Studies

Accumulation/Distribution

The Accumulation/Distribution is a momentum indicator that associates changes in price and volume. The indicator is based on the premise that the more volume that accompanies a price move, the more significant the price move.

The Accumulation/Distribution is really a variation of the more popular On Balance Volume indicator. Both of these indicators attempt to confirm changes in prices by comparing the volume associated with prices.

When the Accumulation/Distribution moves up, it shows that the security is being accumulated, as most of the volume is associated with upward price movement. When the indicator moves down, it shows that the security is being distributed, as most of the volume is associated with downward price movement.

Divergences between the Accumulation/Distribution and the security’s price imply a change is imminent. When a divergence does occur, prices usually change to confirm the Accumulation/Distribution. For example, if the indicator is moving up and the security’s price is going down, prices will probably reverse.

A portion of each day’s volume is added or subtracted from a cumulative total. The nearer the closing price is to the high for the day, the more volume added to the cumulative total. The nearer the closing price is to the low for the day, the more volume subtracted from the cumulative total. If the close is exactly between the high and low prices, nothing is added to the cumulative total.
= (Close – Low) – (High – Close) * Volume                (High – Low)

Average True Range

The Average True Range (“ATR”) is a measure of volatility. It was introduced by Welles Wilder. It measures the average of true price ranges over time.  

1)    High ATR values often occur at market bottoms following a “panic” sell-off.

2)    Low Average True Range values are often found during extended sideways movement, like as those found at market tops or after consolidation periods.

3)    The principle of forecasting based on this indicator can be worded the following way: the higher the value of the indicator, the higher the probability of a trend change; the lower the indicator’s value, the weaker the trend’s movement is.

   Calculation

True Range is the greatest of the following three values:

§     difference between the current maximum and minimum (high and low);

§     difference between the previous closing price and the current maximum;

§     Difference between the previous closing price and the current minimum.

The indicator of Average True Range is a moving average of values of the true range.

Band Envelope

The Band Envelope consists of moving averages calculated from the underling price, shifted up and down by a fixed percentage. The averages can be simple, exponential or weighted. When prices rise above the upper band or fall below the lower band, a change in direction may occur when the price penetrates the band after a small reversal from the opposite direction.

Envelopes define the upper and lower boundaries of a security’s normal trading range. A sell signal is generated when the security reaches the upper band whereas a buy signal is generated at the lower band. The optimum percentage shift depends on the volatility of the security–the more volatile, the larger the percentage.

The logic behind envelopes is that overzealous buyers and sellers push the price to the extremes (i.e., the upper and lower bands), at which point the prices often stabilize by moving to more realistic levels. This is similar to the interpretation of Bollinger Bands.

Remember, because only previous data is used to compute a Moving Average, it will always lag behind the actual prices. As a result, Moving Averages will not predict a change in trend, but rather follow behind the current trend. Use them for trend identification and trend following purposes and not for prediction. 

Sample Trade using Band Envelope:

Lets look at 2007 – 2008 bull market for EURO. Currency moved from 1.20 to 1.60 before GFC. During this bull market Currency often rallied sharply piercing upper band and settling back in to band before resuming up trend.

However It’s very hard to take entry and exit using band envelope. To take sample trade lets combine it with Relative Strength Index.

Buy rules in bull market:

- Price should close above bottom envelope

- RSI (10 days) should turn up above 50 after touching or trading below 50.

Profit booking

- Book profit when RSI (10 days) touch 75

In below chart Green line shows possible entry and Red line possible exit.

In this ways band envelope enable traders to locate support/ resistance and trend.

Bollinger Band

Bollinger Bands creator John Bollinger noted – a move that originates at one band tends to go all the way to the other band. This observation is useful when projecting price targets. Bollinger Bands are plotted at 2 standard deviations above and below a 20-day exponential moving average. As standard deviation is a measure of volatility, the bands are self-adjusting: widening during volatile markets and contracting during calmer periods. As a rule, prices are considered to be overextended on the upside (“overbought”) when they touch the upper band. They are considered overextended on the downside (“oversold”) when they touch the lower band. Using two standard deviations ensures that 95% of the price data will fall between the two trading bands. 

How to use Bollinger Band. 

