Chapter 7. Chart Indicators and Studies

Chart Indicators: Basic Studies

There are many good books that describe ErlangerQuote’s chart indicators and the math behind them in greater detail than we can fit in this manual. Here are my favorites:

Trading for a Living

Dr. Alexander Elder

Wiley, 1993

The best book I know of on trading. He does a great job of explaining indicators and the math underneath them for anyone to understand.

Technical Analysis from A to Z

Seven B. Achelis

McGraw-Hill, 1995

Even though this book is 5 years old it has a complete collection of indicators in a reference format. You can also find this book free on the web at www.equis.com.

Technical Analysis Explained, 3rd Edition

Margin J. Pring

McGraw-Hill,  1995

Pring knows his TA and this book has it all. Very comprehensive, but deep and small print.

Trading Systems and Methods, 3rd Edition

Perry J. Kaufman

Wiley

Only for the brave. This book will take you deep into the most sophisticated thinking about trading indicators. Its breadth is amazing. Expensive.

Table 1 Mitch's Favorite Books for Technical Indicators

The Chart Menu

The menu in the figure below appears when we right click on a chart and select the "Studies" submenu. The menu has three sections as can be seen in the figure below. The top four items are the kind of studies that are drawn on the price chart itself. The Color Study and the Formula Study in the second section allow you to plot your own home made formulas on the price chart and set up elaborate color study visual aids. We will cover them later in the chapter. The third part of the menu is special studies that appear in horizontal bands or "panes" at the bottom of the chart, not in the price action area. All these items are known collectively as indicators, which are perhaps the most talked about part of the Trader’s tool chest.

Figure 1 The right click chart menu, Studies submenu

When considering indicators, you will hear statements like "that stock has broken through its 50 day moving average, "time to buy", "its at the top of its Bollinger Bands, short the stock now", "the MACD says buy", "its Stochastic is Oversold", and so on.

What these comments refer to are where the securities price is in relation to some special graphic, which is in turn based on a special formula. The formulas and graphs help you see a trend, or in some cases, that a change is about to occur. Sometimes these formulas reveal a pattern, such as telling you the stock is in a trading range, or consolidating, or about to bottom out or breakout. Indicators are like X-Ray glasses that let us look deeper inside a stock's price action and make more sense of it. But like an X-Ray the results can often be contradictory.

Price Chart Studies

The following indicators are price based, which means they appear on top of the price chart, not underneath it like chart panel studies.

Simple and Exponential Moving Average

Perhaps the most basic and understandable of indicators is the Moving Average, commonly referred to as the MA, but also called the DMA for daily moving average, and the SMA for simple moving average. The moving average is a trend following indicator, meaning it helps you see the underlying past price movement of the stock or security. It does this by averaging the last N bars and plotting a point with that average value. To come up with a line that follows the chart this calculation is repeated for all the bars and a continuous line is drawn on top of the price chart. You must specify the number of intervals that the moving average corresponds to when you describe it, but the actual interval can be anything from weeks to minutes. For example, a 10-day moving average means that 10 days of data is added, and then divided by 10 to come up with an average for the 10-day period. This is considered a short term moving average, and an example of one is in the figure below. An intermediate length moving average is considered 40 to 50 days long, with 50 days being most common. A long term moving average would be the 200-day.

Figure 2A 10-day Simple Moving Average study or indicator in red

The figure below shows the Preferences for the moving average indicator. As you can see you must enter the Length, which we just saw is the number of periods, and here its showing 10. Note there are no time units in this dialog box. That is because the Interval specified on the chart sets the time base while the moving average automatically adapts to each Interval. If you are displaying a 5 minute chart, then this moving average would be considered a 10 bar or a 10 (5 minute) bar moving average. If the moving average is displayed on a 60-minute chart it becomes a 50-hour moving average.

