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Tutorial 9 - Introduction to technical indicators

Tutorial 9 - Introduction to technical indicators

Executive Summary

This tutorial looks at the use of technical indicators in technical analysis. We start with basic price charts, introduce moving averages and then discuss various technical indicators. Technical analysis uses various technical indicators to help an investor get their timing right. In this tutorial, we introduce technical oscillators such as the Overbought / Oversold (OB/OS) indicator; the Momentum indicator; the Stochastic indicator and the Relative Strength Index (RSI) indicator. We then discuss volume analysis and the On-Balance Volume (OBV) indicator, well as the Volume Price Trend (VPT) indicator. Finally we look at Relative Strength analysis and the Relative Strength indicator and conclude by putting everything that we have learnt about technical analysis together in a technical checklist.

Introduction to Technical Indicators

The world of technical analysis is huge. There are literally hundreds of different patterns and technical indicators investors claim to be successful. Trying to keep this tutorial short was not an easy task, but we will try our best to scratch the surface and introduce you to the different types of charts and the various technical analysis tools.

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

Why use Technical Indicators?

Technical indicators serve three broad functions: to alert, to confirm and to predict.

  1. An indicator can act as an alert to study price action a little more closely. If momentum indicator is waning, it may be a signal to watch for a break of support. Or, if there is a large positive divergence building, it may serve as an alert to watch for a resistance breakout.
  2. Indicators can be used to confirm other technical analysis tools. If there is a breakout on the price chart, a corresponding moving average crossover could serve to confirm the breakout. Or, if a stock breaks support, a corresponding low in the On-Balance-Volume (OBV) could serve to confirm the weakness.
  3. Some investors and traders use indicators to predict the direction of future prices.

Indicators indicate. This may sound straightforward, but sometimes traders ignore the price action of a share and focus solely on a technical indicator. Indicators filter price action with formulas. As such, they are derivatives and not direct reflections of the price action. This should be taken into consideration when applying technical analysis. Any analysis of a technical indicator should be taken with the price action in mind. What is the technical indicator saying about the price action of a share? Is the price action getting stronger? Weaker?

Even though it may be obvious when technical indicators generate buy and sell signals, the signals should be taken in context with other technical analysis tools. A technical indicator may flash a buy signal, but if the chart pattern shows a descending triangle with a series of declining peaks, it may be a false signal. There are various technical indicators which aid us in our interpretation of share charts and prediction of future trends, including:

  • Price Charts (i.e. Closing Line Charts, Bar Charts, Candlestick Charts and Point & Figure Charts);
  • Moving Averages;
  • The Overbought/Oversold (OB/ OS) indicator;
  • The Momentum indicator;
  • The Stochastic Indicator;
  • The Relative Strength Index (RSI) indicator;
  • The MACD indicator;
  • The On Balance Volume (OBV) indicator;
  • The Volume Price Trend (VPT) indicator;
  • The Relative Strength indicator

It is important to note from the outset that it is of vital importance to use as many indicators as possible in order to maximise profit. A technical indicator is a mathematical calculation that can be applied to a security's price and/or volume fields. The result is a value that is used to anticipate future changes in prices. For example: a moving average would fit this definition of a technical indicator. It is a calculation that can be performed on a security's price to yield a value that can be used to anticipate future changes in prices. In your analysis of the markets, it is suggested that you establish whether a market is "trending" or moving "sideways". Once you h

ave established this fact, you will be able to use "leading" and "lagging" indicators more effectively. What type of indicators you use, leading or lagging, is a matter of personal preference. It has been our experience that most investors are better at following trends than predicting them. Thus, we prefer trend following indicators. However, we have met many successful investors who prefer leading indicators.

Trend Following or Lagging Indicators

Moving averages and the MACD are examples of trend following, or lagging indicators. These indicators are great when prices move in relatively long trends. They do not warn you of upcoming changes in prices, they simply tell you what prices are doing (i.e., rising or falling) so that you can invest accordingly. Trend following indicators have you buy and sell late and, in exchange for missing the early opportunities, they greatly reduce your risk by keeping you on the right side of the market. Trend following indicators do not work well in sideways markets.

Trading or Sideways Market or Leading Indicators

The Relative Strength Index (RSI), Stochastic and Momentum indicators are examples of trading or leading indicators. These indicators help you profit by predicting what prices will do next. Leading indicators provide greater rewards at the expense of increased risk. They perform best in sideways, trading markets. Leading indicators typically work by measuring how overbought or oversold a share is. This is done on the assumption that a share that is oversold will bounce back.

Price Charts

Bar Charts - The technical analyst makes use of various charts during his analysis. The earliest forms of technical analysis relied exclusively on price-based charts, particularly the bar chart. A bar chart represents the relationship between price (vertical axis) and time (horizontal axis). Both the highest and lowest prices recorded during the particular trading period (daily, weekly, monthly, quarterly, annually etc.) are plotted and joined with a vertical line or 'bar'. The length of this vertical line would then show within which range the share was traded during that day. The closing price for the session is then indicated on this bar by means of a short horizontal line protruding to the right of the bar called a "tick".

Closing Line Charts - A more recent addition to the technical analyst's armoury are line charts. This chart which represents the relationship between price and time is the simplest type of graph, and the easiest to construct manually. The vertical axis represents a price range extending beyond the highest and lowest limits likely to be attained during the period to be covered. The horizontal axis covers the time over which the price is to be plotted. The information required to construct such a graph can easily be obtained from the business section of most daily newspapers or from one of the weekly financial magazines. Line charts are used in conjunction with moving averages to reveal the main trend of the share and to provide buy and sell signals. Various other indicators, such as the Overbought/Oversold Indicator, have been developed in an attempt to reliably pinpoint the troughs and peaks in the share's movements, allowing traders to take advantage of all the significant price changes.


