Trading with Technical Indicators

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Technical Indicators tell you once to shop for or sell

A Technical Indicator could be a mathematical formula applied to the security’s worth, volume or open interest. The result’s a price that’s wont to anticipate future changes in costs.

A Technical Indicator could be a series information of knowledge of information} points derived by applying a formula to the value data of a security. worth knowledge includes any combination of the open, high, low or shut over a amount of your time. Some indicators might use solely the closing costs, whereas others incorporate volume and open interest into their formulas. the value knowledge is entered into the formula and a knowledge purpose for obtain and sell is made.

Using Technical Indicators

Technical Indicators generally serve 3 functions: to alert, to verify and to predict. Associate in Nursing Indicator acts as Associate in Nursing aware of study worth action. Sometimes, Indicators signal to observe for an opportunity of support. an over sized positive divergence will act as Associate in Nursing aware of sit up for a Resistance jailbreak.

Technical Indicators is utilized in combination with alternative Technical Analysis tools. Investors use indicators to predict the direction of future costs.

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Leading Indicators

These ar designed to guide worth movements. advantages of leading indicators are: early sign for entry and exit points, generating signals and permitting opportunities to trade. a number of the popular leading indicators embrace goods Channel Index (CCI), Momentum, Relative Strength Index (RSI), random generator and William’s nada R.

Price Discounts Everything

Technical Analysis assumes that the company’s fundamentals, at the side of broader economic factors and market science, ar all priced into the stock, removing the requirement to truly think about these factors severally. This solely leaves the analysis of worth movement, that technical theory views as a product of the availability and demand for a selected stock within the market.

Lagging Indicators

These are the indications that will follow a trend instead of predicting a reversal. A insulant Indicator follows an occurrence. These indicators work well once costs move in comparatively long trends. They don’t warn you of coming changes in costs; they merely tell you what prices do (i.e. rising or falling), so you’ll invest consequently. These trends following indicators cause you to purchase and sell late and, in exchange for missing the first opportunities, they greatly scale back your risk by keeping you on the proper aspect of the market. Moving averages and therefore the MACD ar samples of trend following, or insulant indicators.

Moving Averages

Moving Average could be a wide used Technical Indicator of stock costs that helps to disembarrass the volatility within the worth action by filtering out the noise from random worth fluctuations. A Moving Average could be a trend-follow insulant Indicator because it is calculated taking past knowledge into thought. As its name suggests, a Moving Average is a mean that moves as previous values are born out as new values become accessible. Moving Averages is used to spot the present trend in an exceedingly stock.

Types of Moving Averages
There ar three varieties of Moving Averages

a) straightforward Moving Average (SMA)
It is obtained by computing the easy average of worth knowledge over an outlined amount of your time. In general, we tend to cipher the easy Moving Average supported the {closing worth|price|terms|damage} of the safety because it is taken into account to possess a lot of significance as compared to the remainder of worth points (Namely open/high/low price for the day). Thus, a five-day SMA is calculated by adding the terms of 5 days and dividing this total by the overall range of days (in this case, five).

For example, the five days SMA of ITC is calculated as follows:

While calculative the Moving Average when the shut of the commercialism session on July seven, 2017, we are able to cipher the SMA worth by taking the terms of the last five commercialism session, as well as July seven, 2017, and dividing identical by five. At shut of consequent commercialism session on July ten, 2017, SMA is calculated by excluding the terms of July three, 2017 by adding the new datum. (Closing worth of July ten, 2017).

As illustrated within the example below, costs bit by bit decreases from 342.5 to 328.85 over a amount of eight days within the same timeframe the five amount SMA decreases from 336.44 to 332.79, indicating a lag related to the Moving Averages. Hence, larger the fundamental measure, larger is that the lag.

DateClose Price5 Period SMA
03-Jul-17342.5
04-Jul-17337.25
05-Jul-17331.05
06-Jul-17337.10
07-Jul-17334.30336.44
10-Jul-17333.30334.60
11-Jul-17330.40333.23
12-Jul-17328.85332.89

7tH July SMA = 336.44 = (342.50+337.25+331.05+337.10+334.30)

10th July SMA = 334.6 = (337.25+331.05+337.10+334.30+333.30)

11th July SMA = 334.6 = (331.05+337.10+334.30+333.30+330.40)

12th July SMA = 332.89 = (337.10+334.30+333.30+330.40+328.85)

b) Weighted Moving Average (WMA)
Weighted Moving Average moves a step ahead from straightforward Moving Average. Here, we tend to assign a weight to every worth, with an even bigger weight allotted to the foremost recent information points as they’re a lot of relevant than historical information points. The add of weights ought to add up to one (or 100%). As new information points square measure supplemental, the new weights can align consequently. In distinction, in straightforward Moving Average, every worth is allotted an equivalent weight. Ideally, traders calculate WMA on the premise of price.

