Technical Indicators
1. Average True Range – ATR
A measure of volatility introduced
by Welles Wilder in his book: "New Concepts in Technical Trading Systems."
The True Range indicator is the
greatest of the following:
- Current high less the current
low.
- The absolute value of the
current high less the previous close.
- The absolute value of the
current low less the previous close.
The Average True Range is a moving
average (generally 14-days) of the True Ranges. Wilder originally developed the
ATR for commodities but the indicator can also be used for Forex. Simply put, a
currency experiencing a high level of volatility will have a higher.
2. BOLLINGER BAND
Developed by John Bollinger,
Bollinger Bands are charted by calculating a simple moving average of price,
then creating two bands a specified number of standard deviations above and
below the moving average. You can draw the simple moving average analysis on the
same chart as the Bollinger Bands analysis, using the same interval. In
addition, Bollinger Bands are usually plotted with a bar analysis so that the
proximity of the bands to the prices can be easily observed.
The most common uses of Bollinger
Bands are to:
-
Identify overbought and oversold markets
An overbought or oversold market
is one where the prices have risen or fallen too far and are therefore likely to
retrace. Prices near the lower band signal an oversold market and prices near
the upper band signal an overbought market. Overbought and oversold signals are
most reliable in a non-trending market where prices are making a series of equal
highs and lows. If the market is trending, then signals in the direction of the
trend are likely to be more reliable. For example if prices are in an up trend,
a safer trade entry may be obtained by waiting for prices to pullback giving an
oversold signal and then turn up again.
-
Used in combination with an oscillator, generate buy or sell signals
If you use Bollinger Bands in
combination with an oscillator such as Relative Strength Index (RSI), buy and
sell signals are generated when the Bollinger Bands signal an
overbought/oversold market at the same time the oscillator signals a divergence.
- Warn of an impending price
move
The bands often narrow just before
a sharp price move. A period of low volatility often precedes a sharp move in
prices; low volatility will cause the bands to narrow. A top that breaks above
the upper band followed by another that is between the bands signals a potential
top in the market. A bottom that breaks below the lower band followed by another
that is between the bands signals a potential bottom.
Parameters
The length of the moving average
is usually 20 days or less. Bollinger suggested using a moving average that
would catch the first retracement of an up move.
Bollinger used a figure of 2
standard deviations in his work, which was in stock trading. A value of 2
captures about 95% of the variation in price action. Different figures may be
more appropriate for other types of markets.
3. CCI – Commodity Channel Index
Commodity Channel Index (CCI) was
originated by Donald Lambert in 1980. It is based on the assumption that a
perfectly cyclical commodity price approximates a sine wave. Designed to be used
with instruments, which have seasonal or cyclical tendencies, Commodity Channel
Index is not used to calculate cycle lengths but rather to indicate that a cycle
trend is beginning.
The most common uses of Commodity
Channel Index are to:
- Indicate breakouts
This is Lambert’s original
interpretation, buying when the Commodity Channel Index moved above +100 and
selling when the Commodity Channel Index went below -100. Lambert would exit the
trade once the Commodity Channel Index moved back within the -100 to +100 bands.
The assumption with this use of Commodity Channel Index is that once an
instrument breaks +100 or -100 it has begun to trend.
- Generate buy and sell signals
Sell signals are when the CCI
moves from above +100 to below +100 and buy signals are when the CCI moves from
below -100 to above -100. This method works best when the market is
non-trending.
- Indicate Bullish and Bearish
Divergence
In trending markets the Commodity
Channel Index can be used to indicate that the trend is weakening by signaling
divergence. Divergence between the CCI line and the price indicates that an up
or down move is weakening. Bearish Divergence occurs when prices are making
higher highs but the CCI is making lower highs. This is a sign that the up move
is weakening. Bullish Divergence occurs when prices are making lower lows but
the CCI is making higher lows. This is a sign that the down move is weakening.
Parameters
Observation period: (default 5)
The choice of observation period
is important. If the Commodity Channel Index is to be used as Lambert originally
suggested then the Observation Period should be one third of the cycle length.
If the Commodity Channel Index is to be used for purposes other than in relation
to cycles, the Observation Period can be set so that the -100 to +100 bands
contain 70% to 80% of the data.
4. Linear Regression
Linear regression is a statistical
tool used to measure trends. Linear regression uses the least squares method to
plot the line. The linear regression line is a straight line extending through
the prices.
The most common use of Linear
Regression is:
- To trade in the direction of the
linear regression line. Colby and Meyers found that trading in this manner
provided good results using a 66-week figure. The only drawback was a large draw
down in relation to the profitable trades.
