Many different techniques and indicators can be used to follow and predict trends in markets. The objective is to predict the major components of the trend: its direction, its level and the timing. Some of the most widely known include:
- Bollinger Bands – a range of price volatility named after John Bollinger, who invented them in the 1980s. They evolved from the concept of trading bands, and can be used to measure the relative height or depth of price. A band is plotted two standard deviations away from a simple moving average. As standard deviation is a measure of volatility, Bollinger Bands adjust themselves to market conditions. When the markets become more volatile, the bands widen (move further away from the average), and during less volatile periods, the bands contract (move closer to the average).
Bollinger Bands are one of the most popular technical analysis techniques. The closer prices move to the upper band, the more overbought is the market, and the closer prices move to the lower band, the more oversold is the market.
- Support / Resistance – The Support level is the lowest price an instrument trades at over a period of time. The longer the price stays at a particular level, the stronger the support at that level. On the chart this is price level under the market where buying interest is sufficiently strong to overcome selling pressure. Some traders believe that the stronger the support at a given level, the less likely it will break below that level in the future. The Resistance level is a price at which an instrument or market can trade, but which it cannot exceed, for a certain period of time. On the chart this is a price level over the market where selling pressure overcomes buying pressure, and a price advance is turned back.
- Support / Resistance Breakout – when a price passes through and stays beyond an area of support or resistance.
CCI – Commodity Channel Index – an oscillator used to help determine when an investment instrument has been overbought and oversold. The Commodity Channel Index, first developed by Donald Lambert, quantifies the relationship between the asset’s price, a moving average (MA) of the asset’s price, and normal deviations (D) from that average. The CCI has seen substantial growth in popularity amongst technical investors; today’s traders often use the indicator to determine cyclical trends in equities and currencies as well as commodities.
The CCI, when used in conjunction with other oscillators, can be a valuable tool to identify potential peaks and valleys in the asset’s price, and thus provide investors with reasonable evidence to estimate changes in the direction of price movement of the asset.
- Hikkake Pattern – a method of identifying reversals and continuation patterns. Used for determining market turning-points and continuations (also known as trending behavior). It is a simple pattern that can be viewed in market price data, using traditional bar charts, or Japanese candlestick charts.
- Moving averages – are used to emphasize the direction of a trend and to smooth out price and volume fluctuations, or “noise”, that can confuse interpretation. There are seven different types of moving averages:
- simple (arithmetic)
- exponential
- time series
- weighed
- triangular
- variable
- volume adjusted
The only significant difference between the various types of moving averages is the weight assigned to the most recent data. For example, a simple (arithmetic) moving average is calculated by adding the closing price of the instrument for a number of time periods, then dividing this total by the number of time periods.
The most popular method of interpreting a moving average is to compare the relationship between a moving average of the instrument’s closing price, and the instrument’s closing price itself.
- Sell signal: when the instrument’s price falls below its moving average
- Buy signal: when the instrument’s price rises above its moving average
The other technique is called the double crossover, which uses short-term and long-term averages. Typically, upward momentum is confirmed when a short-term average (e.g., 15-day) crosses above a longer-term average (e.g., 50-day). Downward momentum is confirmed when a short-term average crosses below a long-term average.
MACD – Moving Average Convergence/Divergence – a technical indicator, developed by Gerald Appel, used to detect swings in the price of financial instruments. The MACD is computed using two exponentially smoothed moving averages (see further down) of the security’s historical price, and is usually shown over a period of time on a chart. By then comparing the MACD to its own moving average (usually called the “signal line”), traders believe they can detect when
- the security is likely to rise or fall. MACD is frequently used in conjunction with other technical indicators such as the RSI (Relative Strength Index, see further down) and the stochastic oscillator (see further down).
- Momentum – is an oscillator designed to measure the rate of price change, not the actual price level. This oscillator consists of the net difference between the current closing price and the oldest closing price from a predetermined period.
The formula for calculating the momentum (M) is:
M = CCP – OCP
Where: CCP – current closing price
OCP – old closing price
Momentum and rate of change (ROC) are simple indicators showing the difference between today’s closing price and the close N days ago. “Momentum” is simply the difference, and the ROC is a ratio expressed in percentage. They refer in general to prices continuing to trend. The momentum and ROC indicators show that by remaining positive, while an uptrend is sustained, or negative, while a downtrend is sustained.
A crossing up through zero may be used as a signal to buy, or a crossing down through zero as a signal to sell. How high (or how low, when negative) the indicators get shows how strong the trend is.
- RSI – Relative Strength Index – a technical momentum indicator, devised by Welles Wilder, measures the relative changes between the higher and lower closing prices. RSI compares the magnitude of recent gains to recent losses in an attempt to determine overbought and oversold conditions of an asset.
The formula for calculating RSI is:
RSI = 100 – [100 / (1 + RS)]
Where: RS – average of N days up closes, divided by
average of N days down closes
N – predetermined number of days
The RSI ranges from 0 to 100. An asset is deemed to be overbought once the RSI approaches the 70 level, meaning that it may be getting overvalued and is a good candidate for a pullback. Likewise, if the RSI approaches 30, it is an indication that the asset may be getting oversold and therefore likely to become undervalued. A trader using RSI should be aware that large surges and drops in the price of an asset
will affect the RSI by creating false buy or sell signals. The RSI is best used as a valuable complement to other stock-picking tools.
- Stochastic oscillator – A technical momentum indicator that compares an instrument’s closing price to its price range over a given time period. The oscillator’s sensitivity to market movements can be reduced by adjusting the time period, or by taking a moving average of the result. This indicator is calculated with the following formula:
%K = 100 * [(C – L14) / (H14 – L14)]
C= the most recent closing price;
L14= the low of the 14 previous trading sessions;
H14= the highest price traded during the same 14-day period.
The theory behind this indicator, based on George Lane’s observations, is that in an upward-trending market, prices tend to close near their high, and during a downward-trending market, prices tend to close near their low. Transaction signals occur when the %K crosses through a three-period moving average called the “%D”.
- Trend line – a sloping line of support or resistance.
- Up trend line – straight line drawn upward to the right along successive reaction lows
- Down trend line – straight line drawn downwards to the right along successive rally peaks
Two points are needed to draw the trend line, and a third point to make it valid trend line. Trend lines are used in many ways by traders. One way is that when price returns to an existing principal trend line’ it may be an opportunity to open new positions in the direction of the trend in the belief that the trend line will hold and the trend will continue further. A second way is that when price action breaks through the principal trend line of an existing trend, it is evidence that the trend may be going to fail, and a trader may consider trading in the opposite direction to the existing trend, or exiting positions in the direction of the trend.
GO 2:
1 – Technical Analysis: background, advantages, disadvantages
2 - Various techniques and terms