Normally a moving average is a "lagging" indicator meaning its always reacting to the data, not projecting it. The field Offset in this dialog box, is an interesting parameter. It is used to shift the entire moving average waveform forward or backward in time, literally "advancing" it. Since it is a lagging indicator,  traders and Technical Analysts will often shift or offset the moving average study to the right, while the price stays where it is, to give it more predictive qualities. Advancing is often used to reduce what is known as "whipsaws", which are false signals created when a price moves back and forth through the MA several times.

Figure 2B Moving Average Study Preferences

This dialog box also lets you select the color of the moving average line (here red), the line thickness and the Source of the data for the moving average (open, high, low, and close). When the checkbox called Exponential is checked it turns the simple moving average (SMA) into an exponential moving average (EMA). The EMA is much more accurate and responsive than the simple moving average because it gives more weighting to the contribution of the most recent bars to the total average. In other words, bars at the end of the moving average are given more weight than bars at the beginning.

Note in the figure below that the blue EMA more closely follows the movement of the stock and does not overshoot the price changes as much as the red SMA. Still the EMA is not a perfect indicator because it lags, as can be seen clearly around July 24 where it is peaking while the price actually peaked around July 18.

Figure 2C 10-day Simple Moving Average (SMA) (red) and an Exponential Moving Average (EMA) (blue)

Moving Average Interval

The size of the moving average Interval depends upon what type of market trend you are attempting to identify. Generally there are three possible time frames recognized: short, intermediate, or primary (long term). While we may search for the holy grail of moving averages, the perfect length and interval that gives outstanding results, different markets and industries have different cycles and different seasons, and so from the research I have done there seems to be no perfect length.

However, in their book, The Encyclopedia of Technical Market Indicators (McGraw-Hill, 1988), Colby and Meyers examined a large collection of chart indicators, including the simple and the exponential moving averages. They tested the simple moving average on the NYSE between 1968 to 1986 with a variable MA length of 1 to 75 weeks. In both cases they found that the 45-week MA gave the best results.

However what works over one time span (19 years), in one market (NYSE), at a certain moment in history, may not work over another. What we are really looking for is an MA which will work well with a specific time frame: short, intermediate or long. The table below lists short term time frames as well as what is considered the ideal corresponding intermediate and long term frames.

Short Term

Intermediate Term

Long Term

10 day

30 day

200 day/40 week/9 month

15 day

10 weeks (50 day)

45 week

20 day

13 week (65 day)

 

25 day

20 week

12 month

30 day

26 week

18 month

 

200 day

24 month

Table 1 Various Time Frames and their cycles

Note that custom weighted moving averages where you control the weighting or contribution of each bar to the total, can be plotted in ErlangerQuote using Formula Studies.  This will be covered later in this chapter. You can, with a formula study, define the actual math for each bar in the moving average.

Show screen Figure 2D 10-day, 50-day and 200-day Simple Moving Averages on the same chart
Bollinger Bands

Bollinger Bands where created by a man named John Bollinger, who gives seminars, sells videos of his technique, and appears to wear a toupee. His Bollinger Bands are used to show when prices are consolidating and about to breakout. They work by calculating a moving average that is above and below a standard exponential moving average by a fixed number of standard deviations (usually 2). A standard deviation is a measure of volatility, and volatility is a measure of price swings. Large changes in volatility will be represented in wide bands, while lower volatility will cause the bands to narrow. In the figure below the upper and lower BB bands are in blue and the middle moving average band is red.  The bands are self adjusting, that is they contract during calm periods and expand during highly volatile periods.

In the figure below we see that Cisco has entered a period of tighter bands which might signal that the price is about to breakout. During April and May the bands where very wide apart and there was a great deal of price swing.

Figure 3A Bollinger Bands 20 Length and 2 standard deviations

The Preferences for the Bollinger Bands allows you to set the length of the moving average (here set to Bollinger's suggested 20) the number of standard deviations (here 2) and the source of the prices for the formula (open, high, low, close). You can also set the color and thickness of the bands, as well as move the vertical axis to the left or right (default). Note again that the length is 20, the actual time frame is chosen when you set the chart Interval.

Figure 3B Bollinger Bands Preferences

Four Rules

Mr. Bollinger has four rules he recommends traders follow when using his bands.

