Technically Speaking, September 2014

Editor’s note: This was originally published by Thompson Reuters and is reprinted here with permission. Knowing which indicators are widely used can help traders understand why prices react in certain ways.

Technically inclined traders gauge markets with either trend tools or various analyses. They are looking for insight on the strength or weakness of the ongoing trend and on possible beginning of a new trend. This letter focuses on the most popular technical analyses. These analyses should be used in conjunction with trend tools, such as trend line and various Fibonacci ration analyses.

The seven most popular analyses are:

1. Moving averages
2. Bollinger Bands
3. Stochastics
4. Moving Averages Convergence Divergence (MACD)
5. Relative Strength Index (RSI)
6. Ichimoku Kinko Hyo
7. Rate of Change

MOVING AVERAGES

The chart above shows euro/sterling (EURGBP=) with four exponential moving averages drawn on it: 21-day (light blue), 55-day (green), 100-day (dark blue), and 200-day (red). Traders use various numbers of averages. I think three or four averages are ideal
because such a number allows traders to look at short term, medium term, long term, and very long term horizons.  Please notice that the 21-day the exponential moving average acted as a strong declining resistance between March 27 and July 31, 2014. The next exponential moving average, the 55-day one, was only touched in the past six days. The 21- day is the most responsive to the decline if the FX cross, while the 200-day the exponential moving average is the least responsive.

Moving averages have several benefits besides showing a smoothed version of the price behavior. In a trending markets, with a loose definition of trend, moving averages, especially the short-term ones, are flexible support and resistance lines.  In up moves they should occur below the string of rising prices, acting as support; while in down moves, moving averages should act as resistance lines, thus plotted above the prices.

Consequently, the intersection between the underlying market and the moving average should trigger signals to buy when the price breaks above the average and sell signals when the price drops below the moving average.

In strong rallies, prices run away above the moving average and vice versa. When the distance between the two series exceeds the normal for a specific RIC, then we conclude that the market is divergent; it is either overbought (on the upside), or oversold (on the downside). Make sure to gauge what “normal” means for specific markets. The underlying market and its moving average tend to convergence. To do so, the market might either go the opposite way or consolidate while the average catches up.

BOLLINGER BANDS

In this chart you can see different phases of Bollinger Bands on gold XAU=. Expanded bands denote rising volatility, as marked by red arrows, and converging Bollinger Bands, orange arrows, show declining volatility. This characteristic works particularly well to options traders who want to buy and sell volatility. When the gold price penetrates the lower band is suggests oversold conditions, such as in late March and May; meanwhile, price moves against the upper band, such as in early March and mid-June, signal overbought market conditions. Neither condition suggests an immediate reversal of positions. Since non-options traders cannot monetize volatility, they should use the bands in conjunction with oscillators.

STOCHASTICS

The stochastic oscillator is a study which reacts quickly to market changes. It is plotted on a closed scale of 0 to 100.  This means it works well in normal markets, but cannot perform well in strong trends.  In strong up trends, the stochastics lines will struggle
at overbought levels, 90-100, and in strong downtrends, they will flip around just above 0. As the market approaches the end of an uptrend, the daily closings tend to approach the daily highs. Conversely, as the market approaches the end of a downtrend, the closings tend to draw near the daily lows.

Stochastics consist of two lines called %K (the fast line) and %D (the slow line). Classic parameters for this study are 9 and 3. More common parameters are 5 and 3. A cross of %K below %D suggests a decline, while a cross of %K above %D signals a move up. The figure above shows Fast Stochastics (the original oscillator) plotted on the 10-year US Treasury yield. Notice the bullish crossovers marked with blue arrows and the bearish crossovers with yellow arrows.

MOVING AVERAGES CONVERGENCE DIVERGENCE (MACD)

The Moving Averages Convergence Divergence (MACD) is a momentum oscillator. Unlike stochastics, it is plotted on an open scale around the zero line which allows it to fully follow up trends and down trends. The MACD consists of two lines. The first is the difference between two exponential moving averages on 12-day and 26-day; the second is a 9-day EMA of this average spread and acts as a trigger line.  Since it consists of the exponential moving averages, the MACD is less responsive to market fluctuations than stochastics.

The chart above shows the MACD plotted on oil futures. I marked the bullish crossovers with blue arrows and the bearish crossovers with yellow arrows. Notice that the MACD peaked and bottomed at the same time with the underlying market, which means that they are in sync and that the oscillators confirms the momentum of oil.

RELATIVE STRENGTH INDEX (RSI)

The Relative Strength Index (RSI) measures the relative changes between the higher and lower closing prices, seeking to show
overbought and oversold conditions of the market. Just like stochastics, the RSI is plotted on a closed scale of 0 to 100, thus making it less useful in strong trends.  However, the RSI is less responsive and it stretches less than stochastics.

Generally, a peak above the 70% line followed by a top just below it suggests a decline. The opposite is true for a bottom below 30% and a low just around the 30% level. In the chart above, you can see a composite instrument, BRIC FX, a combination of the currencies for Brazil, Russia, India and China (=BRICFX(BRL=+RUB=+INR=+CNH=)

This simple string generated an easy to see candlestick chart. I added the RSI. The RSI formed a top above the 70% line followed by a peak just below this level in July and August. Subsequently, the on-the-fly composite instrument BRIC FX declined.

ICHIMOKU KINKO HYO

The Ichimoku Kinko-Hyo, (or the Cloud), provides a complex set of support and resistance levels, which uniquely extends well past the current date. Moreover, the Ichimoku offers additional information about the sustainability of the current directional move along with signals from the direction and intersection of some of its lines.

This study gauges midpoints of historical highs and lows at different lengths of time and different time periods to identify support and resistance levels, yielding entry and exit points. The Ichimoku Kinko-Hyo consists of five lines:

• Trend line (Kijun)
• Signal line (Tenkan)
• Lagging line (Chiku)
• Two Leading lines (Senkou Span A and Span B)

A combination of the two leading lines creates the cloud. Ichimoku is built on three key time periods for its input parameters – 9, 26 and 52. The trend line suggests the direction of the market. The intersections between the faster signal line and the trend line add value to the users’ analysis. A crossover above the trend line gives a buy signal and a crossover below it provides a sell signal. The lagging line is simply the current close plotted twenty-six periods behind. If both the lagging line and the current market are rising, it confirms the strength of the market, and vice versa.

Finally, the two leading lines create a Cloud-like formation and this is an area of support or resistance. The market must break above the Cloud to give a buy signal or below the Cloud to give a sell signal. The Cloud offers support and resistance in the future, thus helping traders gauge profit-taking or stop-loss orders.

RATE OF CHANGE

The Rate of Change (ROC) is a momentum study which is actually derived from the momentum oscillator. It measures the percentage change between the last or most recent closing and the price “n” periods in the past. In the chart above, the ROC provides trading signals via divergence and crossovers with the zero lines. The S&P500 (.SPX) made higher highs between May and August; however, the Rate of Change made lower lows.  This behavior suggested a decline of the Index. Indeed, the S&P 500 made an aggressive, but short-lived, corrective decline in late July and early August. Moreover, the ROC’s declines below the zero lines suggest sales, and moves above it signal buying opportunities.

CONCLUSION

I recommend using two different oscillators for each chart in order to capture different phases of the market. For instance, stochastics are very responsive to market fluctuations, so it tends to be essential for quick moves, which might be the start of bigger moves. The Moving Averages Convergence Divergence (MACD), however, is less responsive to quick price shifts, but work well in trending markets. Thus, a combination of stochastics and MACD should cover most market phases.