Candlestick Charts - The candlestick techniques we use today originated in the style of technical charting used by the Japanese for over 100 years to analyse the price of rice contracts, long before the West developed the bar and point-and-figure analysis systems. In the 1700s a Japanese man named Homma, a trader in the futures market, discovered that, although there was a link between price and the supply and demand of rice, the markets were strongly influenced by the emotions of the traders. He understood that when emotions played into the equation a vast difference between the value and the price of rice occurred. This difference between the value and the price is as applicable to securities today as it was to rice contracts in Japan centuries ago. The principles established by Homma are the basis for the candlestick chart analysis, which is used to measure market emotions towards a security. Steven Nison is credited with popularising candlestick charting and has become recognised as the leading expert on their interpretation. Candlestick charts display the open, high, low, and closing prices in a format similar to a modern-day bar-chart, but in a manner that extenuates the relationship between the opening and closing prices. Candlestick charts are simply a new way of looking at prices; they do not involve any calculations.

When first looking at a candlestick chart, the learner of the more common bar charts may be confused; however, just like a bar chart, the daily candlestick line contains the market's open, high, low and close of a specific day. Now this is where the system takes on a whole new look: the candlestick has a wide part, which is called the "real body". This real body represents the range between the open and close of that day's trading. When the real body is filled in or black, it means the close was lower than the open. If the real body is empty, it means the opposite: the close was higher than the open. Just above and below the real body are the "shadows". Chartists have always thought of these as the wicks of the candle, and it is the shadows that show the high and low prices of that day's trading. If the upper shadow on the filled-in body is short, it indicates that the open that day was closer to the high of the day. And a short upper shadow on a white or unfilled body dictates that the close was near the high. The relationship between the day's open, high, low, and close determine the look of the daily candlestick. Real bodies can be either long or short and either black or white. Shadows can also be either long or short.

Point and Figure Charts - The Point & Figure (P & F) Chart is a one-dimensional chart based entirely on price which has no time frame, and is therefore capable of revealing the nature of the share price movement over an extended period of time. The chart is constructed using vertical rows of X's and O's to indicate rises and falls in the share price respectively. Like the bar chart, the point and figure chart can be used to identify periods of consolidation. In addition, it has an added advantage in that it can be used to set price objectives i.e. estimations of the price the share is likely to reach on the next up or down move, based on the chart formations.


Moving Averages

Perhaps no facet of technical analysis has more completely captured the imagination of the charting fraternity than moving averages. A moving average is essentially a "smoothed" and "lagging" price line that shows key turning points:

  • Smoothed because the line reveals the basic movements and patterns of the price line without the distracting and misleading "noise" of daily fluctuations, minor corrections or rallies.
  • Lagging because it tends to mirror the essential wave formation of the price line, but later in time. In other words it is delayed.

In short, the purpose of a moving average is to smooth out the daily fluctuations in the share's price so that the basic trends can be seen. In this way, the moving average provides a benchmark against which to judge whether a reversal in a trend has begun. Moving averages are usually used to generate a simple trading system or to confirm data obtained from other indicators. Generally, technical analysts will experiment with a number of different moving averages to establish which is the most effective.

The Simple Moving Average (SMA) - The simple moving average is calculated by dividing the sum of a number of daily share prices, by the number of daily prices added. i.e. SMA = (P1 + P2 + P3 + . . . )/ n

SMA = Simple Moving Average P = Share Price n = no of days or term length of the SMA

It should be apparent from the above formula that every day used in the calculation, whether the first, middle or last day, will carry equal weight. For example: ABC Ltd's closing share prices, over a ten-day period are set out in the table below. A 5-day simple moving average is calculated by adding up the past five days closing prices and dividing the sum by 5, for example, the moving average for day five is calculated as follows: SMA = 102 + 98 + 95 + 96 + 94/ 5 = 97

Simple Moving Average Calculation

DAY

PRICE

TOTAL

SMA

1

102c

2

98c

3

95c

4

96c

5

94c

485

97

6

97c

480

96

7

103c

485

97

8

105c

495

99

9

101c

500

100

10

99c

505

101

TOTAL

990

-

-

Moving averages are generally interpreted by comparing the relationship between the share price and its moving average:

  • A buy signal is given where the share price rises above its moving average i.e. price > Ma. For example: On day 7 in the above table, the share price is 103c, and the moving average is 97c i.e. 103 > 97, generating a buy signal.
  • A sell signal is given where a share price drops below its moving average i.e. Ma > price.

On day 10 in the above table, the share price is 99c, and the moving average is 101c i.e. 101 > 99, generating a sell signal.

The selection of the time period over which one chooses to calculate the simple moving average is of critical importance. Generally there should be a direct relationship between such time period and the market period being reviewed (i.e. the longer the market period under review the greater the time period used to calculate the simple moving average should be). The following formula can be used as an aid to such selection: MA Length = Market Period / 2 + 1. For example: If one is only looking at an 8-day period, the ideal moving average length would be 5.

Moving Average Crossovers

There are often times when you will find it difficult to establish a single moving average period to give accurate buy and sell signals which do not come too late to be of use. Sometimes it can be helpful to apply two or three moving average periods and consider the relationship between them. A moving average crossover is any penetration of a Moving Average (MA). However, close observation of any chart featuring a single MA period will usually reveal a number of whipsaws or false signals. How can we tell which crossovers are going to be valid penetrations? Unfortunately there is no way of knowing for certain, as many whipsaws cannot be avoided and should be regarded as fact of life. However, it is possible to avoid some of these close calls by using filtering techniques.
For example, you may decide to take action on a Moving Average crossover for which a 3% penetration takes place, and ignore all others.

