Friday, September 26, 2008

Trading in tough times


Let's pause for a while and think about the events happening right now. The only words you hear these days are bankruptcy, take over, rescue package, jobless claims, and so on. Lehman goes bust, Washington Mutual taken over by J P Morgan, AIG almost going bust if not rescued, Merril Lynch gone, Investment Bankers become house cats.

What can a trader do at such times? Well, the answer is definitely not in black or white. Never keep an open position without a stop loss. Do not expose yourself to a huge loss. At the same time, volatile times are best for making profits once you set a good stop loss order. Make money but at the same time, play safe. It is definitely possible.

Thursday, September 18, 2008

Stochastics


The Stochastic oscillator compares where a security’s price has closed relative to its price range over a specifically identified period of time. This is a predictive indicator in that it gives advance signals for buying and selling.

The indicator has been developed from the basic observation that prices tend to close near their high in an upward trending market and near their lows in a downward trending market. Further, as an upward trend matures, price tends to close further away from its high; and as a downward trend matures, price tends to close away from its low.

How is Stochastics Used ?

This indicator is often used to predict trend reversal. The indicator tries to determine when prices start to cluster around their low of the day for an up trending market, and when they tend to cluster around their high in a down trending market. Lane's theory is these are the conditions, which indicate a trend reversal is beginning to occur.

The stochastic indicator is plotted as two lines. They are the %D line and the %K line. The %D line is more important than the %K line.

Ranges

The stochastic is plotted on a chart with values ranging from 0 to 100. The value can never fall below 0 or above 100. Readings above 80 are strong and indicate that price is closing near its high. Readings below 20 are strong and indicate that price is closing near its low.

A very powerful move is underway when the indicator reaches its extremes around 0 and 100. Following a pullback in price, if the indicator retests these extremes, a good entry point is indicated.

Reversal

Ordinarily, the %K line will change direction before the %D line. However, when the %D line changes direction prior to the %K line, a slow and steady reversal is usually indicated.

When both %K and %D lines change direction, and the faster %K line subsequently changes direction to retest a crossing of the %D line, but doesn't cross it, this is a good confirmation of the stability of the prior reversal.

Many times, when the %K or %D lines begin to flatten out, this is an indication that the trend will reverse during the next trading range.
These are just some of the important and popular oscillators and indicators. There are many more. You need to study and pick the one that best suits your personality, apply the indicator and specialize to maximize profits.

Relative Strength Index (RSI)



RSI, unlike what the name may suggest, is an indicator of a security’s strength to itself. It does not compare a security with an Index or a security with another security. The formula for RSI is:
here, U - Average of upward price change
D - Average of downward price change

How is Relative Strength Index Used ?

RSI is an indicator that follows price and ranges between 0 and 100.
The most popularly used Relative Strength Index is the 14-day RSI. Other regularly used ones are 9-day and 25-day RSIs. The lower the number of days used for calculation, the shorter the time frame it can be used for. It also tends to be more volatile. The practical application of RSI needs some experience as it cannot be applied directly.

Trading Range

The RSI usually ranges between 30 and 70 in an ideal market. The tops and bottoms are usually formed before the underlying price. In a bull market, this range may be 40 to 80. Similarly, in a bear market, it may range from 20-60.

Chart-type Patterns

RSI very often displays chart-like pattern such as double top, inverted head and shoulders and so on even though they may not show on the actual price charts. One can identify such patterns to trade successfully.

Failure Swings

This is where the Relative Strength Index surpasses a previous high (peak) or falls below a recent low (trough).

Support and Resistance

Supports and Resistances are sometimes more clearly on the RSI chart than on the price charts.

Divergences

When the price makes a new high but the RSI does not do so, it is called a divergence on the RSI chart. Eventually, prices correct and move in the direction of the RSI. Thus, divergences are indications of impending reversal. When the RSI turns and falls below its most recent trough, a confirmation of the reversal is obtained and a “failure swing” is said to have occurred.

Moving Average Convergence Divergence (MACD)


MACD is a lag momentum indicator that shows the relationship between moving averages of prices. It is the difference between a 26-day and a 12-day exponential moving average. On top of this, a 9-day exponential moving average is plotted. This 9-day EMA is called the signal or the trigger line and is used to spot buying or selling opportunities.