5. MACD - Moving Average Convergence Divergence
Moving Average Convergence
Divergence or MACD as it is more commonly known, was developed by Gerald Appel
to trade 26 and 12-week cycles in the stock market. MACD is a type of oscillator
that can measure market momentum as well as follow or indicate the trend. MACD
consists of two lines, the MACD Line and the Signal Line. The MACD Line measures
the difference between a short Exponential Moving Average and a long Exponential
Moving Average. The Signal Line is an Exponential Moving Average of the MACD
Line. MACD oscillates above and below a zero line without upper and lower
boundaries. There is another form of MACD, which displays the difference between
the MACD Line and the Signal Line as a histogram.
MACD Forest displays the positive
and negative difference between the two lines found in an MACD graph (the MACD
Line and the Signal Line) as a histogram above and below a zero line. The
default periods are the same as the periods used by Appel. Remember that Appel
used 26 and 12 because he observed weekly cycles of similar length in the US
stock market. You may wish to change the parameters to match another cycle
period you have observed.
The most common uses of MACD are
to:
- Generate buy and sell signals
Signals are generated when the
MACD Line and the Signal Line cross. A buy signal occurs when the MACD Line
crosses from below to above the Signal Line, the further below the zero line
that this occurs the stronger the signal. A sell signal occurs when the MACD
Line crosses from above to below the Signal Line, the further above the zero
line that this occurs the stronger the signal.
If a trend is gaining momentum
then the difference between the short and long moving average will increase.
This means that if both MACD lines are above (below) zero and the MACD Line is
above (below) the Signal Line, then the trend is up (down). Divergence between
the MACD and the price indicates that an up or down move is weakening.
Bearish Divergence occurs when
prices are making higher highs but the MACD is making lower highs. This is a
sign that the up move is weakening. Bullish Divergence occurs when prices are
making lower lows but the MACD is making higher lows. This is a sign that the
down move is weakening. It is important to note that although Divergences
indicate a weakening trend they do not in themselves indicate that the trend has
reversed. The confirmation or signal that the must come from price action, for
example a trend line break.
Parameters
Short averaging period: (default
12)
Long averaging period: (default
26)
Signal line averaging period:
(default 9)
The default periods are the same
as the periods used by Appel. Remember that Appel used 26 and 12 because he
observed weekly cycles of similar length in the US stock market. You may wish to
change the parameters to match another cycle period you have observed.
6. Momentum
Momentum is an oscillator that
measures the rate at which prices are changing over the Observation Period. It
measures whether prices are rising or falling at an increasing or decreasing
rate. The Momentum calculation subtracts the current price from the price a set
number of periods ago. This positive or negative difference is plotted about a
zero line.
The most common uses of Momentum
are to:
- Indicate overbought and
oversold conditions
An overbought or oversold market
is one where the prices have risen or fallen too far and are therefore likely to
retrace. If the Momentum line moves to a very high value above the zero line,
this is a sign of an overbought market. If the Momentum line moves to a very low
value below the zero line this is a sign of an oversold market.
Overbought and oversold signals
are most reliable in a non-trending market where prices are making a series of
equal highs and lows. If the market is trending, then signals in the direction
of the trend are likely to be more reliable. For example if prices are in an up
trend, a safer trade entry may be obtained by waiting for prices to pullback
giving an oversold signal and then turn up again.
- Indicate Bullish and Bearish
Divergence
Divergence between the Momentum
line and the price indicates that an up or down move is weakening. Bearish
Divergence occurs when prices are making higher highs but the Momentum is making
lower highs. This is a sign that the up move is weakening. Bullish Divergence
occurs when prices are making lower lows but the Momentum is making higher lows.
This is a sign that the down move is weakening.
It is important to note that
although Divergences indicate a weakening trend they do not in themselves
indicate that the trend has reversed. The confirmation or signal that the trend
has reversed must come from price action, for example a trend line break.
Parameters
Observation period: (default 10)
Normally the Observation Period is
set to half the cycle length of the underlying instrument. This means that the
Momentum line will peak and bottom along with prices.
7. MOVING AVERAGE
A Moving Average is a moving mean
of data. In other words, Moving Averages perform a mathematical function where
data within a selected period is averaged and the average ‘moves’ as new data is
included in the calculation while older data is removed or lessened. Moving
Averages essentially smooth data by removing ‘noise’. This smoothing of data
makes Moving Averages popular tools in identifying price trends and trend
reversals.
The differences between the three
types of moving averages lie in the way that they are calculated and whether
they look at all the data available or only the data within a selected period.
This means that each type of moving average has its own characteristics, for
example how quickly each will respond to changes in the underlying price.
Simple Moving Average
Simple Moving Averages are the
most common and popular form of moving average. The primary reason for this is
the relative ease with which Simple Moving Averages are calculated. A Simple
Moving Average is calculated by adding values over a set number of periods and
then dividing the sum by the total number of values. As with other types of
moving averages, Simple Moving Averages smooth the data by removing ‘noise’ over
the selected period. The ability to smooth data makes them a useful tool in
identifying price trends and trend reversals.