A better way to avoid whipsaws involves using more than one moving average at a time. Signals are given by a shorter-term MA crossing above or below a longer-term MA. This procedure has the advantage of smoothing the data twice, thus reducing the possibility of a whipsaw, while warning of a trend change fairly quickly after it has taken place. For example, two MAs which have been found to be reliable in determining primary market moves are the 21-day and 40-day moving averages, when used together.

  • Buy signals are given when the 21-day MA moves above the 40-day MA and when the 40-day MA is advancing.
  • Sell signals are given when the 21-day MA moves below the 40-day MA and when the 40-day MA is declining.

You will notice that the combination of these two moving averages is better than either on its own. By experimenting with combination of moving averages you will begin to see that two moving averages inevitably give better signals than one on its own. You will also note that where the two moving average selected are quite close in terms of period, even more accurate results are possible and avoid most whiplashes or false signals.

Technical Oscillators

The Overbought/Oversold (OB/OS) Indicator - When using a moving average on a price chart, the gap between the moving average and the share price is continually changing. Analysts have found that the optimal time to sell a share is when the gap between the moving average and the price is at its greatest. The overbought/oversold indicator has been developed to calculate the percentage change between the moving average and the price. The overbought/oversold indicator is calculated by subtracting the predetermined moving average from the present share price, and dividing the resultant figure by the predetermined average: i.e. OB/OS = (Share Price - Ma for period n)/ Ma for period n x 100%

You can see that subtracting the moving average from the price gives the "gap" between the two lines. This is then expressed as a percentage of the moving average.

  • When the price is higher than the moving average the OB/OS will be positive;
  • When the price is lower than the moving average the OB/OS will be negative;
  • When the price is the same as the moving average the OB/OS will be zero.

From this you can see that the OB/OS oscillates from positive to zero, to negative to zero and back to positive again. If we draw the OB/OS indicator as a percentage oscillator, oscillating above and below zero, the moving average would be depicted by a solid horizontal line drawn at 0%.

The solid line representing the moving average is used as a basis for interpretation:

  • When the price reaches certain percentage levels away from the moving average, it is said to be either overbought if positive, or oversold if negative. When this happens, the chances are that the price will correct to rectify the situation. Thus, any change in trend of the overbought / oversold indicator may be regarded as a warning of a trend to price change. Note that the percentage level move away from the moving average is calculated by analysing the highest or lowest prices obtained for the share in recent periods.
  • When the share price passes through the 0% line from the overbought (positive) to the oversold (negative) area, or when the overbought/oversold indicator is positive, a sell signal is generated. In other words, when the moving average on the chart breaks through, and moves below the 0% line the share is in a bear trend (the closing price having moved below the moving average).
  • When the share price passes through the 0% line from the oversold (negative) area to the overbought (positive) area, or when the overbought/oversold indicator is negative, a buy signal is generated. In other words, when the moving average on the chart breaks through, and moves above the 0% line the share is in a bull trend (the closing price having moved above the moving average).

Traditional moving average buy and sell signals would be given where the OB/OS indicator breaks up and down through the zero line respectively. The suggestion is, however, that a far better buy and sell signal can be obtained by buying where the OB/OS reaches a maximum negative value and selling where it reaches a maximum positive value. The problem is: How do you know when the OB/OS indicator is at its maximum? Of course you do not know, so you might ask, "What have we achieved by this calculation?" The answer is that we have reduced our problem (of finding the best buy and sell signals) to an oscillator. You can now begin to apply the techniques of statistics and probability to the problem. For example, you may study the price data history of a particular share's OB/OS over a few years and establish that at no stage has it been wrong to buy the share when it fell below minus 10%. In fact, you could then establish a 'buy line' at the minus 10% level.

You can see, however, that every time the OB/OS reaches the buy line, it penetrates it at least twice (on the way down and then on the way up). In technical analysis, we require a clear 'crossover' to give us a signal. With the OB/OS indicator, the second crossover where the OB/OS indicator moves up through the buy line is the correct buy signal. The reason for this is that the OB/OS can remain below the buy line for a considerable period, and while it does, the share price and the moving average lines must be moving down strongly. We only become interested when the trend reverses and the OB/OS indicator begins to move back towards the zero line.

Looking at this, you might conclude that all we need to do now is to put on a plus 10% 'sell line' and our problems are solved! Unfortunately, the matter is not quite so simple. Novice investors and traders in the share market tend to think that buying and selling shares is like the two sides of a coin; the same thing, just the opposite way around. Professional investors know that there is a great difference between buying and selling shares. The point is that when you buy shares, you can optimise in two dimensions; in terms of which share you choose to buy and in terms of when you choose to buy it. But when you sell, you can only sell the shares that you have. You cannot choose which share you want to sell. For that reason you can optimise in the timing dimension only. There is no purpose in setting a sell line because the share which you are holding may never reach there. Whereas you can search through the list of shares available on the share market which have fallen through your buy line in order to buy them, you cannot do that when you wish to sell!

For this reason, the OB/OS indicator is primarily a buying technique. It is designed to get you into the market at the right point, because you make your money when you buy, not when you sell. If you buy at the wrong time, then you have lost whatever happens! Having said that, there are some mechanisms in the OB/OS indicator that can be used to improve your timing when you sell:

  • You can apply a 10-day moving average of the OB/OS indicator to your chart. This will give you a classic moving average sell signal where the OB/OS indicator crosses below the moving average.
  • Watch out for the sideways market at the top of the trend. It often occurs that at the top of the cycle, the share price moves sideways for a while. This is because the smartest and the least smart investors are in the market at the same time (one selling, the other buying). They disagree drastically on the future prospects of the share and this causes it to move around like a cat on a hot tin roof! Do not get involved in this uncertainty. Recognise it for what it is and take your money elsewhere.