The Weighted Moving Average is calculated by multiplying the given value by its allotted weight so dividing the add by total range of days. The weights allotted square measure subjective in nature, and it’s supported the discretion of the dealer. owing to its calculation methodology, WMA can follow costs a lot of closely than a corresponding SMA. The WMA reduces the lag result to AN extent.

ITC

DateClose PriceWeightsWMA
03-Jul-17342.50.07
04-Jul-17337.250.13
05-Jul-17331.050.20
06-Jul-17337.100.27
07-Jul-17334.300.33335.34
10-Jul-17333.30
11-Jul-17330.40332.89
12-Jul-17328.85332.89

7tH July SMA =335.34= (342.50*0.07+337.25*0.13+331.05*0.20+337.10*0.27+334.3*0.33)

10th July SMA = 334.29= (337.25*0.07+331.05*0.13+337.10*0.20+334.3*0.27+333.3*0.33)

11th July SMA = 332.89= (331.05*0.07+337.10*0.13+334.30*0.20+333.3*0.27+330.4*0.33)

12th July SMA = 331.43= (337.1*0.07+334.30*0.13+333.30*0.20+330.4*0.27+328.85*0.33)

c) Exponential Moving Average (EMA)
Exponential Moving Average differs from the straightforward ANd weighted moving average as an EMA is calculated by taking all the historical information points since the beginning of the stock. Ideally, to calculate 100% correct EMA, we should always build use of all the closing costs right from the time of the listing of stock.

Calculation of the EMA could be a three step method

Step 1: Since it’s not sensible to calculate historical information right from the beginning of the stock, we have a tendency to use the SMA worth because the initial EMA worth. So, an easy Moving Average is employed because the previous period’s EMA within the 1st calculation.

Step a pair of: we have a tendency to calculate the weight multiplier factor by dividing 2 by the add of total periods and one.

Step 3: we have a tendency to cipher the EMA of the previous day from this damage, and multiply this range by the multiplier factor. we have a tendency to then add this product with its previous amount EMA to seek out out the ultimate EMA worth.

Therefore, this EMA worth can modification counting on what quantity past information we have a tendency to use in our EMA calculation. The a lot of information points we have a tendency to use, the a lot of correct our EMA are. The goal is to maximise accuracy whereas minimizing calculation time.

Initial EMA worth = 5-period SMA

Weighting Multiplier= (2 / (Time periods + 1)) = (2 / (5 + 1) ) = zero.3333 (33.33%)

EMA = x multiplier factor + EMA (previous day).

A 5-period EMA applies a thirty three.33% weight to the foremost recent costs. A 10-period EMA incorporates a weight multiplier factor of eighteen.18%. The shorter the fundamental measure, larger the weight multiplier factor are. we have a tendency to notice that because the fundamental measure doubles, the weight multiplier factor drops ~50%.

DateClose Price5 Period SMAWeighting factor5 Period EMA
03-Jul-17342.5
04-Jul-17337.25
05-Jul-17331.05
06-Jul-17337.10
07-Jul-17334.30336.44336.44
10-Jul-17333.30334.600.3333335.39
11-Jul-17330.40333.230.3333333.73
12-Jul-17328.85332.7930.3333332.10

7tH July SMA = 336.44 = 5 Period SMA = 336.4410tH 

July SMA= 335.39 = (333.30-336.44) x0.33 + 336.44

11tH July SMA = 333.73 = (330.40-335.39) x0.33 + 335.39

12tH July SMA = 336.44 = 5 Period SMA = 336.44

Comparison of the 3 Moving Averages

As we see by comparing the computation methodology of the 3 Moving Averages, different values are generated. EMA is most commonly used by traders.

Moving AveragesSMAWMAEMA
Advantages1) Smoothened Average2) Less prone to whipsaw3) Best average to consider for support & resistance1)Reduction in price lag, so can be implemented for short term trading1) Reduction in price lag, hence can be used for short term trading2) No omission in price data points
Disadvantages1) Has maximum price lag2) Assigns same weight to all price data.3) Omission of previous data points leading to all price data not made use of1) Omission of previous data points leading to all price data not made use of2) Chance of whipsaw1)Chance of whipsaw

Moving Average Value comparison – The following table represents a comparison between the different values of the 3 types of Moving Averages over the same period of time

DateClose Price5 Period SMA5 Period WMA5 Period EMA
03-Jul-17342.5
04-Jul-17337.25
05-Jul-17331.05
06-Jul-17337.10
07-Jul-17334.30336.44335.34336.44
10-Jul-17333.30334.60334.29335.39
11-Jul-17330.40333.23332.89333.73
12-Jul-17328.85332.89331.43332.10

Graphical comparison on the 3 moving averages.

