In this second part of an introduction on how to do technical analysis of stocks, we look at more tools to analyze stock price movements. If you missed the first part it’s right here.
Trending indicator types
Trending – indicates confirmation of the movement i.e. continuing in the same direction.
Oscillators – indicates a reversal of the trend
Volume – indicates the strength or weakness of the trend
Moving averages. When the current price moves above the moving average this is usually an indicator to buy. When the price moves below the moving average this is usually an indicator to sell. A common practice is to use a few moving averages with different periods. When the moving averages cross each other as in the earlier example that is a signal to enter the market.
Bollinger Bands. Bollinger bands are additional lines added above and below a moving average. The upper and lower Bollinger Bands are the standard deviation from the moving average line in the middle. When the price stays in the upper band and the band and the price are both moving up, that is confirmation that the uptrend in price will likely continue. When both the price and the moving average are moving down and the price stays in the lower band that is confirmation that the price downtrend will continue.
Average Directional Index (ADX), Directional Movement Index (DMI)
The +DMI is the positive Directional Movement Index. It is a moving average usually with a 14-day period which measures how strongly the price moves upwards
The -DMI is the negative Directional Movement Index. It is a moving average also with a 14-day period which measures how strongly the price moves downwards.
+DMI and -DMI show the relative strength of bulls against bears.
The Average Directional Index, ADX is non-directional and just shows the strength of the movement, whether up or down.
During an uptrend, the +DMI indicates the strength of the price movement. When the +DMI crosses the -DMI in an upward direction that is a buy signal.
During a downtrend, when the -DMI crosses the +DMI in an upward direction that is a sell signal.
Theoretically, ADX varies from 0 to 100 but practically it will move between 0 and 60. It shows the strength of the trend regardless of the direction.
When ADX falls below 20 this indicates that the movement is weak. When the ADX rises above 40 that indicates a strong trend, either upwards or downwards. When the ADX rises from below above 20 then the price trend has some strength and will continue. When the ADX falls from above 40 to below 40 this indicates that the price trend has lost its strength.
The ADX is best used to confirm signals from other indicators.
Stochastic Oscillator. Consists of two moving averages that move between 0 and 100. From 0 to 20 indicates oversold and therefore is a buy signal. From 20 to 80 is in the middle or neutral ground and from 80 to 100 indicates overbought and therefore is sell signal.
Moving Average Convergence/Divergence – MACD – shows the strength of a trend and indicates its further direction. MACD takes two moving averages, with different time periods, subtracts the longer moving average from the shorter moving average to produce an oscillator. The MACD oscillates above and below zero. It is usual to add a histogram to the MACD chart which tracks the distance between the MACD oscillator and the price. The histogram also oscillates above and below the zero mark.
When the shorter period moving average is above the longer period moving average and the histogram is above zero, this is a strong indicator of rising prices. When the shorter period moving average moves below the longer period moving average and the histogram is below zero, then this is an indicator that the price trend is weakening and the price will fall.
For a more in-depth look at Moving Average Convergence divergence, check here.
Relative Strength Index, RSI – shows the strength of the trend and the probability of its change. RSI moves between 0 and 100. An RSI from 0 to 30 indicates the stock is oversold. This indicates that the price will rise and is a strong buy signal. Once the RSI goes above 70 that indicates that the stock is overbought. That suggests that the price is about to fall. This is a sell signal.
Volumes -. Volume is displayed as bars which indicate the number of trades executed during the period. When the volume bars increase and the price increases this indicates that the price trend will continue. When the price rises but the volume falls that is called divergence. This means any rise is weakening and the price will likely soon fall.
When the price falls and the volume increases this is called convergence and indicates that the price will soon go up.
Money Flow Index (MFI) – displays the volume and intensity of trading at a particular point in time. MFI moves from 0 to 100. When the MFI moves from the high side down below 20 this indicates that the stock is oversold and suggests that the price will rise. When the MFI moves from below to over 80 this indicates that the stocks overbought and will soon fall.
When the MFI and the price converge this indicates that the price will rise. When the MFI and the price diverge this indicates that the price will fall.
When the price and the MFI move in parallel then you can detect levels of support and resistance. A breakout of the MFI from a rising pattern in parallel with the price indicates that the price will soon fall. A breakout of the MFI from a declining pattern in parallel with the price indicates that the price will soon rise. Often the MFI breaks before the price which is why MFI can be a good indicator for trading.
Accumulation/Distribution (A/D) – looks at price movement and compares with volume trends. When the volume moves in parallel with the price this confirms the price direction. This means that the trend will continue in the same direction.
When volume and price diverge this indicates that the price direction will soon change. This is a strong indicator of price trend reversal – in this case, decline. When the volume and price converge this is a strong indicator that of a trend reversal and that the price will soon rise.
Elliot Wave Theory
Elliot wave theory seeks to identify repetitive wave patterns in price movement. Elliot himself was an accountant and first developed and published his theory in the 1930s. He linked market price movements to human behavior and natural rhythmic cycles.
Elliot’s wave theory says that the wave patterns of stock price movements display fractal patterns, following Fibonacci ratios at each level of analysis much like the structures of ferns, leaves, seashells, and snowflakes.
The theory divides each wave into two parts. The first part is called the impulse section and a second part called a correction section.
Following the principles of waves within waves, the impulse section of the wave consists of five legs and the correction section of the wave consists of three legs.
Like a fern or a snowflake, the same fractal pattern repeats the closer you look.
The Elliot wave patterns can be found with both up trending prices and with down-trending prices. On price downtrends the impulse section is a downward trend with five shorter waves and the corrective section is an upward trend with three shorter waves.
The theory says there are patterns called diagonal triangles at the beginning or at the end of impulse and correction waves.
So was do all these confusing lines mean. The importance of the diagonal triangles is that identifying where the impulse wave reverses into a corrective wave is a key point to enter the market.
Elliot waves today
Since Elliot published his theory there have been adherents and those who have challenged and refuted the theory. But still today Elliot wave theory is considered a core component of technical analysis and is used by many analysts to help identify trends and market entry and exit points.
To find out more about Elliot wave theory, check here.
This has just been a simple introduction to technical analysis applied to stock prices. There are many other indicators that are used to determine which stocks, which industries, which sectors or which asset classes to take long or short positions, and when to enter those positions and when to exit. Here are more reference materials on technical analysis.
Can you beat the market?
Some say you can, some say you can’t and some say that without powerful tools and nerves of steel it is more likely that your emotions will take over just when you needed to get in earlier, wait longer, bale out sooner or hold on longer.
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