The overbought/oversold indicator is subject to the following criticisms:

  • Because the overbought / oversold indicator measures the rate of change between a moving average and a share price, it is sensitive to any changes in price trend. As a result it is more sensitive to the effects of "noise" of a specific share.
  • The overbought / oversold indicator tends to generate false buy or sell signals, particularly when the first part of a bull or bear trend is steep, causing the indicator to jump sharply away from the price.
  • The overbought / oversold indicator is usually a price follower and not a price determinant.

Novice investors and traders in the share market often become emotionally attached to a particular share. They tend to believe that once it is going up, it will go up forever. They are called the "irrepressible optimists". It seems that as a market reaches its highest point, the voices of the irrepressible optimists reach frenzy. The important thing is to remain calm and be objective! Professional investors begin with the understanding that the share market is by its nature cyclical. What goes up must come down. The share which you just sold will return to an OB/OS of minus 10% because the OB/OS indicator is an oscillator and if not that share then another. The secret is to get out while you have a profit. No one has ever become bankrupt by taking a profit and you should never regret selling a share too soon or chastise yourself for having taken a profit.

The fact is that every day there are many opportunities in the share market which pass you by. You need only to open the Business Day newspaper and look at the daily 'top ten up' to see that this is true. Why should it make any difference to you that one of these shares is one that you happen to have held three weeks ago? You will always miss opportunities in the share market no matter how skilled you become. Do not let this interfere with your objectivity. A professional is a person who sells too soon.

Returning to our analysis of the OB/OS indicator, it is useful to stand back for a moment and ask yourself what, in fact, does this indicator measure? The answer to that question is that it measures the rapid departure of the share price away from its moving average. This departure must be rapid because if it were not, then the moving average would move down with the price line, and there would be no material OB/OS gap. Now, under what circumstances would you expect the share price to depart rapidly away from its moving average? In general, this sort of thing only happens when the share market overreacts to some event.

The Momentum Indicator - There are many kinds of momentum indicators, from the simple rate of change (ROC) indicator to the more complex relative strength index (RSI) indicator, which will be covered later. Here we will deal with the basic rate of change indicator. Shares often behave in much the same way as a bounced ball - before they reach their highest point they tend to slow down. The Momentum indicator tries to measure the slowing-down process that occurs in these sideways markets so that the investor can anticipate the new trends, either up or down. The Momentum, or rate of change indicator, shows the percentage changes in price over the selected period. Effectively, it measures the slope of the curve. In other words, the momentum indicator shows the difference between two points, "A" and "B", which are a specific distance apart using the following formula: Momentum = Point B - Point A/ Point A x 100%

Thus:

  • Where point A and B are equal, the momentum will be zero.
  • Where point B is greater than momentum will be positive. This will be indicated by an upward slope.
  • Where point A is greater than point B momentum will be negative. This will be indicated by a negative downward slope.

The Momentum indicator has a number of important uses:

  • It can give you advanced warning of turning points in a cycle.
  • You can apply a buy line to your momentum oscillator in much the same way as you can with the overbought/oversold indicator.
  • The Momentum indicator is also very helpful in identifying the cyclical movements of shares and indicators.

For instance when one represents momentum as a percentage oscillator, oscillating above and below zero:

  • A positive rising momentum value (above the central line) indicates that the price trend is not only rising (velocity increasing) but that it is also accelerating. This is a bullish trend and indicates that the price is firmly in a strong uptrend.
  • A negative falling momentum value (below the central line) indicates that the price trend is not only falling but that it is also accelerating downwards. This is bearish and indicates that the price is firmly in a strong downtrend.
  • A falling momentum in the positive area indicates that the price trend is still rising, but that it is decelerating. It is during this phase that momentum warns that the price is ready to fall.
  • A rising momentum in the negative area indicates that the price trend is still falling, but that it is decelerating. It is during this phase that momentum indicates the price is ready to rise.

The Stochastic Indicator - Up until now we have discussed line indicators that oscillate around zero. The difficulty with such indicators (such as the overbought/oversold and momentum indicators) is that the degree of oscillation varies considerably from one share to another. To overcome this problem and standardise buy and sell levels for all shares, irrespective of their volatility, mathematicians have come up with formulae which always oscillates between 0 and 100. The Stochastic Indicator and Relative Strength Index (RSI) are examples of this. Although the stochastic indicator was designed primarily for the ultra-short term and short-term investor, it has proven just as valuable to even long-term investors. As with all oscillators, like the overbought/oversold indicator, the stochastic indicator indicates overbought and oversold levels.

The stochastic indicator is based on the premise that closing prices tend to accumulate near the tops of each period's trading range during price up-trends, and at the bottom during price downtrends. This can be seen by studying a simple bar chart. As a downward trend turns into an upward trend, bullish sentiment gains momentum, and you will find that the share begins to close closer to its daily high than its daily low. As the bull trend matures and begins to turn down, the share begins to close closer to its low. The stochastic indicator measures the relationship between the close, high and low on a scale of 1 - 100. The value of the stochastic indicator on any given day, is the position of the closing price in percentage terms relative to the high and low of the trading range. The actual calculation of the stochastic indicator, like many indicators, requires the user to first select a period over which the calculation will be measured. Once this has been done, the simplified formula for calculating the stochastic is as follows:

Stochastic Indicator = Close - Low / High - Low x 100%

For example:

  • If the closing price for the day is equal to the day's high, the stochastic indicator will have a value of 100%.
  • If the closing price for the day is equal to the day's low, the stochastic indicator will have a value of 0%.

The value of the stochastic indicator on any given day is the position of the closing price in percentage terms relative to the high and low of the trading range. After a strong rise or fall, prices tend to consolidate. If during this consolidation, prices close away from the extremes, the stochastic indicator will start to move in the opposite direction indicating an imminent price reversal.

So how does this help you decide when to buy or sell?

