Computerized technical analysis is more objective than classical charting. When an indicator is up, it’s up, and when it’s down, it’s down. There’s no fiddling with the angle of a ruler.
Technical analysis software contains a wealth of indicators, but you aren’t going to use all of them. Compare this to sitting down in a restaurant and picking up a menu. You’re not going to order every item on the list, only select an appetizer, a main course, and a dessert. In trading, we need to select just a handful of indicators and learn to use them.
A perfect indicator doesn’t exist. Markets are complex; you cannot win using a single tool. Some indicators work best during trends, others in trading ranges. Trends and ranges are easy to recognize in the middle of a chart, but the closer we get to the right edge, the foggier they become. That’s why we need to combine trend-following indicators, which are good for trends, with oscillators, which work better in trading ranges. Let’s begin by selecting several indicators, and in later chapters we’ll combine them into trading systems.
In selecting indicators, you may begin using what I show you here but please feel perfectly free to choose others. Just remember to keep their number down to five or, at a maximum six. That’s more than enough; using more will only create confusion. I call this approach ‘Five bullets to a clip.’
The first tool I like to add to every chart is a pair of moving averages.
Before using any indicator we must understand how it is constructed and what it measures.
Each tick on your computer screen reflects a transaction between a buyer and a seller – a momentary consensus of value. Buyers bid low, sellers ask for more, but they feel pressure to act before some undecided trader steps in and snatches away that deal. When a buyer and a seller step forward from the crowd and trade with each other, a price tick appears on your screen. The consensus of value it represents keeps changing with every new tick, and those ticks coalesce into bars or candles.
I highly recommend using exponential moving averages (EMAs) rather than simple ones. EMAs are more sensitive to changes but they don’t react to the dropping off of old prices like simple averages.
The main message of any EMA is the direction of its slope. It rises when the crowd trading a stock grows more optimistic – bullish. It declines when that crowd grows more pessimistic – bearish.
A fast EMA (which I like coloring red on my chart) reflects a shorter-term consensus of value. A slow EMA (colored gold) reflects a longer-term consensus of value. I always use a pair of EMAs, with the time window of the slow EMA twice as long as the fast EMA. My pairs may be 13 and 26 or 11 and 22 bars, etc.
The zone between the two EMAs is extremely important – I call it THE VALUE ZONE. A swing trader aims to buy below value and sell above it – or sell short above and cover below value.
Stocks go down twice as fast as they rise. Professional traders love shorting – betting on price declines. Here you see a bearish trend in 3D Systems, Inc. (DDD), identified by the downsloping EMAs.
To add these two EMAs to your chart, follow these steps:
1.) Find the “Overlays” area located below the chart
2.) Select “Exp. Moving Avg” from one of the overlay dropdowns in that section. We’ll create the gold, 26-period EMA line first.
3.) Change the corresponding “Parameter” setting from the default (20) to “26”
4.) Change the corresponding “Style” setting from “Auto” to “Solid (Thick)”
5.) Change the corresponding “Color” setting from “Auto” to “Gold”
6.) Now, on the next line, select “Exp. Moving Avg” again from the overlay dropdown
7.) Change the “Parameter” from 20 to “13”
8.) Set the “Style” to “Solid (Thin)” and then set the color to “Red”
9.) Press the “Update” button
The bar marked “K” shows a pattern called a “KANGAROO TAIL” – an extremely tall bar protruding from a tight weave of prices, which typically augurs in trend reversals. The slow (gold-colored) EMA turns down, indicating a downtrend. While the value of this stock is being destroyed, DDD keeps rallying into its value zone in areas marked “Pb” for pullbacks. They provide excellent shorting opportunities for savvy traders.
Bullish traders do the opposite. When a rising slow moving average identifies an uptrend, they buy pullbacks into the value zone.
First, when Mr. Market becomes depressed, he may offer to sell you his shares for a song, and that’s when you should buy. Second, when Mr. Market becomes manic, he may offer you a crazy price for your shares – and that’s when you should sell. These prescriptions are logical but hard to follow because Mr. Market’s mood is very infectious. Most people want to buy when he is manic (near the top) and sell when he is depressed (near the bottom).
We need to diagnose Mr. Market’s condition and instead of becoming infected by it do the exact opposite – buy when he is depressed and sell when he is manic.
The tool that will help us do that is an envelope or a channel. It consists of two lines parallel to a moving average – one line above and the other below. A well-drawn channel contains approximately 95% of prices for the past 100 bars. What’s inside a channel is normal, what’s above is mania and what’s below is depression. Channels help us recognize Mr. Market’s extremes – and trade against them.
Remember that a channel is a tool, not a complete trading system. Prices dipping below their channel shouldn’t be taken as an automatic buy signal, and prices rising above it shouldn’t be taken as an automatic sell signal. We’ll use several technical indicators, including EMAs and channels, as building blocks from which we’ll construct trading systems in later chapters.
There are several methods of building channels. The most basic and straightforward is to draw two lines parallel to a slow EMA. For example, if you use a pair that consists of a 13-day and a 26-day EMA, build the channel around the 26-day EMA. If at the right edge of the screen your EMA stands at $100 and you decide to use a 5% channel, the upper channel line will be at $105 and the lower at $95.
Such channels are fine if you track a very small number of stocks because you can easily find the proper percentage for every stock. Some stocks require wider channels than others. Channels on the weekly chart have to be twice as wide as the daily channels. Because of these complexities, traders look for channels that automatically adjust their width to the volatility of any stock or index.
Keltner channels fit the bill. They are based on the concept of Average True Range (ATR), a sensitive measure of any stock’s volatility. When a stock approaches its upper Keltner channel, it’s overbought: Mr. Market is manic, and we should avoid buying, no matter how tempting it feels. On the contrary, consider taking profits on long positions and look for shorting opportunities. When a stock sinks towards its lower Keltner channel, it is oversold: Mr. Market is depressed, and we should avoid shorting. On the contrary, consider taking profits on short positions and look for buying opportunities.
My partner in SpikeTrade.com Kerry Lovvorn likes to plot not one but three ATR channels on his charts. It is normal for prices to oscillate within +/- one ATR. They go to +/- two ATRs during healthy rallies and declines, but any move outside of +/- three ATRs tends to be unsustainable.
To add Keltner Channels to your chart, follow these steps:
1.) Find the “Overlays” area below the chart
2.) Click on the empty overlay dropdown box in that area and select “Keltner Channels” from the dropdown
3.) Type “26,2.7,26” into the “Parameters” box, replacing the default settings (Note: That is “twenty-six comma two point seven comma twenty-six”)
4.) Select “Dashed” from the “Style” dropdown
5.) Click the “Update” button
free ChartSchool at StockCharts.com. Just enter “Keltner Channels” into the “Search” box on the right-side of the StockCharts homepage to find it.
A popular volatility-based channel is called Bollinger Bands – but popular doesn’t always mean the best. Bollinger Bands’ volatility makes them useful for options traders because prices of options are driven by volatility. Stock, index and futures traders are better off using more sedate Keltner channels.
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