1)    The simplest way to use Bollinger Bands is to use the upper and lower bands as price targets. In other words, if prices bounce off the lower band and cross above the 20 day average, then the upper band becomes the upper price target.

2)    A crossing below the 20-day average would identify the lower band as the downside target. In a strong uptrend, prices will usually fluctuate between the upper band and the 20-day average. In that case, a crossing below the 20-day average warns of a trend reversal to the downside.

Characteristics of Bollinger Bands.

• Sharp price changes tend to occur after the bands tighten, as volatility lessens.
• When prices move outside the bands, a continuation of the current trend is implied.
• Bottoms and tops made outside the bands followed by bottoms and tops made inside the bands call for reversals in the trend.
• A move that originates at one band tends to go all the way to the other band. This observation is useful when projecting price targets

Calculation  

First Find out Average (20) = Closing price of last 20 days               

                                                           20 

Now find out Standard Deviation 

Upper Band = Average (20) + Std Deviation

Lower Band = Average (20) – Std Deviation

Directional Movement Index

Directional Movement helps determine if a security is “trending.” Developed by Welles Wilder. This is a New Concepts in Technical Trading Systems, it can be used either as a system on its own or as a filter on a trend following system.

Two lines are generated in a DMI study, +DI and -DI. The first line measures positive (upward) movement and the second number measures negative (downward) movement. A buy signal is given when the +DI line crosses over the – DI line while a sell signal is generated when the +DI line crosses below the – DI line.

In addition to these crossover rules, Wilder believes one should also follow the extreme point rule. When a crossover occurs, use the extreme price as the reverse point. This rule is designed to prevent whipsaws and reduce the number of trades. The extreme point rule requires that on the day that the +DI and -DI cross, you note the “extreme point.” When the +DI rises above the -DI, the extreme price is the high price on the day the lines cross. When the +DI falls below the -DI, the extreme price is the low price on the day the lines cross.

The extreme point is then used as a trigger point at which you should implement the trade. For example, after receiving a buy signal (the +DI rose above the -DI), you should then wait until the security’s price rises above the extreme point (the high price on the day that the +DI and -DI lines crossed) before buying. If the price fails to rise above the extreme point, you should continue to hold your short position.

In addition to these crossover rules, Wilder believes one should also follow the extreme point rule. When a crossover occurs, use the extreme price as the reverse point. For a short position, use the high made during the trading interval of the crossover. Reverse a long position using the low made during the trading interval of the crossover.

Exponential Moving Averages

In order to reduce the lag in simple moving averages, technicians often use exponential moving averages (also called exponentially weighted moving averages). EMA’s reduce the lag by applying more weight to recent prices relative to older prices. The weighting applied to the most recent price depends on the specified period of the moving average. The shorter the EMA’s period, the more weight that will be applied to the most recent price. For example: a 10-period exponential moving average weighs the most recent price 18.18% while a 20-period EMA weighs the most recent price 9.52%. As we’ll see, the calculating and EMA is much harder than calculating an SMA. The important thing to remember is that the exponential moving average puts more weight on recent prices. As such, it will react quicker to recent price changes than a simple moving average. Here’s the calculation formula.

Calculation of EMA

Exponential Moving Averages can be specified in two ways – as a percent-based EMA or as a period-based EMA. A percent-based EMA has a percentage as it’s single parameter while a period-based EMA has a parameter that represents the duration of the EMA.

The formula for an exponential moving average is:

EMA(current) = ( (Price(current) – EMA(prev) ) x Multiplier) + EMA(prev)

For a percentage-based EMA, “Multiplier” is equal to the EMA’s specified percentage.

For a period-based EMA, “Multiplier” is equal to 2 / (1 + N) where N is the specified number of periods.

For example, a 10-period EMA’s Multiplier is calculated like this:     

          2                       =          2                 =  0.3333 

(Time Period + 1)               (5 +1)

This means that a 10-period EMA is equivalent to an 33.33% EMA.

Note: StockCharts.com only support period-based EMA’s.

Below is a table with the results of an exponential moving average calculation for Eastman Kodak.