  • The ideal buying area is between the 10% and 20% range. In other words, a buy signal is generated when the %D line breaks through the %K line below the 20% but above the 10% level, from the left to the right, and %K is in a positive or upward trend.
  • When the stochastic indicator is used as a selling tool, the ideal area is defined as the 85% to 90% range. In other words, a sell signal is generated when the %D line breaks through the %K line from left to right and there is a sharp down trend in the %D line between 85% and 90%.

The Relative Strength Index (RSI) Indicator - The Relative Strength Index ("RSI") indicator was developed by Welles Wilder in 1978. It is a very popular oscillator but the name "Relative Strength Index" is slightly misleading. Relative strength generally refers to the ratio of a security or index to another security or index. As such, the ratio is a measure of the strength of one entity relative to the strength of another entity. The Relative Strength Index (RSI) indicator should not be confused with the relative strength indicator. These two indicators are totally unrelated!

The RSI indicator does not compare the relative strength of two securities, but rather the internal strength of a single security against itself. A more appropriate name might be "Internal Strength Index." Relative strength charts, on the other hand, compare two market indices, which are often referred to as Comparative Relative Strength. The Relative Strength Index (RSI) indicator is a method of measuring the relative strength of a share against itself, as opposed to measuring it against its sector or another share. It is a smoothed and weighted velocity index with a fixed scale between 0 and 100. The RSI indicator is defined as being equal to the average value of 'up-day' closes divided by the average value of 'down-day' closes over that period.

The formula for the RSI indicator is as follows:

RSI = 100 - 100 / 1 + RS), where RS = Average price of the last 'n' days up / Average price of last 'n' days down

Note:

  • "Up Days" are days on which the closing price was higher than the previous day; and
  • "Down Days" are days on which the closing price was lower than the previous day.

For example, suppose that you were calculating the RSI for the following 21-day period:

Day

Price

Change

0

4000

-

1

4050

+ 50

2

4075

+ 25

3

4125

+ 50

4

4100

- 25

5

4150

+ 50

6

4160

+ 10

7

4125

- 35

8

4170

+ 45

9

4200

+ 30

10

4175

- 25

11

4210

+ 35

12

4220

+ 10

13

4200

- 20

14

4250

+ 50

15

4300

+ 50

16

4275

- 25

17

4225

- 50

18

4250

+ 25

19

4220

- 30

20

4200

- 20

21

4170

- 30

The table above shows twelve days on which the share price went up (blue) and nine days on which it fell (red). The total of the rises was 430, and the falls added up to 260. The RSI calculation for day 21 can now be calculated as follows:

RS = Average price of the last 'n' days up /Average price of last 'n' days down = (430/12) / (260/9) = 35.83/ 28.89 = 1.24 and putting this number into the RSI formula:

RSI = 100 - 100 / (1 + RS) = 100 - 100 / (1 + 1.24) = 100 - 44.64 = 55.36

From this analysis, you can see that the direction of the RSI indicator will be determined by the 'speed' with which the share price moves either up or down. Three strong rises of 50c each would outweigh 18 small declines averaging 25c, so that even where the net movement over the period is negative, the RSI indicator would be high and vice versa. Note that the algorithm for the RSI indicator ensures that the result is always positive and between 0 and 100, no matter what data is included. It can never fall below zero.

The RSI indicator is effectively a sophisticated momentum or price-following oscillator that allows the investor to quantify on a scale of 1 to 100 the change in the closing price thereby allowing a direct comparison to be made between shares. Simple momentum which shows the difference between two points which are a specific distance apart but does not indicate share performance between those two points i.e. it is simply point "A" minus point "B" expressed as a percentage of point "B". In contrast the RSI indicator takes the average value of up days divided by the average value of down days over that period. The relationship between momentum and the RSI indicator is of significance. In short, the direction of the RSI indicator will be determined by the "speed" with which the price moves either up or down. Even where the net price movement over the period is negative, the RSI indicator will be high and vice versa. In other words, momentum will often be positive when RSI indicator is low.

Buy and sell lines are triggered by a break up through 30 (bullish) and a breakdown through 70 (bearish). You will find that the period of the RSI influences the volatility of the indicator and the positioning of your buy and sell lines. Welles Wilder recommended using a 14-day RSI indicator, but since then, the 9-day and 25-day RSI indicators have also gained popularity. Because you can vary the number of time periods in the RSI calculation, it is suggested that you experiment to find the period that works best for you. (The fewer days used to calculate the RSI, the more volatile the indicator. Alternatively the longer the period, the less volatile the RSI becomes, and the closer the buy and sell lines are to each other). A popular method of analysing the RSI is to look for divergence when the security is making a new high, but the RSI is failing to surpass its previous high. When the RSI then turns down and falls below its most recent trough, it is said to have completed a "failure swing." The failure swing is considered a confirmation of the impending reversal.

There are five uses for the RSI indicator, which can be applied to commodity charts as well as to other security types.

  1. Tops and Bottoms - The RSI indicator usually tops above 70 and bottoms below 30. It usually forms these tops and bottoms before the underlying price chart.
  2. Chart Formations - The RSI indicator often forms chart patterns such as head and shoulders or triangles that may or may not be visible on the price chart.
  3. Failure Swings - This is where the RSI indicator surpasses a previous high (peak) or falls below a recent low (trough). Failure swings are also known as support or resistance penetrations or breakouts.
  4. Support and Resistance - The RSI indicator shows, sometimes, more clearly than price, levels of support and resistance.
  5. 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 indicator. Prices usually correct and move in the direction of the RSI indicator.