Moving average - weighted
As with Simple Moving Averages,
Weighted Moving Averages smooth the data by removing ‘noise’ over the selected
period. However a Weighted Moving Average will be more sensitive to recent
changes in data. This is because a Simple Moving Average gives all observations
equal emphasis in its calculation, but a Weighted Moving Average assigns a
greater weight to the most recent observations.
Moving average - exponential
The Exponential Moving Average is
similar to the Weighted Moving Average in that they both assign greater weight
to the most recent data. Where they differ is that instead of dropping off the
oldest data point in the selected period of the moving average, the Exponential
Moving Average continues to maintain all the data. In other words, a 5 day
Exponential Moving Average will contain more than 5 pieces of data information.
Each observation becomes progressively less significant but still includes in
its calculation all the price data in the life of the instrument. The
Exponential Moving Average is another method of weighting a moving average.
The most common uses of Moving
Averages are to:
- Identify the trend
A common method involves looking
at the slope of the Moving Average and the relationship of the prices to the
Moving Average. For example, if the Moving Average is sloping down and prices
are below the Moving Average then prices are considered to be in a downtrend.
The opposite is true for an up trend. If prices are moving above and below the
Moving Average and the Moving Average is flat then a nontrending market exists.
- Give buy and sell signals
This can be achieved a number of
ways. The first method looks at the relationship between the close and a single
Moving Average. If the market closes above the Moving Average then a buy signal
is generated, if the market closes below the Moving Average then a sell signal
is generated. The second method uses two Moving Averages, one with a shorter
observation period than the other. Buy and sell signals are generated when the
short moving average crosses over the long moving average. For example if the
short moving average crosses above the long moving average a buy signal is
generated; a sell signal is generated when the short Moving Average crosses
below the long Moving Average.
Note:
Both of these buy and sell techniques are most effective when the market is
trending. If the market is non-trending then these techniques are likely to give
false signals. This is simply because the market needs to continue in the
direction of the buy or sell signal in order for the trade to be profitable.
Exponential Moving Averages are used in the same manner as the other types of
moving average, usually to identify price trends and trend reversals.
Parameters
Averaging period: (default 5)
The exact averaging period to be
used will depend upon the purpose of the moving average. If you are using moving
averages to identify the trend, then the length of the averaging period should
reflect the length of the trend you are trying to identify. The longer the trend
- the longer the averaging period. For example, if you are looking at a daily
chart to identify the long-term trend, you may decide to use an averaging period
of 200. For short and medium term trends periods of 20 and 50 could be used
respectively.If you are using moving averages to generate buy and sell signals
then shorter, more responsive averaging periods are normally used. For example a
two moving average system may use averaging periods of 5 and 20.
Note:
When selecting an
averaging period there is a tradeoff between the averaging period, the number of
signals generated and the risk associated with the signal. A longer averaging
period will generate less signals but will require a larger price move before
responding, sacrificing potential profits in order to confirm the signal. A
shorter averaging period will generate more signals and require less of a price
move before responding, however the risk that the signal is false increases.
8. PARABOLIC TIME PRICE - SAR
Parabolic Time Price is a system
that always has a position in the market, either long or short. You would close
out the current position and enter a reverse position when the price crosses the
current Stop And Reverse (SAR) point.
The SAR points resemble a
parabolic curve as they begin to tighten and close in on prices once prices
begin to trend. This explains the name - Parabolic Time Price. Parabolic Time
Price is usually charted with a bar analysis so that the stop and reverse points
are easily identified. If you are long, the SAR points will be below the prices
and the signal to go short will be when prices cross the current SAR point from
above. If you are short, the SAR points will be above the prices and the signal
to go long will be when prices cross the current SAR point from below.
When a new position is entered the
SAR points will be positioned far enough away from the prices to permit some
contra-trend price movement. As the market begins to trend the SAR points will
move with prices and progressively tighten as the trend continues. This is
accomplished by the use of an acceleration factor that increases up to a given
limit each time a new extreme in the direction of the trend is reached.
The most common uses of Parabolic
Time Price are:
- As a Stop And Reverse system
Signals to stop out of the current
position and enter a reverse position are when prices cross the current SAR
point. For example if the SAR points are below prices you would be long with an
order to close out the current long position and enter a short position at that
period’s SAR point. Once you are stopped into a short position the SAR points
will be above prices and the current period’s SAR point will be the level at
which you will be stopped out of your short position and enter a long position.
When applied in its original form Parabolic Time Price is a system that is
always in the market. In order for this technique to be successful the
underlying market needs to be trending strongly. If Parabolic Time Price is
applied in a non-trending market then it is likely that losses will result
because the buy signals will occur at the top of the range and the sell signals
at the bottom of the range.
- As an entry and exit technique
in a trending market
By using Parabolic Time Price in
conjunction with an analysis that indicates market trend such as MACD, you would
take only long trades when the trend was up and only short trades when the trend
was down.
- To select a level at which to
place a stop loss
After a trade has been entered
using another method or technique, the SAR points of Parabolic Time Price are
used to trail a stop on the position.
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