1.        Quick moves in the price of the stock tend to occur after the bands have tightened, as the volatility decreases. Usually the first increase in volatility from these bands signals the start of a new move or trend.

2.        When the price moves outside the bands, it’s usually a sign of a continuation of the trend, until the prices move back into the bands.

3.        Bottoms and tops outside the bands followed by bottoms and tops inside the bands usually call for a reversal of the trend.

4.        A move that originates in one band tends to go all the way to the other band.

Bollinger Bands Tell a Story

The chart example below for the stock Emulex tells an interesting story when examined with Bollinger Bands. This chart has a Nasdaq Line graph overlaid on it in the color magenta. From the beginning of April to the 3rd week, Emulex fell like a rock, dropping about 60 points from 218 to 40 in one day. The Nasdaq fell as well, as you can see on the chart, from 5000 to below 3500. By mid July the Nasdaq had recovered and was within 800 points of its February high. But poor Emulex had only traded up to 70 and still had a long way to get to 220. But in August it started recovering and moved up fast until August 25, 2000. On that day someone put out a fake press release stating that Emulex was having serious financial problems and the President was going to resign. The crude release managed to get on Bloomberg because a reporter was unable to get through to the company, and at the same time they did not add any disclaimer that the source had not be verified. The news was on CNBC in seconds, and Emulex dropped like a dead cat full of lead on a hot day, and went from 112 to 40 in about twenty minutes. At about 10:30 trading was halted in the stock at about 50.

Around 2:30 the stock opened for trading again, opened at 110, and settled at 105. You can see the Bollinger Bands stretched at the last day and the candlestick with enormous wicks. The wick on the bottom is particularly huge.

The total volume that day was 11 million shares, with 1.5 million being a normal day. 11 million shares times $100 per share is $1 billion, which is a lot of money to change hands over a fake rumor. If anyone knew this was going to happen they could have made millions of dollars shorting the stock on the way down or buying it low and selling it high in a few hours. It took the FBI only a few days to trace the bogus press release to a young trader who had once worked for a internet press release company and knew all the tricks to make it look real. He was trying to recover from an option trade that had gone against him on Emulex. On the way to repairing his mistake his greed took over and took made profits of over $250K as Emulex fell. Now he faces up to 15 years in prison.

Figure 3C Emulex with  Bollinger Bands

 

Donchian Channels

Channels are lines that surround a stock price movement, which help in projecting future price action. The Donchian channel was created by a gentleman named Richard Donchian while at Shearson. While the family carefully guards the details of the exact formulas, generally it uses the highest high and the lowest low of a period of time to plot the channel. The chart requires a "look back" period, and that is entered in the Preferences (called Length), as shown in the figure.

In the chart example below you can see AOL with the Donchian channel indicator set to a look back period of 20. The way it gives signals is as follows. If you are in an uptrend then the bottom line is the important line. When the bottom line turns down and the price action of the next bar goes lower, then the trend is down. These channels are sometimes used as a guide to setting trailing stops.

Figure 4A Donchian Channels 20

In the figure below we changed the look back period to 10. Notice how it finds more conditions that give signals of a downtrend.

Figure 4B Donchian Channels 10

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Figure 4C Donchian Channels Preferences

Envelopes

An envelope is nothing more than two moving averages offset by a fixed moving average. They are placed above and below a middle or basis line moving average. The Preferences allow you to set the normal parameters for these moving averages, such as Length, Offset, and Source, along with the color and thickness of the line. In addition you can set the Percent for the envelope which is simply how much to offset the MA. In the figure below the Percent is set to 10%, and the top and bottom moving averages (blue lines) are 10% above and below the price of the basis moving average (the red line).

While envelopes use percent instead of standard deviation for setting the band's offset, they are similar to Bollinger Bands in this way: the edges of the envelope represent buyers or sellers who have pushed prices to extremes. When price hits an extreme it usually turns around and finds a new stability point.