Buying Guidelines

  • Ensure that the security is in an uptrend, i.e. the price is above an established trend line. (Note: If the market is non-trending where prices are fluctuating in a horizontal trading range, the RSI indicator could be used to profit from the cyclical variations if of sufficient amplitude).
  • The RSI indicator should indicate that an oversold condition exists, i.e. the RSI indicator has dropped below 30.
  • Look for divergences in the slope of the lines between the RSI indicator and the price line in the area below 30. If there is divergence, the price would have made a new low which is not confirmed by the RSI indicator. The RSI would form a double bottom or, preferably, two successive rising troughs. This is a warning of an imminent reversal in the price trend.
  • If the above holds true and the RSI indicator is still near the lower boundary, a good buy signal will be given when the RSI rises above its previous peak (a bottom failure swing).
  • An alternative, but probably less effective, buy signal to that given above, is generated by the crossing of the 30 line on the upside, i.e. after bottoming below 30.

Please note that divergence will probably not occur in most cases. In the absence of divergence, a purchase will assume greater risk.

Selling Guidelines

  • Ensure that the security is in a downtrend, i.e. the price is below an established trend line.
  • The RSI indicator should indicate that an overbought condition exists, i.e. the RSI indicator is above 70.
  • Look for divergences in the slope of the lines between the RSI indicator and the price line in the area above 70. If there is divergence the price would have made a new high but the RSI indicator has not. The RSI would form a double top or, preferably, two successive lower peaks. This is a warning of an imminent reversal in the price trend.
  • If the above holds true and the RSI indicator is still near the upper boundary, a good sell signal will be given when the RSI falls below its previous trough (a top failure swing).
  • An alternative, but probably less effective, sell signal is generated by the crossing of the 70 line on the downside, i.e. after peaking above 70.

Please note that divergence will probably not occur in most cases. In the absence of divergence, a sell signal will not be as effective.

The MACD Indicator - The MACD ("Moving Average Convergence/Divergence") indicator was developed by Gerald Appel. It is a trend-following momentum indicator that shows the relationship between two moving averages of prices. In other words, it is the difference between a 26-day and 12-day exponential moving average (EMA). A 9-day exponential moving average, called the "signal" (or "trigger") line, is then plotted on top of the MACD to show buy/sell opportunities. The result is an indicator that oscillates above and below zero. The MACD indicator is calculated by subtracting the 26-day moving average of a security's price from a 12-day moving average of its price. The result is an indicator that oscillates above and below zero.

The MACD indicator is the difference between two moving averages of price. When the shorter term moving average rises above the longer term moving average (i.e. the MACD rises above zero), it means that investor expectations are becoming more bullish (i.e. there has been an upward shift in the supply/demand lines). By plotting a 9-day moving average of the MACD, we can see the changing of expectations (i.e. the shifting of the supply/demand lines) as they occur. The MACD indicator proves most effective in wide-swinging trading markets.

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

Crossovers - The basic MACD trading rules for crossovers are:

  • Sell when the MACD falls below its signal line.
  • The buy signal occurs when the MACD rises above its signal line.

It is also popular to buy/sell when the MACD goes above/below zero:

  • When the MACD falls below zero, it means that the 12-day moving average is less than the 26-day moving average, implying a bearish shift in the supply/demand lines.
  • When the MACD is above zero, it means the 12-day moving average is higher than the 26-day moving average. This is bullish as it shows that current expectations (i.e. the 12-day moving average) are more bullish than previous expectations (i.e. the 26-day average). This implies a bullish, or upward, shift in the supply/demand lines.

Overbought/ Oversold conditions - The MACD indicator is also useful as an overbought/oversold indicator. When the shorter moving average pulls away dramatically from the longer moving average (i.e. the MACD rises), it is likely that the security price is overextending and will soon return to more realistic levels. MACD overbought and oversold conditions vary from security to security.

Divergences - An indication that an end to the current trend may be near occurs when the MACD diverges from the security.

  • A bearish divergence occurs when the MACD is making new lows while prices fail to reach new lows. An ideal sell signal is given by bearish divergence and a move below the trigger line which is then followed by a downward penetration of the zero line.
  • A bullish divergence occurs when the MACD is making new highs while prices fail to reach new highs. An ideal buy signal occurs when there is bullish divergence, accompanied by the oscillator moving above the trigger line and then a crossing by both lines above the zero line.

Both of these divergences are most significant when they occur at relatively overbought/oversold levels. Trend lines can be used to help spot probable changes in trend.

The On-Balance Volume (OBV) Indicator - When analysing bar charts, it is very useful to consider the volume histogram at the bottom of the chart. This gives you a clear indication of the daily volume traded. In general:

  • Before a price starts to rise, the volume traded increases dramatically as the smart money buys into shares; and
  • When an upward trend begins to falter, you will see a decline in volumes.

The On-Balance Volume indicator has been devised in order to predict such movements. On-balance volume is a cumulative or running total to which the current volume is added, if the current closing price is higher than the previous, or subtracted, if the current closing price is lower than the previous. If the current closing price is equal to the previous, the cumulative figure is carried forward, i.e. OBV any particular day = previous days OBV ± volume.

Consider the following example:

Day

Price

Volume

Move

OBV Total

1

500c

2 000

-

0

2

510c

4 000

+4 000

4 000

3

510c

3 000

-

4 000

4

505c

2 000

- 2 000

2 000

5

515c

3 500

+3 500

5 500

On day 1, the closing price is 500c with 2 000 shares traded, but we do not know what happened on the previous day and so no move or total is recorded. On day 2, the share moves up 10c with 4 000 shares traded so the total is increased accordingly. Day 3 sees the share stable or unchanged at the same price, and no change is made to the OBV total. On day 4, the share price falls back to 550c on 2 000 shares traded and so the total must be reduced by this amount. On day 5, the total is increased again because 3 500 shares have traded on a price rise to 515c.