How is MACD Used ?

MACD is best used in markets that are prone to wide swings in a trading sense. The three best methods of using MACD effectively are:

Crossovers

The primary use of this indicator for trading is to buy when the MACD rises above the signal line and to sell when the MACD falls below its signal line. Another use is to buy when MACD goes above zero and sell when MACD goes below zero.

Overbought/Oversold

MACD can be put to use as an overbought/oversold indicator too. When the shorter MA pulls away too much from the longer MA, it means that the security/Index is over-extended and that it is likely to return to realistic levels soon. This of course, depends on the nature of the movement of the security or Index that is being analyzed.

Divergences

The divergence of MACD from the price may indicate that an end to the current trend is at hand. A bearish divergence happens when the MACD is making new lows but the prices do not. Similarly, a bullish divergence occurs when MACD is making new highs but the prices do not make new highs. Divergences are more important when they occur at the overbought/oversold levels.

Tuesday, September 16, 2008

Bollinger Bands


First proposed by John Bollinger, Bollinger Bands are one of the most popular overlays. This indicator gives you an idea of how the volatility for a security is related to the price levels over a specific period of time. An integral part of the Bollinger Bands is Standard Deviation. Standard deviation ensures that volatility is immediately factored in. The bands can expand or contract based on the volatility.

Bollinger Bands are actually made up of 3 distinct bands. The attempt is to capture a majority of a security's price movement within the bands. A simple moving is at the core of the band and is at the middle. The upper one is the SMA + 2 standard deviations and the lower one is the SMA -2 standard deviations. An example is 20 SMA with 20 SMA + 2 standard deviations and SMA – 2 standard deviations.
The SMA and the number of deviations can be adjusted to suit the personality of the security that is being analyzed.

Saturday, September 13, 2008

Parabolic SAR


The Parabolic SAR indicator was proposed and developed by W. Wilder, who also discovered the more famous RSI and DMI indicators. Parabolic SAR displays the suggested trailing stop losses in visual terms. I'm leaving out information on the formula because its very complex and may distract the user. We'll focus more on the behavior of the indicator and how to make the best use of it.
The indicator also helps you in taking a position by displaying the indicator and the price on the same chart. The buy and sell signals are generated when the upper or lower SAR cross the price line.

The main variables that make up the Parabolic SAR are Step and Maxmum Step. Wilder suggests keeping the values at 0.02 and 0.20. Parabolic SAR performs best in trending markets

The higher the value of the step, higher is the sensitivity of the indicator with respect to price change, but that does not mean that a very high step is desirable. When it is too high, the indicator is too volatile and this limits its usefulness. The Maximum Step is used for adjusting the SAR as price moves. The lower the Maximum Step, the higher the distance to the trailing stop from the price.

Sunday, September 7, 2008

Technical Analysis Indicators and Overlays

Indicators and Overlays

Indicators are the lines formed out of calculations based on the price, volume, time, or another related parameter.
Indicators that are derived and plotted over the price chart use the same scale as the price and are known as Overlays.
Some of the popular Indicators are the following:
  • Moving Average Convergence Divergence (MACD)
  • Relative Strength Index (RSI)
  • Stochastics
  • Williams %R

Some popular Overlays are the following:

  • Moving Averages
  • Moving Average Envelopes
  • Parabolic SAR
  • Bollinger Bands

Wednesday, September 3, 2008

Advanced Technical Analysis - A Series

In this series, I'll cover advanced Technical Analysis topics. It is assumed that you know the basics of Technical Analysis and have some experience actually trading real money. If you do not have experience, you can easily find study material by googling around. As for trading experience, start a paper trading account if you do not have a trading account already. Do not experiment with real money if you haven't done that already.
It is well known that Technical Analysis is useless without the proper combination of Risk and Management. I'll add Mind Management to this list.
My personal choice of indicators are the following:
  • MACD
  • Stochastics
  • RSI
  • Williams% R

In this series, we'll focus more on the behavior and the use of indicators, understanding what they are trying to say and not restrict our focus to the math angle.

The most important element also is the study of waves. Study need not be to the depth of an Elliot or O'Nealy, but enough to give practical chances in the market. The aim is always to ride a good position as far as possible and to cut out a bad one early.