So these bands basically set upper and lower boundaries of a price movement. For example, if the price hits the upper band, a sell signal would be initiated, while if the price hits the lower band a buy signal would be created. Deciding on the percentage shift is trickier and depends on the overall volatility of the stock for the period you are examining. If the volatility were high you would move the bands apart more, and if it were low you would move them closer in.

 

Figure 5A Envelopes

Figure 5B Envelopes Preferences

Panel Chart Studies

The following indicators are panel based, which means they appear in horizontal bands under the price chart. They have a small title in the left upper corner, and a set of labels that appear in the vertical axis area under the price chart. The Panels can be relocated and moved up and down with Shift-drag, or overlaid on top of each other with Ctrl-drag The one you click on is the indicator that will appear on top when you Ctrl-drag the mouse.

Choppiness

Choppiness is a modern indicator based on ideas of chaos theory and fractal geometry. Benoit Mandelbrot was the one person most responsible for the great interest in the subject of fractal geometry. He showed how fractals can occur in many different places in both mathematics and elsewhere in nature. They could be found underlying cloud formations, waves, leaves, fingerprints, and sunflowers, and his ideas provided some exciting glue between mathematics and nature. Using computer graphics and with the help of IBM, Mandelbrot was able to show how to express fractal geometry using computer graphics.

Figure 6 The classic Mandelbrot image

While most of us think there are only whole number dimensions, like 1D, 2D, and 3D, in fractal geometry there exist fractional dimensions in between the whole number dimensions. So there are a number of fractional dimensions between a 1D line and a 2D plane. Fractals are basically a measurement of the dimensionality of a system; they are able to express different images based on the fractional nature of dimension. 

E. W. Dreiss, a trader based in Australia, came up with the creative idea of using fractal geometry as a way to measure price movement in a security. He cleverly assigned a "dimension" to a price movement chart. A chart that was trending and linear could be given the whole dimension of 1 while a chart that was totally choppy and not trending could be said to have a dimension of 2. Somewhere in between these two values represented fractional states and different degrees of choppiness.  In the figure below we added a Choppiness indicator with the parameters set in the Preferences. A pane is inserted at the bottom of the chart and a blue line is used to indicate the choppiness index along the chart. If you select a different stock this study will continue to exist at the bottom of the chart, and will readjust for the new security.

Figure 7A Choppiness indicator

The Choppiness Index or CI varies between 0 and 100, the higher the index the choppier the price action is and the lower the index the more trending the price action. Since it is a trending indicator it has a length, which sets the look back period, here in the example its set to 14. There are two bands in the Choppiness indicator: Inside Band Color and Outside band color. The display only shows on of the two band colors, red if its insider the Upper or Lower bands and yellow if its inside the bands. The bands can be set but default to Fibanocci numbers of 38.20 and 61.80. When the choppiness indicator is under 38.20 it will display the red Outside band. If its above 61.80 it will display the yellow Inside band.

Dreiss explains the way he works with CI in an article in November 1991 Technical Traders Bulletin: "Low readings in the CI correspond closely with the end of strong impulsive movements either up or down, while high readings occur after significant consolidations in the price." A good article on the subject of Choppiness by Gibbons Burke appeared in Futures Magazine in October of 1993. You can find a copy on the web at http://www.quote.com/quotecom/qcharts/help.asp?option=choppiness

Conventional Trading Wisdom

The Choppiness indicator has an inverse relationship to price action and a trend is considered broken when the CI is below the lower line and reverses. Again this does not tell you the direction of the market it just gives a fundamental different perspective on the change of a trend in general. You can see this in the Figure above at the right side of the chart where AOL's 14 day Choppiness has dropped below the red Outside band color, indicating maximum trending and hence minimum choppiness. If you look at the price chart you can see that the bullish uptrend that started around the 14th of August, now appears to be broken. If other signals confirmed that this is a turning point, it could likely that we are headed towards a new trend direction down and it might be a good time to sell, or go short.