The OBV total is plotted on a chart so that areas of accumulation and distribution can be easily seen as a zigzag pattern. The OBV indicator can be interpreted as follows:

  • A rising line indicates accumulation by strong buyers; and
  • A falling line indicates distribution by strong sellers.
  • Often, the share price appears to be moving aimlessly sideways, but in fact there is a process of steady accumulation going on which will ultimately lead to a strong price rise. This volume accumulation would not be obvious to a person who simply looked at a share price chart, but it is clearly evident on the OBV chart.
  • Traditionally, the OBV indicator gives a "buy" signal when it breaks steeply through a 10-day moving average so rapidly that the angle between the OBV indicator and the 10-day moving average is acute (and vice versa). This rule, however, tends to lead to many signals, some of which turn out to be whiplashes or false signals.

The Volume Price Trend (VPT) Indicator - Some analysts feel that the OBV indicator is deficient in that it takes no account of the extent of a price movement. In other words, the OBV total increases by the same amount when a share price rises; regardless of whether the rise is by 1c or 100c. To overcome this difficulty, they developed the Volume Price Trend (VPT) indicator. The VPT chart is one of the most powerful charts available to the investor today. Although primarily designed for short-term investor, like the stochastic indicator, it has proven just as useful to long-term investors (after all short-term volume extremes could also signal longer-term trends). The VPT indicator is a cumulative line, to which the current percentage change in share price, from the previous period, multiplied by the current volume, is added (if the share price is moving up) or subtracted (if the share price is moving down) to 'hash' number or running total.

Taking the same data as we had in our OBV example, the VPT would be as follows:

Price

Volume

% Change

Hash Volume

VPT

1

500c

2 000

-

-

0

2

510c

4 000

+ 2.0

+ 8 000

8 000

3

510c

3 000

-

4 000

8 000

4

505c

2 000

- 0.98

- 1960

6 040

5

515c

3 500

+ 1.98

+ 6930

12 970

The 'hash volume' is calculated by multiplying the percentage change by the volume traded. Volume is often best observed on a simple bar chart. The VPT total produced on a chart is quite similar to the OBV chart. It does not appear to offer any significant benefits in predicting an impending bull or bear trend, and often the OBV gives an earlier warning. The VPT indicator, however, makes it easier for investors to assess the balance between selling and buying pressures. The volume of shares traded is an indication of the size of the two groups of traders on the share market, namely buyers and sellers. The percentage change in the closing price of the share is an indication of the relative size of each group.

  • When there are more buyers than sellers (i.e. demand > supply) the price of the share will rise as buyers compete with each other to purchase shares.
  • Similarly, when there are more sellers than buyers (supply > demand), the price of the share will fall as sellers compete with each other to sell shares.

Thus, in simple terms the VPT indicator represents the amount of money going into or out of a share, thereby aiding investors in assessing the balance between selling and buying pressure. Sharp movements in the VPT line will therefore probably indicate the presence of a big buyer or seller:

  • An increase in the VPT indicator is caused by a percentage increase in price. A steep rise in VPT indicator is caused by either a large percentage increase or a large volume, or both. A large percentage price change accompanied by high volume is the most emphatic type of action, and is often suggestive of further movements in the same direction. Thus a sharp rising line would generate a buy signal.
  • A decrease in the VPT indicator is caused by a percentage decrease in price. A steep fall in the VPT indicator is caused by either a large percentage decrease or a large volume, or both. A sharp falling line thus generates a sell signal.

With the VPT chart you may also note the following:

  • The VPT chart is often more volatile than the OBV chart because the share price changes tend to exaggerate the effect of adding or subtracting the volume. The only way to really decide which of the two indicators is better is to examine them individually on many different shares. Volume can, of course, be used as it stands in arriving at buy and sell decisions. Increases or decreases in activity can be identified on a bar graph, or by recording daily volume and noting marked changes. The VPT and OBV techniques attempt to provide a more formal context for interpretation of volume activity.
  • The VPT indicator will be especially helpful when your moving averages are at the weakest. The technique of volume price trend charting is aimed specifically at taking advantage of the shorter moves which go to make up the longer trends.
  • The VPT indicator is an extremely sensitive tool that can be used to gain profits when the long-term trend in an industry or share price proves to be static. This is because even within an apparently inactive long-term trend there are fluctuations in buying and selling pressure.
  • The object of VPT analysis is to gauge the balance between buying pressure and selling pressure so that if there is a movement away from this balance, it is relatively easy to judge its source (i.e. more sellers or more buyers) and act accordingly. Before you can construct a VPT chart, you will have to choose a suitable time period. A daily chart is generally too sensitive, while a monthly chart is not sensitive enough. You will probably find that a weekly chart is the most useful.
  • When the VPT chart moves sharply upwards from a support level and breaks through the previous resistance level top, a buy signal is given. A sell signal is given when the VPT line moves down from the resistance level and passes through the previous support level bottom.

A trend line may be drawn to connect any tops or bottoms. Steeper trend lines indicate that the top or bottom of the move is being approached, and you should get ready to adjust your position accordingly. Shallower trend lines indicate that the move is likely to be protected. Signals, which are not valid, occur when an upward moving VPT line breaks through a rising trend line and its rate of climb has decreased. The same applies to VPT lines that are falling.

  • It is suggested that you always trade with the trend of the VPT chart, and never buy shares while a falling trend prevails. Likewise, do not buy shares that are moving against the trend of the VPT chart in the relevant sector.
  • You should use your VPT charts in conjunction with other types of charts, and ignore chart patterns such as triangles, flags and so on when these occur on your VPT charts, as they do not give reliable signals.
  • You will find that not all shares, or even sectors, are good propositions for VPT charting, and where this occurs you should not attempt to use them.

The OBV indicator is in many ways simply a less sophisticated version of the VPT chart. Many technical analysts prefer the OBV chart, however. They argue that buying and selling pressure does not always immediately lead to large price fluctuations, which the VPT indicator needs to show a large move i.e. if large volumes are being sold with a small price movement, the VPT indicator will not react strongly. However, large sale volumes (i.e. institutional activity) with a small price movement will have a big impact on the OBV chart.

