IndicatorsConstruction and Interpretation

Budapest - November 18th, 2010Guido Riolo, MSTA

Head of Technical Analysis for EMEABloomberg

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What is Technical Analysis?

Definition: The study of “market action” primarily through the use of charts for the purpose of forecasting future price trends.

Market action refers to:

1. Price – what does it cost? By far the most important

2. Volume – how many people are buying/selling? Secondary info

3. Open Interest – number of existing contracts in the market (futures and options)

4. Other data sets like Put/Call ratio and Volatility

Based on three premises.

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Three Premises of T.A.

1. Market Actions Discount Everything

Anything that can influence the price of a security is reflected in the current price. Therefore knowing why a price goes up or down is not important.

For example, earnings, politics, management changes, legal activity

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2. Prices Move in Trend

Newton’s first law states “An object in motion continues in motion unless acted upon by an unbalanced force.”

Think of this as changes in supply and demand

Leads to the saying “The trend is your friend”

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Three Premises of T.A.

3. History Repeats Itself

The key to understanding the future lies in the study of the past.

Chart patterns have been identified that reflect changes in future prices

Head and shoulders, flags, double tops / bottoms, et cetera

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Three Premises of T.A.

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But does it work?

And if it does, why?

Two main questions:

1. Do prices trend?

Prices trend because human activities are cyclical, as a result interest rates, economic activities and market prices are also cyclical

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But does it work?

And if it does, why?

Two main questions:

1. Do prices trend?

2. Are we irrational?

We have three structures in the brain: Cerebrum, Cerebellum and Limbic System.They are progressively older in evolutionary terms and deal with progressively less sophisticated issues.In the limbic system the Amygdala deals with emotions, in particular fear, processing of rewards, aggression and emotional memory.

Do we trade with the Cerebrum or with the Amygdala?

Types of Charts

Line vs. Bar vs. Candle

Open

High

Close

Low

Open

Low

Close

High

Open

Close

High

Low

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Low

Open

Close

High

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Types of Charts

Point and Figure – a series of columns full of either X’s or O’s representing rising and falling price respectively.  25.00                                    

 24.00       X   X   X                    

 23.00       X O X O X O                 X

 22.00       X O X O X O                 X

 21.00   X   X O X O   O     X           X

 20.00   X O X O X     O X   X O     X   X

 19.00   X O X O X     O X O X O     X O X

18.00 X O X O       O X O X O     X O X

17.00 X O X         O X O   O X   X O  

16.00 X O X         O X     O X O X    

15.00 X O X         O       O X O X    

14.00 X O                   O X O X    

13.00 X                     O X O X    

12.00 X                     O X        

11.00 X                     O          

10.00                                  

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Basic Concepts

Trend Line – a line drawn on a chart connection two price points to estimate support, resistance, and confirm a change in trend

Support – is found in an uptrend as an upward sloping or horizontal line serving as “support” for a price correction

Resistance – is found in a downtrend as a downward sloping or horizontal line serving as “resistance” for a price rally.

Channel – a support and resistance line combined

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Moving Averages

A moving average is simply the price of a security smoothed out over time. It is called a “moving average” because each point on a moving average refers to a set number of historical prices.

A 50 day SIMPLE moving average refers to the average of the closing values for the last 50 days.

Common moving averages are 50-200, 15-50, 5-30

Buy signal is generated when Price crosses above a moving average A shorter term moving average crosses above a longer term moving average

Sell signal is generated when Price crosses below a moving average A shorter term moving average crosses below a longer term moving average

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Moving Averages

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ATR: Average True Range

The True Range for a day is defined as the greater of the three values:

Current High – Current Low

Previous Close – Current Low

Current High – Previous Close

This means that the True Range will be daily range plus any prior gap

From a psychological point of view, the gap is assigned to the following day

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We then take the average (simple or exponential) of the True Range

Ideally the ATR will expand in a trending phase

Best use of the ATR is to calculate a trailing stop

Since the ATR is the “normal” current volatility, if the market goes against us by more than the value of the ATR, then we should close the position

ATR: Average True Range

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DMI: Directional Movement Index

We start with the Average True Range

If the new bar has higher highs and higher lows, the change in highs goes to +DM

If the new bar has lower lows and lower highs, the change in lows goes to -DM

If the new bar has lower lows and higher highs, it depends on which one’s larger

+DMI is average of +DM / ATR; -DMI is average of –DM / ATR

ADX is average of difference of +DMI and –DMI over the sum of +DMI and -DMI

ADXR is the midpoint between 2 ADX readings

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DMI: Directional Movement Index

+DMI gives us the strength of the uptrend component

-DMI gives us the strength of the downtrend component

ADX gives us the overall strength of the trend

ADXR confirms the strength of the signal provided by ADX

If +DMI>-DMI, moves up are more convincing than moves down

If –DMI>+DMI, moves down are more convincing than moves up

If ADX is greater than 20-25 the indication from DMI is more meaningful

Ideal signals are given when ADX is greater than 25 and rising

Beware of divergences and extreme readings

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Ichimoku Kinko Hyo: At a glance