For the first period’s exponential moving average, the simple moving average was used as the previous period’s exponential moving average (yellow highlight for the 5th period). From period 6onward, the previous period’s EMA was used. The calculation in period 6 breaks down as follows:

1.     (C- P)  =  (13 – 11.4) = 1.6

2.     (C-P) * K= 1.6* 0.3333 = 0.5332

3.     ((C-P)*K) + P = 0.5332 + 11.4 = 11.9

EMA period (N) Smoothing Constant (K): 0.33333

Period               Closing Price           Previous Period EMA [P]                 EMA

1                             10

2                             11

3                             10

4                             12

5                             11                                                                               11.4

6                             13                                    11.4                                     11.9

7                             12                                    11.9                                     12.0

8                             13                                    12.0                                     12.3

9                             11                                    12.3                                     12.9

10                            16                                    12.9                                    13.9

MACD

MACD (“Moving Average Convergence/Divergence”) is a trend following momentum indicator. MACD is the difference between a 9-day and 24-day Simple Moving Average with a 9-day Exponential Moving Average (the “signal” or “trigger”) line plotted on top to show buy/sell opportunities. 

Three popular ways to use the MACD are crossovers, overbought/oversold conditions and divergences. 

· Crossovers:

The basic MACD trading rule is selling when the MACD falls below its signal line and buys when the MACD rises above it. It is also common to buy/sell when the MACD goes above/below zero. 

· Overbought/Oversold Conditions:

The MACD is also can be used as an overbought/oversold indicator. If the shorter moving average pulls away dramatically from the longer moving average and the MACD rises it is likely that the security price is overextended and will soon return to more realistic levels. 

· Divergences:

Expect the end a current trend may be near when the MACD diverges from the price of a security. A bearish divergence occurs when the MACD is making new lows while prices fail to match these lows. Likewise, a bullish divergence occurs when the MACD is making new highs whilePrices fail to follow suit. Both of these divergences are most significant when they occur at relatively overbought/oversold levels.

Money Flow Index

The Money Flow Index (“MFI”) is a momentum indicator that measures the strength of money flowing in and out of a security. It is related to the Relative Strength Index, but where the RSI only incorporates prices, the Money Flow Index accounts for volume.

Interpretation

The interpretation of the Money Flow Index is as follows:

• Look for divergence between the indicator and the price action. If the price trends higher and the MFI trends lower (or vice versa), a reversal may be imminent.
• Look for market tops to occur when the MFI is above 80. Look for market bottoms to occur when the MFI is below 20.

Divergences at points “A” and “B” provided leading indications of the reversals that followed.

Calculation

The Money Flow Index requires a series of calculations. First, the period’s Typical Price is calculated.

Typical Price = (High + Low + Close) /  3

Next, Money Flow (not the Money Flow Index) is calculated by multiplying the period’s Typical Price by the volume.

Money Flow = Typical Price * Volume

If today’s Typical Price is greater than yesterday’s Typical Price, it is considered Positive Money Flow. If today’s price is less, it is considered Negative Money Flow.

Positive Money Flow is the sum of the Positive Money over the specified number of periods. Negative Money Flow is the sum of the Negative Money over the specified number of periods.

The Money Ratio is then calculated by dividing the Positive Money Flow by the Negative Money Flow.

Money Ratio = (Positive Money Flow)/ Negative Money Flow

Finally, the Money Flow Index is calculated using the Money Ratio.

Moving Averages

Reading a chart without moving averages is like baking a cake without butter or eggs. Those simple lines above or below current price tell many tales, and their uses in market interpretation are unparalleled. Simply stated, they’re the most valuable indicators in technical analysis.

Why moving averages are considered to be an essential tool for technical analysis?  You can trade without moving averages, but you do so at your own risk. After all, these lines represent median levels where your competition will make important buying or selling decisions. So it makes sense to predict what they’re going to do before the fact, rather than afterward.

Different types of moving averages are used as an indicator by different analysts according to their perception and common use. Some of the commonly used moving averages are:

10 days, 20 days, 30 days, 40 days, 50 days, 1000 days, 200 days. Let’s discuss some of the important moving averages.

1) 10 days:   10 days moving averages are considered to be “Fast”, as it moves fast with change in price. As a human characteristic we can more easily remember things happened 10 minutes ago rather than 50 minutes ago or 1000 minutes ago. 10 Days moving average moves faster along with change in price. Usually 10 Days moving averages are used for Short Term horizon or to decide Short term trend.