The Relative Strength Indicator - Imagine you had the opportunity to bet on a horse race, half-way through the race. Which horses would you bet on? The horses near the front, the middle or the ones near the back of the bunch? Hopefully you would place your bet on the horses near the front ... the potential winners. This is what this technical indicator tries to highlight; the potential winners. Relative Strength analysis is a simple but useful concept which is often forgotten by technical analysts. Suppose you are interested in buying gold shares, and wish to determine which ones have been displaying the greatest technical strength. How would one do so? One criterion would be to determine the particular share's strength relative to the JSE Gold Mining index. This can be achieved by using the Relative Strength Indicator. The Relative Strength Indicator is a line chart indicator, which calculates the relative strength as the simple division of one share's closing price against that of another e.g. an index.

Relative strength analysis can be used to determine which share in a particular sector is performing best. For example: If you wanted to find out the relative strength ratio between a banking share and the rest of the market on any particular day, it would be calculated by dividing the closing price of the banking share by the Banking Index. In simple terms, the graph shows the strength of the share in relation to its sector by comparing the closing price of the share to the JSE Index for its sector (e.g. the Banking Index, the Industrial Share Index, the Gold Mining Index, and the JSE Overall Index etc.).

Relative strength analysis is also very useful for monitoring changes in key relationships. For example, it is interesting to examine the performance of the JSE Gold Mining Index against the Dollar price of gold. All things being equal, you would expect these two indicators to perform more or less in line with one another. However, perceptions often run ahead of reality as investors try endlessly to guess which way the price of gold will go next. When the market is bullish on gold, the JSE Gold Mining Index outperforms the Dollar price of gold, and vice versa. You should experiment widely with various indicators and shares to try and establish relationships which repeat themselves. The basic point is that if you take a blue chip share relative to its sector, then both top and bottom of the calculation are equally affected by inflation. This means that the result must give you an oscillator which moves between fairly constant highs and lows. It is preferable to choose blue chip shares for this exercise because they are less likely to have radically changed their nature over the past four or five years. In general, charting formations do not work on the relative strength indicator. A simple moving average such as a 10-day simple moving average (SMA) can alert you to a change in the direction of a key relationship.

The Relative Strength Indicator works during declining and rising markets:

  • A significant increase in the ratio over a period results in an upward slope, indicates that the share has outperformed the sector. In addition, if the share does not decline as much as the sector does, the ratio will continue to rise. Thus, if the ratio holds up during the ensuing bear market, the share should do very well during the ensuing bull market.
  • A significant decrease in the ratio over a period results in a downward slope, which indicates that the share has under-performed the sector.
  • If the trend is moving sideways, it is called market performing, which means that the share is moving in line with the rest of the market.

Note: It is not the value of the Relative Strength Indicator which is important, but rather the change in value (i.e. trend) which is of interest.

Putting It All Together

It must be remembered that no technical indicator should be used alone. Technical analysis is a blend of many approaches (e.g. Elliot Wave Theory, Cycle Theory, Gann Studies, Point and Figure Charting) and each approach adds something to the technical analyst's knowledge of the market. Technical analysis is much like putting together a giant jigsaw puzzle. Each technical tool holds a piece of the puzzle. It is suggested that you combine as many technical approaches as possible. Each works better in certain market situations. The key is knowing which tools to emphasise in the current situation. That comes with knowledge and experience.

All these approaches overlap to some extent and complement one another. The day that you see these interrelationships, and are able to view technical analysis as the sum of its parts, is the day that you deserve the title of technical analyst. A technical checklist is provided to help you touch all the bases, at least in the early stages. Later on, the checklist becomes second nature. This checklist is not all-inclusive, but does have most of the more important factors to keep in mind. Remember the technical analyst is constantly seeking for clues to future market movement. The final clue that leans you in one direction or the other is often some minor factor that has gone largely unnoticed by others. The more factors that you consider, the better the chances of finding that right clue.

Going through the checklist would not guarantee the right conclusions. It is only meant to help you ask the right questions. Asking the right questions is the surest way of finding the right answers. The keys to successful share market investment are knowledge, discipline and patience. Assuming that you the knowledge, the best way to achieve discipline and patience is doing your homework and having a plan of action. The final step is putting that plan of action to work. Even that would not guarantee success, but it will greatly increase the odds of winning on the share market!

Technical Checklist

  1. What is the direction of the JSE Overall Index?
  2. What is the direction of the sector or group index?
  3. What are the weekly (i.e. longer-term) charts showing?
  4. Are the major, intermediate, and minor trends up, down, or sideways?
  5. Where are the important support and resistance levels?
  6. Where are the important trend lines?
  7. Are the volume indicators confirming price action?
  8. Are there any major reversal patterns visible?
  9. Are there any continuation patterns visible?
  10. What are the price projections from those patterns?
  11. Which way are the moving averages pointing?
  12. Are the oscillators overbought or oversold?
  13. Are any divergences apparent on any of the oscillators?
  14. What are the point and figure charts showing?
  15. Is the security outperforming or underperforming relative to the JSE Overall Index and/ or its sector?

After you have arrived at a bullish or bearish conclusion, ask yourself which way the market will trend over the next one to three months and whether you will buy or sell in this market.

Conclusion

In this tutorial on technical indicators we discussed various ideas and through trial and error; you will find that technical analysis is more an art than a science. All in all the different technical theories can be viewed as puzzle stones, the combination of which should lead you to the ultimate goal of technical analysis, the set-up of the highest probability scenario for a specific market direction. The established scenario will not look the same for every technical analyst. This is due to the fact that a different combination and weighting of technical indicators might be applied and that a subjective interpretation of the technical constellation can decisively influence the outcome. However, the technical indicators discussed in this tutorial need to be understood as you will use them in the Wen Professional Plus technical analysis software. It is important to know why you need them and how they can assist you to determine the future prices of shares.

Support

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