(Blue-5 Period EMA, Green-5 Period WMA, Pink-5 Period SMA)

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As we seen in the above graph, when there is a sharp correction in price as in the case of ITC, EMA and WMA reacted the most since they are assigned a higher weight to the most recent prices as compared to the SMA.

(Blue-10 Period EMA, Green -89 Period EMA, Pink 200 Period EMA)

From the above graph, we can clearly see that L&T Fin is in a long term uptrend, the short term and medium term averages are trading above its long term, 200day Moving Average which is also showing an upward momentum. A price dip towards its medium term average can be considered as a buying opportunity.

Buy/Sell signals based on crossover

A buy signal is generated when a bullish crossover occurs i.e. the short term Moving Average crosses the long term Moving Average, popularly referred to as a golden cross. For example, when the 89day EMA crosses above the 200day EMA, a bullish trade can be initiated. On the other hand, a bearish dead cross occurs when the short term Moving Average crosses below the long term moving average. The signals generated tend to occur with a lag as we make use of 2 Lagging Indicators. The best trading opportunities are obtained in a trending market as compared to the sideways market wherein whipsaws or false signals are generated.

Price89 Period EMAAction /ViewTechnical Term
Trading Above 200EMACrosses above 200EMABullishGolden cross
Trading Below 200EMACrosses below 200EMABearishDead cross
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From the above graph we see how moving averages can be used to generate trading signals

Moving Averages can also be used to generate signals with simple price crossovers. A bullish signal is generated when prices move above the Moving Average. A bearish signal is generated when prices move below the Moving Average. Advantage of price signals is that the time lag is reduced and traders are able to react at an early stage.

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As in the Fortis Ltd case shown above, traders could have initiated a short position or could have closed their long positions when the stock price closed below its 200day EMA. Consequently, a huge surge in trading volumes with MACD Histogram getting into the negative territory indicated a change in momentum which gave added information to traders to take a bearish view, resulting in a fall in stock price by 18%.

Support & Resistance Levels

Moving Averages also tend to act as support and resistance levels. A stock in a long term uptrend could find support near its medium term EMA during a pullback, similarly a stock in a long term downtrend could face resistance near is medium term moving average during any bounce back. In fact, some moving averages may offer support or resistance simply because it is widely used by many traders. As an example, a trader may not short a stock if it is trading near its 200day EMA because of the fear that other traders may be using it as a buying zone.

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In the above example of JSW Steel, we see how the stock has taken support along its medium term 89day EMA on multiple occasions and has acted as a good support level to purchase the stock.

Moving Averages in sync with Candlestick pattern

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Moving averages can also be traded in tandem with candlestick patterns. In the above chart of Bata India Ltd, the bullish candlestick pattern can be traded with added confidence as it coincides with the support of 200day EMA.

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In the above chart of United Spirits Ltd, the buy signal generated by the bullish crossover coincides with a cup and handle breakout on the daily chart, affirming a bullish bias in the stock.

Difference between technical and fundamental analysis

Moving averages are used based on trading horizon.

Moving AverageTrading Time frame
5 period MAShort term
13 period MAShort term
50 period MAMedium Term
89period MAMedium Term
200 period MALong Term

Observations on Moving Average

  • It is used in a trending market to give clear trend direction by eliminating the noise.
  • In case of a sideways market, Moving Average would lead to whipsaws making the use of other indicators like RSI and Stochastic more helpful.
  • Signals generated by moving averages tend to have a lag.
  • It is used best when combined with technical indicators and price patterns.

Bollinger Bands

Bollinger bands, created by John Bollinger, are a Trending Indicator that can show you not only in what direction the stock price is going, but also how volatile the price movement of the stock is. Bollinger bands consist of two bands—an upper band and a lower band—and a Moving Average and are generally plotted on top of the price movement of a chart.

How Bollinger bands are constructed?

Bollinger bands are typically based on a 20-period Moving Average. This Moving Average runs through the middle of the two bands. The upper band is plotted two standard deviations above the 20-period moving average. The lower band is plotted two standard deviations below the 20-period moving average.

A standard deviation is a statistical term that measures how far various closing prices diverge from the average closing price. Therefore 20-period Bollinger bands tell you how wide, or volatile, the range of closing prices has been. The more volatile the stock price, the wider the bands will be. The less volatile the stock price, the narrower the bands will be.

Bollinger band trading signal

Entry signal—when the bands widen and begin moving in opposite directions after a period of consolidation, you can enter the trade in the direction the price was moving when the bands began to widen.