2)  50 days:    In football game seats on the 50-yard line give football fans the ideal place to watch a game unfold. Similarly it’s no different when traders focus their attention on the 50-day moving average. This neutral ground between bulls and bears offers a perfect view of the market’s playing field. They are also known as “middle”, and are usually used for Middle Term horizon or to decide Middle term trend.

3)  200 days:    It is considered as “Slow”, as it moves slowly with change in price. It is most decisive for longer term horizon investments. Vision of mountain will be clearer by watching it from 200 meter instead in .         

Most trading strategies are based on moving averages. As we earlier discuss different traders use different moving averages for strategic decisions.

 SOME OF THE TRADING INDICATION BY USING MOVING AVERAGES:

While prices are below the moving average it is an indication of bearish behavior in relation to the trend length being viewed.  When price falls from above the moving average to below the moving average it warns that the price trend being viewed may be weakening. When price rises from below the moving average to above the moving average, it is a bullish indication of the price trend length under scrutiny

How to use moving averages:

1. The 10-day moving average commonly marks the short-term trend, the 50-day moving average the intermediate trend, and the 200-day moving average the long-term trend of the market.

2. Moving averages generate false signals during range-bound markets because they’re trend-following indicators that measure upward or downward momentum. They lose their power in any environment that shows a slow rate of price change.

3. The characteristic of moving averages changes as they flatten and roll over. The turn of an average toward horizontal signifies a loss of momentum for that time frame. These increases the odds that price will cross the average with relative ease. When a set of averages flat line and draw close to one another, price often swivels back and forth across the axis in a noisy pattern.

4. Moving averages emit continuous signals because they’re plotted right on top of price. Their relative correlation with price development changes with each bar. They also exhibit active convergence-divergence relationships with all other forms of support and resistance.

5. Price location in relation to the 200-day moving average determines long-term investor psychology. Bulls live above the 200-day moving average, while bears live below it. Sellers eat up rallies below this line in the sand, while buyers come to the rescue above it.

6. Don’t use long-term moving averages to make short-term predictions because they force important data to lag current events. A trend may already be mature and nearing its end by the time a specific moving average issues a buy or sell signal.

7.  By using 50 days moving average, the trade entry will come at the ideal time, rather than at the ideal price. For example, a pullback may hit its low many bars before issuing a decent buy signal.  

     Traders must choose between an ideal price and ideal time in most of their entries. Ideal price means entering into high volatility when price gets stretched to an extreme. Ideal time means standing aside until a pattern sets up for the move. Trading by price reduces risk but requires more patience. Trading by time takes on higher risk in exchange for the likelihood of an immediate move.

8. Inversely, entry will be ideal when lower high of correction are broken to the upside of 50 SMA

9.  Price action at the 50-day average flags many short-sale opportunities. Keep in mind that it’s best to stay with the trend when taking trades off this indicator. This means waiting until price breaks below it on strong volume then rallies back to test it from below. The subsequent reversal should set off sell signals across all kinds of trading platforms.

10. Price’s interaction with the 50-day average is obvious from a quick glance at the chart. Over and over again, it drops just below the average, sits there for a few bars and makes another run at the highs. How does a trader find the ideal time to go long and not miss the next run-up? 

Parabolic SAR

Described by Welles Wilder in his 1978 book, “New Concepts in Technical Trading Systems,” the Parabolic SAR (PSAR) sets trailing price stops for long or short positions. Wilder was looking for a system that could capture most of the gains in a trending market without relying on some external method to retain profits.

The Parabolic SAR provides excellent exit points. You should close long positions when the price falls below the SAR and close short positions when the price rises above the SAR.

If you are long (i.e., the price is above the SAR), the SAR will move up every day, regardless of the direction the price is moving. The amount the SAR moves up depends on the amount that prices move.

Another use of parabolic SAR is that when Parabolic SAR is coming down on every day and on particular day closing price ended above SAR value, investor may create long position and opposite. 

Rate Of Change

The Rate of Change is an oscillator that displays the difference between the current price and the price x-time periods ago. As prices increase, the ROC rises and as prices fall, the ROC falls. The greater the change in prices, the greater the change in the ROC. 

