established in 2010 and has an expense ratio of 1.65%. It will move inversely to the S&P 500.
- XIV is an inverse VIX ETN, which means it will typically move in the same direction as the S&P 500, and in the opposite direction of VIX. It was established in 2010 and has a 1.35% expense ratio.
- UVXY is an ultra, meaning it will move twice as much as the underlying VIX contracts it holds (similar to TVIX). It is structured as a commodity pool, holding multiple assets in the fund. It was established in 2011 and has an expense ratio of 0.95%. It typically moves inversely to the S&P 500.
- VXZ is an ETN based on medium-term VIX futures contracts, and will therefore be slightly less volatile than the short-term VIX futures ETNs (such as VXX). It was established in 2009 and has a 0.89% expense ratio. It typically moves inversely to the S&P 500.
These VIX-related ETPs, as well as a number of others that are available, offer investors ways to pinpoint how they want to trade volatility. There are leveraged ETPs, which give double exposure, useful for hedging large amounts of a stocks with a small VIX related position. Also there are various “expiry” ETPs; VIX-related ETPs based on longer-term VIX contracts will be less volatile than ETPs based on shorter-term VIX contracts.
While VIX-related ETPs are easy to make trades in if you have a brokerage account, there are some drawbacks. These ETFs typically way overshoot the corresponding move in the S&P 500. For example, a 1% drop in the S&P 500 may equate to a 3% rise (or something similar) in VXX. This can make precisely tuning a hedging strategy difficult.
Also, these products are not long-term investments, and are primarily meant for only short-term trading purposes. In the ETPs that move inversely to the S&P 500 there is long-term downward bias, making a buy and hold strategy in these products a bad choice.
The Bottom Line
Volatility is the measure of variance in price over time, but since investors don’t worry about prices going higher, volatility is usually only a concern when prices are dropping. The fear caused by dropping stock prices typically results in sharp moves, lack of investor confidence and rising volatility and VIX readings. VIX options are one way to trade fluctuations in the VIX. Payoffs can be big, but timing needs to be excellent as the options are European style.
Exchange traded products listed on the stock exchange are another way to profit from, or hedge against, volatility. While it is easy to enter and exit trades, the VIX and S&P 500 don’t always move exactly opposite, which can make fine-tuning a precise hedging strategy difficult. ETPs that move inversely to the S&P 500 also have a long-term downward bias, which means—like options—they should be used for short-term trading purposes only.
– Guide to the Average Directional Index (ADX) Indicator
The Average Directional Index (ADX) is a three-line indicator that includes the ADX line, Minus Directional Indicator (-DI) and Plus Directional Indicator (+DI). The indicator was developed by Welles Wilder–who also developed the Average True Range and Parabolic SAR among other indicators–and it helps traders determine if a stock or other asset is trending, and how strongly it is trending. Before using the indicator traders should understand how the indicator works, its uses for trading, and its limitations.
What Is the Average Directional Index (ADX)?
The indicator uses three lines to tell both the trend direction and the trend strength. When the +DI is above the -DI, buying is stronger than selling. When -DI is above the +DI, selling is stronger than buying.
The ADX line helps determine the strength of the trend. An ADX reading above 20 (some traders use 25) indicates a trend is present and attention should be paid to the +DI and -DI to determine the direction of the trend (see above). When ADX is below 20 a trend likely isn’t present, and therefore trend traders may wish to avoid trades in the asset.
The indicator is typically calculated over 14 days, although the indicator can be used on any chart, such as a 1-minute, hourly or weekly chart. A longer period than 14 days can be used by longer-term traders to produce less trade signals.
All charts created using StockCharts.com
The indicator has three lines, and each one must be calculated. The indicator is also based on True Range and Average True Range calculations – other indicators developed by Welles Wilder.
- Calculate the True Range for what will eventually be our +DI and -DI lines. True range is the greatest of the following: Current High minus current Low; Current High minus previous Close (absolute value); Current Low minus previous Close (absolute value).
- These values then need to be “smoothed,” typically over 14 days. Smoothing is discussed below.
- Divide the smoothed +DI by the 14-day smoothed True Range to find the 14-day +DI value, which will be used as the line on the chart. Multiply by 100.
- Divide the smoothed -DI by the 14-day smoothed True Range to find the 14-day -DI value, which will be used as the line on the chart. Multiply by 100.
- The Directional Movement (DX) equals the absolute value of +DI minus -DI divided by the sum of +DI and – DI.
- Average Directional Index (ADX) is a 14-day average of DX. All following ADX values are smoothed by multiplying the previous 14-day ADX value by 13, then adding the most recent DX value and dividing this total by 14.
To get the smoothed +DI and -DI values, use the following steps for each:
- Sum 14 True Ranges to get TR14
- Smooth it: TR14 – (TR14/14) + Current TR
- For following calculations: Prior TR14 – (Prior TR14/14) + Current TR14
To get the ADX values, use the following steps:
- ADX14 = 14 period Average of DX
- Following ADX values = ((ADX14 x 13) + Current DX Value)/14
Thankfully, the ADX is available on most trading platforms—so calculating by hand isn’t required—such as ThinkorSwim, and a number of free online charting sites including FreeStockCharts.com and StockCharts.com.