Exit Signal- when the bands narrow the price of the stock moved away from the breakout turns and starts moving back toward the current price of the stock set a trailing stop loss to take you out of the trade if the trend reverses.

Exit Signal- when the bands narrow the price of the stock moved away from the breakout turns and starts moving back toward the current price of the stock set a trailing stop loss to take you out of the trade if the trend reverses.

Bollinger band example:

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Benefits of Bollinger bands

  • They help you identify price trend.
  • They identify current market volatility.

Moving Average Convergence Divergence (MACD)

The Moving Average Convergence Divergence (MACD) is an oscillating indicator that shows you when trading momentum changes from bullish to bearish and vise versa. The MACD can also show you when traders are becoming over-extended, which usually results in a trend reversal for the stock price.

The MACD is usually plotted below the price movement on a chart.

How the MACD is constructed

The Moving Average Convergence Divergence is constructed based on a series of moving averages and how they relate to one another. The standard MACD looks at the relationship between a stock price 12-period and 26-period Exponential Moving Average. If the 12-period Moving Average is above the 26-period Moving Average, the MACD line will be positive. If the 12-period Moving Average is below the 26-period Moving Average, the MACD line will be negative.

The MACD line is accompanied by a trigger line. This line is a 9-period exponential moving average of the MACD line.

MACD trading signal

Entry signal—When the MACD crosses above the trigger line, you can buy the stock price knowing that momentum has shifted from being bearish to being bullish.

Exit signal—When the MACD crosses below the trigger line, you can sell the stock price knowing that momentum has shifted from being bullish to being bearish.

Benefits of MACD

  • They help you identify price trend.
  • They identify current market volatility.

MACD example:

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Slow Stochastic

The Slow Stochastic is an oscillating indicator developed by George Lane that can show you when investor sentiment changes from being bullish to bearish and from being bearish to bullish. The Slow Stochastic can also show you when trades are being over-extended, which usually results in a trend reversal for the stock price.

How the Slow Stochastic is constructed

The Slow Stochastic consists of two lines—%K and %D—that oscillate in a range between 0 and 100.

%K is constructed based on where the current closing price of a stock is in relation to the range of closing prices for that same stock price in the past. %D is a moving average of %K.

If the closing price of the stock price is near the top of the range of past closing prices, the %K line (followed by the %D line) will move higher.

If the closing price of the stock price is near the bottom of the range of past closing prices, the %K line (followed by the %D line) will move lower.

Slow Stochastic trading signal

The Slow Stochastic produces trading signals as it crosses in and out of its upper and lower reversal zones. The upper reversal zone is the area of the indicator that is above 80. The lower reversal zone is the area of the indicator that is below 20. When %K is above 80, it shows the stock price may be overbought and may be reversing trend shortly. When %K is below 20, it shows the stock price may be oversold and may be reversing trend shortly.

Entry signal—when %K crosses from above 80 to below 80, you can sell the stock price knowing that investor sentiment toward the stock price has shifted from being bullish to being bearish.

When %K crosses from below 20 to above 20, you can buy the stock price knowing that investor sentiment toward the stock price has shifted from being bearish to being bullish.

Exit signal—when %K reverses direction after having crossed either above 20 or below 80 and crosses over %D, you can exit your trade knowing that investor sentiment is changing direction again.

Slow Stochastic Example

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Benefits of the Slow Stochastic

  • It helps you identify when investor sentiment towards the specific stock changes
  • It helps confirm the strength of current trends

Retracement

It is the correction that occurs in the price of a share.

Market trendRetracement will be in
Fallingupward direction
Risingdownward direction

Normally, it is seen 38.2%, 50% and 61.8% are good retracement levels and the markets have a tendency to take support in case of an uptrend and face resistance in case of a downtrend at or around these levels.

These levels also give an indication of the current trend or a likely change in the same. Although the retracement levels work more often than not, there could be times where prices may move beyond the normal retracement levels.

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Retracement Example

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Stop Loss

Stop loss can be defined as an advance order to sell an asset when it reaches a particular price point. Stop loss is used to limit loss or gain in a trade. The concept can be used for short-term as well as long-term trading. It is used so that the trader does not suffer unlimited losses.

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Key takeaways

  • Technical Indicators broadly serve three functions: to alert, to confirm and to predict.
  • Technical Indicators are of two types leading and lagging.
  • Capital gains from equity funds and debt funds are considered long-term if the investment horizon if more than 1 year and 3 years respectively.
  • Moving Averages and the MACD are examples of lagging indicators.
  • There are 3 types of moving averages: SMA, WMA, EMA.
  • Bollinger bands expand and contract based on the volatility in a scrip
  • MACD is used to indicate change in trading momentum from bullish to bearish and vice versa.