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Archive for the ‘Technical Analysis’ Category

Overview of Indicators

You would think that any activity based on just two groups of people – Buyers and Sellers – would be a simple affair. After all, just determine who is dominant in the current market, the sellers or the buyers, and them act accordingly. Just start up the charting software and observe the prices and volume. What are the charts saying besides buying and selling? How can we approach this numerical Babel in an organized, coherent manner? Our objective is to take this chart information and be able to read them like a book. Is this series of movements a trend? How far down should I allow this price go before I consider buying? How do I formulate my stops? These are the vital questions that indicators can answer. If I didn’t have the power of technical indicators I would be guessing, trading by whim, by instinct, by emotion. Technical indicators represent the “control panel” of my analysis engine. Let’s take a quick overview of what technical indicators are and how they should be used.

Types of Indicators

There are two broad categories: Technical and Market indicators. Technical indicators function at the “micro-level” of our charts. We use technical indicators to interpret current time data. They provide us with information at time specific intervals, i.e., three minute, one hour or one day charts. On the other hand Market indicators function at the “macro-level” of our analysis. Instead of focusing on a series of three minute price movements, market indicators interpret entire sectors, markets, economies. As such, market indicators follow a more comprehensive time frame of weeks, quarters, years. Examples of market indicators include the unemployment rate, consumer sentiment, housing starts and Consumer Price Index.

Technical Indicators

Technical indicators have a limited function: they Alert, they Validate and they Anticipate. If we accept this premise then we will avoid the unfortunate habit of basing our trading decisions solely on technical indicators. We will also avoid the habit of allowing technical indicators to become an end in themselves. There are hundreds of indicators and oscillators with new ones being written each week. Leave the indicator search to the Don Quixote’s who believe that the one, true method is only an equation away. If we confine our use of indicators to alerting, validating and anticipating, we are on our way to good trading set-u8ps based on solid analysis of the price/volume data.

What Indicators and When?

Ironically, the most reliable technical indicators are those that have been around the longest. Indicators fgenerally fall into four categories and we will review each category with example indicators for each.

Trend Indicators

The primary tool for detecting and monitoring trends are Moving Averages. Moving averages come in a variety of flavors from the very simple (simple moving averages) to the more complex (exponential moving averages). They primarily follow price/volume data, helping to smooth out spikes in price behavior. They are excellent tools for identifying and confirming trends in the market, but since they are lagging indicators (follow prices) they are not good predictors of price activity unless they are used with another, complementing technical indicator.

Momentum Indicators

Momentum indicators allow us to measure the speed at which prices and volume are changing. Momentum indicators take the form of oscillators, that is, they represent values that range above and below a centerline, normally valued at zero. Commonly used momentum oscillators include “Rate of Change” (ROC), “Relative Strength Index” (RSI) and “Stochastic’s” developed by Dr. George Lane.

Volume Indicators

Volume indicators are used to confirm the robustness and strength of a trend. Examples of volume indicators are the “Volume Oscillator”, the “Price and Volume Oscillator”.

Volatility Indicators

Lastly, the volatility indicators are used to validate price behavior. Volatility indicators are often used with volume indicators to validate price behavior. “Bollinger Bands”, C”Chaiken Volatility” and “Keltner Channels”.

General Guidelines for Using Indicators

Given the enormous number and variety of technical indicators, a specific explanation of each is beyond the scope of this article. However, some general guidelines will assist the beginning trader as he or she builds their analytical muscle:

1) Select just two or three indicators and master their use and interpretations

2) Avoid using indicators that are so similar that their conclusions lead to false signals and inaccurate information on Price/Volume activity. Always use indicators that help analyze different components of price/volume behavior. For example, don’t use two momentum oscillators as a basis for your trade decision since they are focused on basically the same aspect of price/volume behavior.

3) Indicators that complement each other but are not based on the same data will often not correlate and will sometimes contradict. This makes a conclusion more reliable when they do agree.

4) Most of the most popular indicators and oscillators are built into charting software. Plan to spend some time learning how to setup and display these indicators to fit your trading style. Remember, each trader is different and developing your own way of analyzing the charts will help you as you solidify your trading style and experience.