Figure 7B Choppiness indicator preferences

 

Directional Movement

The Directional Movement indicator is designed to help you see if a security is trending or not. Invented by Welles Wilder and explained in his book New Concepts in Technical Analysis, it requires comparing a 14-day positive directional indicator (+DI) to a 14 day negative direction indicator (-DI). These two averages can be plotted on top of each other, as shown in the figure below. The +DI is blue and the -DI is red. A buy signal is generated when the +DI rises above the -DI while a sell signal is generated when the +DI falls below the -DI. If you study the chart of AOL in the figure below, around August 14 you can see the blue +DI clearly rose above the red -DI, and kept diverging. This would have been a great time to go long in AOL as it rose from about 50 to 60 in only two weeks.

However if you look really close around July 31 to Aug 14 there where plenty of times when the +DI above -DI signal was given and the stock actually turned around and dropped. These are called whipsaws. They are false signals and cause unneeded trades to occur. Whipsaws need to be avoided.

To accomplish this Wilder creates what is known as the "extreme point rule". This rule says that the day the +DI crosses over the -DI, you note the extreme high or low of the day (using the high wick of the candlestick for example or the High(D) if you where doing this in a formula).  Then on the next day enter a buy order only when the price moves at least 3% above the extreme point if buying, and below the extreme point if selling.

Figure 8A Directional Movement indicator, no ADX showing

In the figure below we have blown up the section of the chart around August so you can see where the +DI crossed the -DI on August 14 (the cursor track is on the day before, the 13th, so as to not obscure the wicks on the candles). On the 14th the stock got as high as 53 1/4. Using the 3% rule the stock would have to get to 54.84 the next day before you would accept a true buy signal. The next day the stock got as high as 55, and as you can see it continued up from there.

Figure 8B Directional Movement indicator, no ADX showing

Recently another indicator was added to the Direction Indicator, called the Average Directional Indicator, or ADX. The purpose of the ADX is to show the trend or non trendness. A rising ADX indicates a strong trend, while a falling ADX indicates no trend. In the figure below the ADX is moving up since August 14, which indicates that there is a trend in place.

Figure 8C Directional Movement indicator, ADX showing

You can turn the ADX on and off from the Direction Movement Preferences dialog box. You can give it a Length, a color and a thickness. Here we made the ADX navy green to contrast against the bright blue and red of the DI. Again like the Choppiness indicator, DI and ADX are trending indicators, which means that they are giving indications after they have transpired. The direction of the ADX does not correlate with the direction of the trend, only that there is a trend.

Figure 8D Directional Movement Preferences

MACD

The MACD is one of the most famous and well-known indicators, trailing in significance only after the moving average. Invented by Gerald Appel, who publishes Systems and Forecasts, MACD stands for Moving Average Convergence Divergence, a mouthful that can be boiled down to one thing—crossovers. MACD looks for when moving averages crossover each other. What tends to make MACD more complicated is that there are a number of moving averages and they are connected in a more abstract way than most people are accustomed to but its really not a big deal.

First the basic MACD is nothing more than two moving averages. There is a short term moving average called the Fast Length and a longer term moving average called the Slow Length. These settings default to 12 and 26 periods or bars. The difference of these two moving averages is called the MACD line and is painted blue in the default of the example below. The second line in the MACD is called the Signal line, and it is made up of an exponentially smoothed version of the Slow line. The red Signal lines smoothing length can be controlled and defaults to 9 in our example. In our example the red line is the signal line and the blue line is the MACD line.

Figure 9A MACD

The way the MACD is read for signals is when their fast line crosses the slow line and is moving up, and is above the 0 base line, the stock is in an up trend and its safe to go long. When the fast line falls below the slow line and is below the 0 line, the stock is in a downtrend and its safe to sell or go short. An expanded figure of the MACD is shown below so you can easily identify the crossovers.

A third feature of the MACD is the Histogram, which is simply another way to help you see the trend. Rather than trying to look really close and see where the two moving average crossovers are occurring, the histogram shows the difference between the fast and slow lines. This is shown as a little vertical bar chart. When its above the base line and pointing up, the stock is in an uptrend, or below the line and pointing down, when its in a down trend. As you can see in the figure above for IBM the magenta histogram makes it very easy to identify when the stock has broken out and is moving up. The size of the histogram is an indication of the strength of the trend.