The 10-day ROC is an excellent short- to intermediate-term overbought/oversold indicator. The higher the ROC, the more overbought the security; when the ROC falls expect a rally. As with all overbought/over-sold indicators, watching for the market to start its correction before placing a trade. Often extremely overbought/oversold readings usually imply a continuation of the current trendAnd any overbought market may remain that way for some time. 

To construct a 10-day rate of change oscillator, the latest closing price is divided by the close 10 days ago: 

Calculation 

ROC =   (Close of day – Close 10 days ago)      *       100     

                         Close 10 days ago  

Relative Strength Index

The Relative Strength Index (RSI) is an oscillator first introduced in 1978 by Welles Wilder in Commodities (now Futures) Magazine. The RSI compares the magnitude of a stock’s recent gains to the magnitude of its recent losses on a scale from 0 to 100. RSI represent the strength of stock. 

• Tops and Bottoms.The RSI usually tops above 70 and bottoms below 30. It usually forms these tops and bottoms before the underlying price chart.
• Chart Formations.
  The RSI often forms chart patterns such as head and shoulders or triangles that may or may not be visible on the price chart.
• Failure Swings.
  Also known as support or resistance penetrations or breakouts. This is where the RSI surpasses a previous high (peak) or falls below a recent low (trough).
• Support and Resistance.
  The RSI shows, sometimes more clearly than price themselves, levels of support and resistance.
• Divergences.
  Divergences occur when the price makes a new high (or low) that is not confirmed by a new high (or low) in the RSI. Prices usually correct and move in the direction of the RSI. 

  Calculation: 
          RSI =      100 – (100/1+ (U  / D))

Where:

U=an average of upward price change

D=an average of downward price change 

Stochastic

The Stochastic Oscillator was popularized by George Lane. It is based on the observation that as prices increase, closing prices tend to be closer to the upper end of the price range. In downtrends the closing price tends to be near the lower end of the range.

The Stochastic Oscillator is made up of two lines that oscillate between vertical scales of 0 to 100. The %K is the main line and it is drawn as a solid line. The second is the %D line and is a moving average of %K. What makes the Stochastic unique is its use of a “smoothing factor” for the initial

%K line. The %K (full) line plotted is a n-period SMA of the initial %K line (wheren is equal to the middle parameter).

Three ways to interpret the Stochastic Oscillator:

Buy
when the Oscillator (either %K or %D) falls below 20 and then rises back above that level.

Sell
when the Oscillator rises above 80 and then falls below that level.

Buy
when the %K line rises above the %D line and

sell 
when the %K line falls below the %D line.

Calculation

The Stochastic Oscillator has four variables:

%K Periods.
This is the number of time periods used in the stochastic calculation.

%K Slowing Periods.
This value controls the internal smoothing of %K. A value of 1 is considered a fast stochastic; a value of 3 is considered a slow stochastic.

%D Periods.
This is the number of time periods used when calculating a moving average of %K. The moving average is called “%D” and is usually displayed as a dotted line on top of %K.

%D Method.
The method (i.e.Exponential, Simple, Time Series, Triangular, Variable, or Weighted) that is used to calculate %D.

The formula for %K is:

(Today’s Close – Lowest in % K periods)  / (Highest High in % K Periods – Lowest low in % K period)

For example, to calculate a 10-day %K, first find the security’s highest-high and lowest-low over the last 10 days. As an example, let’s assume that during the last 10 days the highest-high was 100 and the lowest-low was 60–a range of 40 points. If today’s closing price was 90, %K would be calculated as:

75 = (90 – 60) * 100 / (100-60)

The 75% in this example shows that today’s close was at the level of 75% relative to the security’s trading range over the last 10 days. If today’s close was 80, the Stochastic Oscillator would be 50%. This would mean that that the security closed today at 50%, or the mid-point, of its 10-day trading range.

The above example used a %K Slowing Period of 1-day (no slowing). If you use a value greater than one, you average the highest-high and the lowest-low over the number of %K Slowing Periods before performing the division.

A moving average of %K is then calculated using the number of time periods specified in the %D Periods. This moving average is called %D.