The Big Picture

Using technical indicators give you a lorgnette into the continuing drama of the market (I’ve always wanted to use “lorgnette” in a sentence – word for the day). Use your indicators as a mechanic uses her Snap-On tools or as a stylist uses his shears and you will be part of that small 10% of all traders who actually makes money.

High Probability Trading, in my opinion, is defined as those Trades that are Low Risk with a Very Good Chance of working out. In other words, making Trades with the Odds in your Favor.

For the most part, High Probability Trading is trading in the direction of the major Trend. There are numerous ways to define a Trend. For example, Moving Average crossovers, MACD, ADX/DMI, and other Indicators. One of the most simple ways to define a trend, yet often overlooked, is by using Price Action itself. The Market does not go straight up and/or straight down, it moves in a series of Waves, Higher Lows and Higher Highs or Lower Highs and Lower Lows. When a pattern of Higher Lows and Higher Highs or Lower Highs and Lower Lows changes, the Market may be providing a warning sign that a potential Trend Reversal is imminent.

A Technical Approach to define an Up Trend, Down Trend, and Sideways Trend by using Price Action itself is to apply the Market Cycle Model. The Market Cycle Model suggests that a Market has to be in one of four Market Stages.

The Four Stages of the Market Cycle, as illustrated in Figure 1, are a Basing Sideways Trend (Stage 1) with predominantly equal Lows and equal Highs, an Up Trend (Stage 2) with Higher Lows and Higher Highs, a Topping Sideways Trend (Stage 3) with predominantly equal Highs and equal Lows, and a Down Trend (Stage 4) with Lower Highs and Lower Lows.

Figure 1. The Four Stages of the Market Cycle.

Stage 1 (or Basing Sideways Trend) is where the Market is in a state of Equilibrium. During this stage, there will usually be several swings between Support at the bottom of the Sideways Trading Range and Resistance at the top of the Sideways Trading Range. This is the point where many Traders try to Enter LONG into the Market and catch the bottom price, however, it doesn’t do much good to initiate LONG positions yet until the beginning of Stage 2.

Stage 2 (or Up Trend) is where the Market is Advancing. This is the ideal time to initiate LONG positions, ideally on a Correction or when the Market pulls back to re-test the breakout from Stage 1. Initiating a LONG position here is a Low Risk, High Probability, and potentially High Return Trade. See Figure 2. This situation is Optimal for a LONG Entry as each successive High becomes Higher than the previous. The less the Market pulls back, the stronger the Market.

Stage 3 (or Topping Sideways Trend) is where the Market is in another state of Equilibrium. The Up Trend loses momentum and starts to Trend Sideways. During this stage, there will usually be several swings between Resistance at the top of the Sideways Trading Range and Support at the bottom of the Sideways Trading Range. This is the point where many Traders try to Enter SHORT into the Market and catch the top price, however, it doesn’t do much good to initiate SHORT positions yet until the beginning of Stage 4.

Stage 4 (or Down Trend) is where the Market is Declining. This is the ideal time to initiate SHORT positions, ideally on a Correction or when the Market rallies to re-test the breakout from Stage 3. Initiating a SHORT position here is a Low Risk, High Probability, and potentially High Return Trade. See Figure 2. This situation is Optimal for a SHORT Entry as each successive Low becomes Lower than the previous. The less the Market rallies, the weaker the Market.

Figure 2. Low Risk, High Probability, and potentially High Return Trade.

The key to successfully trading a Market is to:
(1) know how to Identify what Stage of the Market Cycle the Market is in,
(2) know what Direction you need to be Focusing your Trades on (determined by (1) above),
(3) know when a Favorable Opportunity presents itself to Enter the Market, and
(4) know how to Manage your Trades.

Figure 3.  A 15 Minute Chart of the E-Mini S&P500 Futures Contract (Oct through Nov 2008) clearly showing the Market Cycle.

In the Trading Concepts E-Mini Trading Course you will learn the Market Flow Analysis Method that will change the way you analyze charts altogether. This will help eliminate any confusion that you may have about the Markets and make your analysis more objective. Once you grasp this approach, trading the Market will become much easier for you… and more Profitable!