Created in Japan in the 1960s and therefore based on a 6-day trading week

It’s the only study I have never seen anyone tinker with parameters

It looks at where there is harmony in the markets

The Conversion Line is the midpoint in the range covered in the last 9 periods

The Base Line is the midpoint in the range covered in the last 26 periods

The Leading Span 1 is the midpoint between Base and Conversion, plotted forward

The Leading Span 2 is the midpoint in the last 52 periods, plotted forward

The Lagging Span is the line chart of the price, plotted back

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Ichimoku Kinko Hyo: At a glance

There are many ways of using this indicator. Many people use it for timing

Can also be used to establish the direction of the trend and to differentiate between a correction and a change in trend

In a trend, you would expect both price and Lagging Span on the same side of the cloud

When Lagging Span and price are not in agreement, the trend is identified by the position last time they were in agreement

Quite often corrections find support or resistance at the Conversion or Base

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Stochastics

It is often divided into Fast, Medium and Slow Stochastic

It assumes that trending markets can consistently close near the extreme prices

When a rally cannot close near the high, the trend might be in danger

It’s an oscillator and therefore tries to identify tops and bottoms

It is best used in a sideways, oscillating market

It compares the last price with the overall range covered in the last X periods

It then calculates a number of subsequent moving averages of the %K line

The signal is given when %K and its moving average %D cross in extreme territory (overbought or oversold) and then both come out into the neutral area

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One of the most complete indicators, it is based on Moving Averages

It is trend following but improves timing when compared with MAs

It gives divergences like an oscillator

At the core there are three exponential Moving Averages

We take a 12 and a 26 day Moving Averages of the closing prices

We then calculate the difference, by taking the slower out of the faster (12-26)

We then calculate a 9 day EMA of the resulting line

We finally calculate the difference between the first line (MACD) and the second (Signal) and plot it as a histogram (MACD2)

MACD: Moving Average Conv-Div

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MACD: Moving Average Conv-Div

In a sustained trend the fast MA moves away the slow MA, towards the price

This causes the MACD line to move in the direction of the trend

The MACD moving away from the Signal is identified by a bigger histogram

As an uptrend slows down, it still records new highs, but without pulling away from its MA, and that causes a divergence

The MACD line measures the speed of movement. The MACD2 the ability of the MACD to move away from its MA

In a sideways market it will give you many false signals

Its indications can be used selectively. If the trend is up, a sell indication is a great point to take partial profit, the successive buy can then be used to accumulate

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RSI: Relative Strength Index

Quite possibly the most widely used indicator

…and the one with the most misleading name

It is an oscillator and it’s great at identifying divergences

If you use it for trading timing, use multiple timeframes (3-9-14 is very popular)

It is the relative strength of the uptrend supporters vs. the downtrend ones

It compares the money made by buyers when the price went up to the money made by sellers when the market was down. Divides them by the overall number of periods in the interval (not just the ones up or down) and makes a ratio. Finally, brings it in a closed scale between 0 and 100

When too much money is made on one side if compared to the other, the market is not balanced and a correction might be coming

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Parabolics SAR

Great tool to use to identify objective exit points

Great in fast, trending markets…

…dangerous in sideways ones

SAR should not override one’s target but complement it

I personally prefer using it one time degree higher (i.e. if my entry is decided on a daily chart, I look at the weekly Parabolic to decide when to leave)

Beneficial feature: it allows the new trend to develop, the other side of the coin is that it does not give much space to corrections to develop

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First SAR is placed at the extreme price of the previous move (i.e. at the start of an uptrend the first support is given by the previous reaction low)

We then take 2% (AF, acceleration factor) of the distance between the previous SAR and the “extreme price” (highest high) reached so far. We then add this to the previous SAR to calculate the new SAR

In order to make it parabolic, every time there is a new extreme price, the AF is increased by 2%, up to a max of 20%

The only exception occurs when tomorrow’s SAR would fall into today’s* range

When the price hits the current SAR, the position is stopped and reversed

If you follow this rule very strictly, your broker will be extremely happy, but use it wisely, and it can take you out of trouble when discipline has abandoned you

Parabolics SAR

* Or yesterday’s

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Rate of Change & Momentum

They are the most basic oscillators, comparing the current price with the close X periods ago. Periods used tend to be harmonics of 20 (the trading month) or Fibonacci numbers (just like for the moving averages)

The only difference between the two is that ROC expresses this change in percentage terms while Momentum shows it in absolute value. The two lines will look exactly the same in the short run, but substantially different in the long run

Position relative to the 0 line give the direction of the trend, the slope of the line indicates the speed

Therefore a positive Momentum line pointing down indicates that the current uptrend is slowing down

They can also be used to identify extreme readings and divergences

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Contact Details:Guido Riolo<MSG> on Bloombergguidoriolo@bloomberg.net+4420 7330 7211

All opinions expressed are my own and do not reflect the opinionsof my employer. All examples used and indications given are for educational purposes only and are not meant to be an indication to buy, sell or otherwise trade any security.All indicators will occasionally give false trading signals and they should only be used after careful consideration of their behaviour and of their possible consequences.

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