Figure 9C MACD chart expanded

The Preferences for the MACD, shown in the figure below, offer a number of arrangements. The Length for the fast and slow moving averages are set in MACD section in Fast Len and Slow Len, currently 12 and 26. The smoothing factor for the exponential moving average of the difference of the 12 and 26 moving average, is set in Smoothing, in the Signal Line section, and its currently 9. For shorthand the software titles this MACD as MACD(12,26,9). The accepted wisdom when using the MACD indicator is that a 12,26,9 MACD is used for selling while a 8,17,9 is used for buying. If you try to change these numbers you will see a slight shift in where the MACD charts.

The Preferences allows you to control if the MACD is displayed as an oscillator, or simple moving average (the default) and if drop lines are included. Drop lines are vertical lines drawn from the blue MACD line to the zero axis. The centerline (zero base) can be turned on or off and the Histogram can be turned on or off.

And of course like other indicators you can display it on either the left or right axis, and you can control the color and line thickness of all the graphs.

Figure 9C MACD Preferences

Conventional Trading Wisdom

The basic rule is to sell when the MACD drops below its signal line and buy when the MACD rises above the signal line. In other words when the Histogram rises above the zero line in a positive direction it’s a buy and when it drops from above to below the line it’s a sell. This is a crossover signal. Another signal can be produced if the MACD is viewed as an oversold or overbought signal. When the MACD rises (shorter moving average pulls away from the longer moving average) it is a sign the security is overextended and will eventually return to a more normal level.
Momentum

Indicators fit into three categories—trend following, oscillators, and miscellaneous. Momentum is an oscillator type of indicator—its helps to reveal turning points and extremes but is not very useful during a trend. In physics, momentum is the tendency for an object to continue to move once its in motion. In the case of a marble rolling down an incline, momentum builds as the incline becomes steeper and slows when the incline lessens. Stock prices have a form of momentum. Once prices start moving in a direction they often tend to keep going. And they tend to speed up like a marble going down a steeper plane. Stock price momentum may come about because of the herd following psychology of investors—the more people that buy, the more people jump in. The Momentum indicator, which seems to have no inventor, basically measures the amount the price has changed in a given time frame and reports it as a ratio. The more price change in a week, the more momentum, the less change in that week, the less momentum. Prices can be increasing in a positive direction in which case momentum is upward, or prices can be dropping in which case momentum is downward. As falling or rising prices begin to slow, the momentum indicator will tend to flatten out and turn horizontal.

Conventional Trading Wisdom

Momentum is used to signal when a market is about to have a reversal. When the indicator bottoms out and then turns up the signal is to buy. When the indicator tops out and turns down, the signal is to sell. In the example below for Apple, you can see that while Momentum is a healthy 11, the graph is turning flat and peaking, which is just what happens before a price reverses. So here momentum may be predicting a trend reversal downward, and time to sell. However, sometimes when the Momentum indicator reaches an extreme high or low and stays at that value, it may indicate that current trend will continue rather than reverse.

Figure 10A Momentum indicator

The Momentum Preferences allow you to set the Length of the oscillator, here 12, the Source, color, and line thickness. You can also control the color of the centerline, whether to display a centerline, and what price axis, left of right, on which to display.

Figure 10B Momentum indicator Preferences

ROC

The Rate of Change or ROC indicator is identical to the Momentum indicator except the Momentum uses a ratio for its scale while ROC uses a percent between 0 and 100. So in the case of Apple in the chart below you can see its Last ROC is about 24% which means the rate of change is 24% for the prior 12-day period. See the Momentum indicator for more details.

Figure 11A Rate of Change (ROC) Indicator

The Rate of Change Preferences work the same as the Momentum Preferences.