How ADX Is Useful
ADX can be used as part of a trading system that includes entry and exit signals, as well as for analytical insight.
When the +DI crosses above the -DI, initiate a long position. Since this type of signal is prone to “whipsaws” (when the multiple signals occur in quick succession) only take the signals that occur in the direction of the overall trend. A 50 or 100 period moving average can help determine the overall trend direction. As long as the price is above the moving average, initiate a trade when the +DI crosses above the -DI [see also Ultimate Guide to the Stochastic Oscillator].
Once a long trade is initiated, place a stop loss order below a recent low, like what is shown in Figure 2. Since the strategy centers around entering during a trend, and trends can persist for a long time, there is no specific profit target provided by the indicator.
When the -DI crosses above the +DI, initiate a short position (or also exit long positions). Only take new trade signals when they occur in the direction of the overall trend. A 50 or 100 period moving average can help determine the overall trend direction. As long as the price is below the moving average, initiate a short trade when the -DI crosses above the +DI.
Once a long trade is initiated, place a stop above a recent high, like what is shown in Figure 2. Since the strategy centers around entering during a trend, and trends can persist for a long time, there is no specific profit target provided by the indicator.
Beyond the crossover trading strategy, the ADX, +DI and -DI lines can help analyze a market.
Figure 4 shows an overall uptrend, as the price is making higher highs and higher lows and is also above a longer-term moving average. The ADX can help analyze this trend as it is occurring.
Working from left to right, the price is staying above the moving average, indicating the overall uptrend. When the +DI and -DI are close together it indicates a consolidation or pullback is occurring within the overall trend.
Over the course of the seven months, the ADX is continually making progress higher, moving from near 20 in January to over 40 in July. This shows the trend has been continually strengthening. This is due to how far +DI is above -DI; the large separation between the lines shows very strong upward momentum.
In July, +DI and -DI converge once again, indicating a consolidation or pullback in the overall uptrend. Looking up to the price, this is confirmed, as the price has been moving with more of a sideways trajectory in the July.
+DI and -DI lines crossover signals are prone to “whipsaws.” This is when the lines cross back and forth over each other in a short amount of time, generating multiple trade signals and likely resulting in losses. This is remedied by only taking trade signals in the direction of the larger trend (as discussed above). A trend line or moving average helps establish this longer-term trend.
The value of 20 or 25 may also not be ideal for isolating a trending market. The ADX may move above 25 only to fall back below it, for example. Just because the indicator moves above 20 or 25 doesn’t mean that trend will persist. It is also possible that a trend is in effect when the ADX is below 20; the trend is just not moving quickly.
Since it is an average, it can also be slow to react to trend changes. Like a moving average, it will always be lagging behind price. During a strong trend this can help keep traders stay in the trade, but the downside is that it will also typically get them in and out later than an indicator that is less “smoothed.”
The indicator does not provide a profit target. While that means the profit potential on trades is open ended, leaving room for big gains, it also means a lot of profit can be given back before a reversal signal is generated by the indicator. Therefore it is recommended that some profit taking strategy is implemented (see: 3 Ways to Exit a Profitable Trade).
The ADX indicator is a combination of three lines – ADX, -DI and +DI. When +DI is above -DI, it means buying is stronger than selling. When ADX is above 20 (or 25) it indicates a trend is in place. The direction of the trend is determined by whether +DI is above -DI, or vice versa.
Use a crossover trading system by isolating the dominant trend. If the trend is up, take long signals when +DI crosses above -DI. If the trend is down, take short signals when -DI crosses above +DI. Also use the ADX, +DI and -DI to analyze a trend once it is in place.
The ADX indicator does not include profit targets, and a stop loss must be manually implemented based on recent price action. ADX is also prone to “lagging” signals and a reading of 20 or 25 doesn’t necessarily mean a trend will persist. Also, a reading below 20 or 25 doesn’t necessarily mean a trend doesn’t exist, it just may be slow moving.
– Force Index Indicator: How to Use the Force Index
The Force Index indicator was developed by Alexander Elder in the book “Trading for a Living.” It fluctuates above and below zero, providing information on the power of a price movement based on price direction, magnitude of movement and volume. The Force Index helps confirm trending price waves and corrections, and highlights potential price reversals. To use the Force Index effectively, traders should understand how the indicator works, its applications, as well as its strengths and weaknesses.
What is the Force Index?
The Force Index fluctuates above and below zero. The indicator is above zero when the price is above the prior close; it is below zero when the stock price is below the prior close. This occurs when the indicator is set to calculate Force Index value for each period. Typically the indicator is averaged over more than one price bar though.
Set the indicator to 13 periods and it will take an average reading of the Force Index values over 13 periods to creates a smoother average, and provide more useful information.
How far the indicator moves above or below zero is based on the magnitude of the price move (from the close of the last price bar) and the volume for that price bar. Large price moves on large volume create significant and noteworthy swings on the Force Index. A large move with little volume creates a smaller swing on the Force Index.