Figure 11B Rate of Change (ROC) Indicator Preferences

RSI

The Relative Strength Index or RSI was introduced by a gentleman named Welles Wilder in the June 1978 issue of Stocks and Commodities magazine, and then popularized in his book, New Concepts in Technical Trading Systems, 1978.  Like the Momentum and Rate of Change indicators, RSI is a momentum-based oscillator that has a range of 0 to 100. The name does not make very good sense, because this indicator does not compare the strengths of two stocks, rather it measures the internal strength of a single stock and should have been called Internal Strength Index or ISI. There is another indicator that compares the strengths of two stocks but it’s called the Comparative Strength Index. An oscillator reaches a top when it reaches a high level associated with tops in the past. Overbought means too high and ready to turn down. When the RSI in a stock reaches a value above 70 it is considered overbought. An oscillator becomes oversold however when it reaches a level associated with bottoms in the past. Oversold means too low and ready to turn up. When the RSI of a market or stock reaches a value below 30 it is considered oversold.

In the figure below you can see the RSI is hovering just below 70 so it’s almost in the overbought area. Overbought would indicate that there are too many shares that have been bought, and we may be facing a situation where there are many more sellers than buyers. The Preferences for the RSI indicator allow you to set up your own colors for the Inside and Outside colors. The inside colors are between 30 and 70, and have been set to yellow in this example. This would be considered a no information area from the oscillator. The Outside color is the color when the RSI is <30 or >70, and here its set to green. You can also control the Upper and Lower Band values, and you can have a histogram drawn in the bands.

Figure 12A Relative Strength Index showing Inside Color

Conventional Trading Wisdom

The most popular way of analyzing the RSI of a chart is to look for "divergences" (e.g. when the trend of an indicator does not agree with the price) in which the security is making a new high, but the RSI is failing to surpass a previous high. This divergence becomes evidence of an impending reversal of the trend. Further when the RSI falls below the most recent low, its assumed to have completed a "failure swing" in which case the reversal is confirmed.

In the figure below you can see the RSI for Apple blown up around a new high it is making. The RSI is showing a higher value than the previous high around the 17th of June, and so the RSI is not showing an impending reversal yet.

Figure 12B Blow up of Relative Strength Index reaching a top

 

Figure 12C Relative Strength Index showing Outside Color

In his book Wilder identifies other uses for the RSI including the ability to show tops and bottoms, to reveal chart patterns and formations, failure swings, divergences, and support and resistance.

 

Figure 12D Relative Strength Index Preferences

Stochastic

Perhaps the most difficult thing about the Stochastic is knowing how to pronounce it. Its spoken like this: "sto-kas-tik". The definition of stochastic is "pertaining to or arising from chance" and in math the idea defines a process where a sequence of values is drawn from another sequence of jointly distributed random values. In the case of charting,  Stochastics is another oscillator that compares where a security's closing price is relative to its price range over a given time period. The idea is that when a stock is trending upward, prices in a given interval tend to close at their highs, and when it’s trending downward, they tend to close at their lows. This leads to the idea that as a trend erodes or decays, stocks close further away from their highs. The stochastic oscillator then tries to project when prices are grouping near their lows in an upward moving market or grouping near their highs in a downward market.

The Stochastic is made up of two moving lines, the main line is called the %K and the second line, which is a moving average of the %K, is called the %D line. In the Stochastic Preferences the %K defaults to an Interval of 14 and the %D defaults to a smoothing of 3. The %K is colored blue while the %D is colored red and the %D is considered the more significant of the two lines.  Like the RSI indicator, the Stochastic has bands that the indicator can be in and those are called the Inside band and the Outside band. These colors are set in the Preferences and are expressed in actual values. In the figure below Apple is in the Outside band which means its over 80. The Stochastic has turned flat and is now hovering in the overbought condition. This could be a sign of a reversal.

Figure 13A Stochastic Oscillator Indicator showing Outside Color

Conventional Trading Wisdom

The Stochastic can be used several ways to help you buy and sell securities. First you can buy when the oscillator falls below 20, then turns and rises from that level. You can in turn sell when the oscillator rises above 80 and then falls back down. Second, you can buy when the %K lines rises above the %D line and sell when the %K falls below the %D. To make this easy to view you could turn this into a color study since both the stochastics have historical data. Third you can look for divergences, for example when prices are making new lows and the Stochastic is failing to past its previous low.

Figure 13B Stochastic Oscillator Indicator Preferences

 

Volume

Volume is one of the more basic indicators, and in fact it performs no real mathematical functions but rather displays pictorially a simple value that represents the total number of shares traded in the time frame or interval. If you switch to a daily chart a volume bar is for the volume on that day. If it’s the current day the daily volume bar will grow as the day continues and end at 4:30 EST. However if you switch to a 60-minute chart, each volume bar will represent an hour instead of a day.

The main use of volume is in providing clues about the intensity or magnitude of a certain price.

Figure 14A Volume Indicator

Conventional Trading Wisdom

When volume is high it is usually where there is a good deal of agreement that prices will move higher. On the other hand high volume may also occur as a market bottoms out, and traders may panic and sell. At the same time high volume can be a sign of a new trend, such as a reversal or a breakout. Low volume can show signs that a market is indecisive. During times of low volume a stock may consolidate. When markets are at bottoms they often exhibit low volume until some event cause a new interest in buying. Overall volume is looked upon as a measure of the health of any movement. Good healthy uptrends are accompanied by a surge in volume. Surprisingly a healthy downturn also has high volume (of course this is only healthy to you if you are shorting).

In the figure below you can see that Target took a big drop at the end of the month. In this case Target opened down about 5 points or 20% because its retail sales where lower than the street expected. There was a great deal of volume during that gap which would indicate that it’s a healthy drop, and a good representation of the stock's new value.

 

Figure 14B Volume Indicator showing volume spike and gap down

 

Figure 14C Volume Indicator Preferences

 

Open Interest

Open Interest is an indicator that should be with options not stocks because it only works with options. A stock option is a trading instrument that allows speculation to be made on stock without owning them, they are contracts that you will buy or sell the stock. These contracts are traded on several options exchanges. A contract represents one hundred shares of stock. The open interest is the total number of contracts that trade. Below we show the price chart for the September $55 Apple Call. You can see it has a short life, it started trading in small numbers in the third week of July, and it will expire on September 15, 2000. The number of contracts traded each day is shown in the Open Interest study below and you can see that it is rising each day as more people trade this option.

Conventional Trading Wisdom

The use of open interest as a signal is similar to regular volume described previously. Price movements with large numbers of contracts trading hands are more significant and have more conviction than price moves with lower volume. Since options are much less liquid than stocks because they have less overall customers, the use of open interest as an indicator is more open to interpretation and thus more trick that stock volume.

Figure 15A Open Interest (Option)

 

Figure 15B Open Interest (Option) Preferences

 

On Balance Volume

Another momentum indicator is On Balance Volume, or OBV. This is simply a running total of volume that is either flowing into or out of a stock. The rule for the OBV algorithm is when a stock closes up from the previous interval, the volume is added to a running total and when it closes less than the previous interval’s close, it is subtracted from the running total. This indicator was developed by a gentleman with a gravely voice named Joe Granville in the early 70s, as a method for measuring buying and selling pressure, and promoted in his book with the catchy title (not!) New Strategy of Daily Stock Market Timing for Maximum Profit.

Conventional Trading Wisdom

The basic idea of OBV is that OBV changes before the price changes as the "smart" money begins to move into the stock. If the price of a security moves before the OVB moves (which would mean indirectly that there was low volume on the price move), this is considered a non-confirmation, and these can occur at tops or bottoms. The most natural evidence from this indicator is an increase in shares when near a price bottom usually signals a price change about to occur. It also reveals the "quality" of a trend, because if the OBV rises as a price rises it shows it has health (see Volume). Normally when interpreting OBV, traders focus on the slope of the OBV rather than the actual number. An increasing slope with increasing price would confirm a trend in either the up or down direction.

Figure 16A On Balance Volume

 

Figure 16B On Balance Volume Preferences