When there is little volume or price movement the Index oscillates around zero, showing the price has no well defined direction or power. Under most circumstances, trades are avoided when there is a lack of strong movement as indicated by the Force Index.
All chart created using http://www.StockCharts.com
Figure 1 shows how the Force Index acts. We see spikes on the indicator when large price movements on large volume occur. The Force Index (20) is the 20-period average of Force Index (1), and therefore creates smoother values and stays either above or below zero for longer stretches.
Be sure to also read our Visual Guide to 8 Candlestick Patterns Every Trader Must Know
Force Index Calculation
Here’s the calculation for the force index:
Force Index (1) = [Close (current period) – Close (prior period)] x Volume
Force Index (20) = 20-period Exponential Moving Average of Force Index (1)
A 13-period average highlights short-term trends, and is suitable for shorter-term traders. A 100-period Force Index average will highlight longer-term trends and is preferred by longer-term traders.
The Force Index is available on most trading platforms, such as ThinkorSwim, and a number of free online charting sites including FreeStockCharts.com and StockCharts.com.
How It’s Useful
The Force Index has three primary uses: trending confirmation, isolating corrections within trends and highlighting underlying strength or weakness (divergence).
The indicator visually shows when a strong shift in buying or selling momentum occurs. When the Force Index clings to the zero line, there is little momentum and traders may want to stay on the sidelines instead of initiating trades.
When the Force Index moves forcefully below zero it shows strong selling pressure; when the indicator stays below zero it signifies a downtrend.
A forceful rise above zero on the indicator shows strong buying pressure; when the indicator stays above zero it signifies an uptrend.
Figure 2 shows a price range, uptrend and downtrend. When the indicator moves below its own small range created around the zero line, it signals the start of the price downtrend. When the indicator rallies back above zero it indicates the potential for a price uptrend.
Using trend identification and a short-term Force index, traders can find entry points into the trending move.
During an uptrend, buy when the 2-period Force Index drops below zero and then rallies back above zero.
During a downtrend, short-sell when the 2-period Force Index rallies above zero and then drops back below zero.
This will create a very active strategy. Increase the number periods on the Force Index to decrease the number of trading signals.
In Figure 3 a moving average (60) has been added to the chart to help highlight the trend, along with a 4-period Force Index. Alexander Elder recommended using a 22-day exponential moving average on the chart and a 2-period Force Index to isolate the trend and pullbacks. Traders will find that different combinations work better with different stocks and trading styles.
During an uptrend only long positions are taken when the Force Index moves back above zero (from below). A stop loss is placed immediately following the entry, just below the recent low. The trade is held until the trader receives an exit signal based on their own method, or the Force Index moves back below zero.
For a downtrend, only short positions are taken when the Force Index drops below zero (from above). A stop loss is placed immediately following the entry, just above the recent high. The short trade is held until the Force Index moves back above zero.
Divergence on the Force Index shows that either volume or the magnitude of price moves has slowed and therefore the trend may be weakening and vulnerable to a reversal.
Divergence is when the indicator and price are not moving in the same direction. For instance, the price is making new highs, but the indicator is making a lower high. Or price is making a new low but the indicator is making a higher low.
Figure 4 shows a “bullish divergence.” The price makes a new low (or similar low to the former), but the Force Index makes a higher low, showing that selling pressure is diminished and the price is vulnerable to a reversal higher.
Divergence is not a trade signal, nor does it provide good entry timing. It only alerts traders to the vulnerability of a reversal. Yet that reversal could take a long time to develop, or if momentum picks up again the reversal may not come at all. Another entry method must be used in conjunction with divergence to make it useful for trading purposes.
Force Index Limitations
The Force Index is prone to “whipsaws” which is when the indicator jumps back and forth across the zero line. If using the indicator for trade signals this can result in a number losing trades before a stronger price move develops.
Increasing the number of periods of the Force Index can help in this regard, but then entry and/or exit signals based on the signal will also be delayed.
The indicator accounts for volume, direction and the magnitude of price movements—all key components in trading—but it is still up to the trader to determine when to utilize the indicator’s signals for trading purposes.
Trend confirmation and divergence provide some analytical insight, but won’t always be accurate. Some other form analysis, another indicator or an entry and exit method must be applied to these concepts to make them tradeable.
Proponents of the Force Index
The creator of the indicator is Alexander Elder, a New York trader born in Leningrad. He has worked as a doctor, psychiatrist, and even taught at Columbia University. His medical and psychology background, coupled with decades of trading experience, give him a unique insight into developing trading systems and helping traders. More information is available at http://www.elder.com.
The Bottom Line
The Force Index is used in various capacities, including trend confirmation, trade signals within a trend and divergence. The indicator fluctuates above and below zero showing the force of the current price move based on direction, magnitude and volume. Since the indicator moves back and forth across the zero line it is prone to providing false signals. Using the indicator in conjunction with other indicators or price/trend analysis will help filter out some of the false signals, and will make divergences more tradeable.
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