Technical Indicators

Technical indicators are based on mathematical equations that produce values that are plotted on charts. For example, a moving average calculates the historic average price of a share or CFD and plots it on your chart as a line. As your share or CFD chart moves forward, the moving average is revised accordingly. The system then plots new points. As you’ll see, this moving average irons out a lot of the temporary price fluctuations (because it is based on a larger sampling of data) and provides a smooth line that indicates the direction in which the share or CFD is moving (see *Figure 1*).

We have previously identified some of the key factors in technical analysis and in this lesson we will expand on your knowledge and will cover Technical Indicators and Price Patterns. Technical indicators are the interpreters of the CFD markets. They examine price information and translate it into simple, easy-to-read signals that assist you in determining when to buy and when to sell.

*Figure 1 – Technical Indicator: Moving Average*

Each technical indicator provides unique information but most traders will have a preference for a particular indicator. It is important to familiarize yourself with all of the technical indicators. The one weakness associated with technical indicators is that it is based on historical price data and there is therefore a lag behind the current market; however, they still provide valuable information.

Technical indicators are divided into the following categories:

Trending Indicators

Oscillating Indicators

Volume Indicators

Trending indicators identify and follow the trend of a share or CFD. Traders are most successful when there is a trend on which they can capitalise. It is critical that you therefore know when a share or CFD is on a trend and when it is consolidating. In this section, we will talk about Moving Averages.

Moving Averages

Moving averages are the most fundamental trending indicator. They indicate the direction in which a share or CFD is going and where potential levels of support and resistance may be. Moving averages themselves can serve as both support and resistance levels because they will be watched by many traders and will be influential.

Regarding moving averages we shall examine three key topics:

How a Moving Average is constructed

Moving averages utilise the average closing prices of a share or CFD, plotting these points on a price chart. The result is a fairly smooth line that follows price movements (see *Figure 2*).

You can influence the volatility of a moving average by adjusting the time-frame the indicator uses to obtain an average price. Moving averages that examine a shorter time are more volatile (and therefore more erratic). Moving averages that examine a longer time-frame are less volatile (and therefore smoother).

*Figure 2–Moving Average*

Moving Average Trading Signal

Moving averages provide useful trading signals for shares or CFDs that are following trends.

Entry signal – when a share or CFD is enjoying an upward trend and bounces back up after hitting an upward-trending moving average, or when a downward-trending share or CFD bounces back down after hitting a downward-trending moving average.

Exit signal – when you trade in an upward-trending share or CFD you should set a stop-loss below the moving average. As the moving average rises you can move your stop-loss up along with the moving average or use a trailing stop loss which will automatically adjust your stop loss level. If the share or CFD moves below the moving average by your predetermined value, your stop-loss will prompt you to sell.

When you trade in a downward-trending share or CFD, set a stop-loss above the moving average. As the moving average falls, move your stop-loss down along with the moving average. If the share or CFD breaks far enough above the moving average, your stop-loss will prompt you to sell.

Strengths of a Moving Average

Weaknesses of a Moving Average

Bollinger bands are a trend indicator named after their creator, John Bollinger, and they indicate both the direction and volatility of a share or CFDs price movement. There are just two Bollinger bands, an upper band and a lower band, which work above and below a moving average.

The following three topics are critical in respect of Bollinger bands:

How Bollinger Bands are Constructed

Bollinger bands are typically based on a 20-period moving average. A moving average is sandwiched between the two bands.

A standard deviation is a statistical term that measures how far various closing prices diverge from the average closing price. The upper band is plotted two standard deviations above the 20-period moving average. The lower band is plotted two standard deviations below the 20-period moving average (see* Figure 3*).

Therefore, 20-period Bollinger bands tell traders how wide, and therefore volatile, the range of closing prices has been during the past 20 periods. When the price has been volatile, the bands will be wider. When the price has been relatively stable, the bands will be narrower.

*Figure 3–Bollinger Bands*

Bollinger Band Trading Signal

Bollinger bands provide useful breakout signals for shares or CFDs that have been consolidating.

Entry signal – when the bands widen and begin moving in opposite directions after a period of consolidation (see Point A on *Figure 4*), you can enter the trade in the direction the price was moving when the bands began to widen. Clearly you are trying to capitalize on renewed volatility.

Exit signal – at some point after the breakout occurs, the bands will begin to move back toward each other (see Point B on *Figure 4*). When this happens, you should set a trailing stop-loss to prompt you to sell if the trend reverses (see Point C on *Figure 4 *).

*Figure 4–Bollinger Bands Exit Signal*

Strengths of Bollinger Bands

Weaknesses of Bollinger Bands

As their name suggests, oscillating indicators are indicators that move back and forth as prices rise and fall. Oscillating indicators can help you decide how strong a current trend is and warn when that trend is in danger of losing momentum and being reversed.

When an oscillating indicator moves too high, the share or CFD is considered to be ‘overbought’ (too many people have bought it and there are not enough buyers left in the market to push the price higher). This indicates the upward trend is at risk of losing momentum-causing the trend to reverse or the price to stagnate.

When an oscillating indicator moves too low, the share or CFD is considered to be ‘oversold’ (too many people have sold it and there are not enough sellers left in the market to depress the price). This indicates the downward trend is at risk of losing momentum-causing the trend to reverse or the price to stagnate.

The following oscillating indicators are worth examination:

The moving average convergence/divergence (MACD) is an oscillating indicator developed by Gerald Appel. It can indicate when trading momentum changes from being bullish to bearish and vice versa. The MACD can also indicate when traders are becoming over-extended, which usually results in a trend reversal for the share or CFD.

The MACD is usually plotted below the price movement on a chart.

It is worth looking at the following three aspects of the MACD:

How the Moving Average Convergence/Divergence (MACD) is Constructed

The moving average convergence/divergence compares a series of moving averages and their relationships. The standard MACD looks at the relationship between the 12-period and 26-period exponential moving averages of a share or CFD. When the 12-period moving average is above the 26-period moving average, the MACD line will be positive. If the 12-period moving average is below the 26-period moving average, the MACD line will be negative (see *Figure 5*).

The MACD line is accompanied by a trigger line. This line is a 9-period exponential moving average of the MACD line.

*Figure 5–Moving Average Convergence/Divergence (MACD)*

You can also plot the MACD as a histogram below the chart. When the histogram is above the 9-period signal line (illustrated by a horizontal line on the histogram), it is signalling that the 12-period moving average is above the 26-period moving average (see *Point A of Example 1*). When the histogram is below the 9-period signal line, it is signalling that the 12-period moving average is below the 26-period moving average (see *Point B of Example 1*).

*Example 1–Moving Average Convergence/Divergence (MACD) Histogram*

Moving Average Convergence/Divergence (MACD) Trading Signal

The moving average convergence/divergence (MACD) produces trading signals as it crosses the trigger-line.

Entry signal – when the MACD rises above the trigger line, you can buy as the market shifts from being bearish to bullish.

When the MACD falls below the trigger line, you can sell as the market shifts from being bullish to bearish.

Exit signal – when the MACD falls below the trigger line after you buy, you can sell as the market shifts from being bullish to bearish.

When the MACD rises above the trigger line after you sell, you can buy as the market shifts from being bearish to bullish.

Strengths of the Moving Average Convergence/Divergence (MACD)

Weaknesses of the Moving Average Convergence/Divergence (MACD)

The slow stochastic is an oscillating indicator. Developed by George Lane , it can alert you to a shift of investor sentiment from bullish to bearish or vice versa. The slow stochastic can also alert you to when traders are becoming over-extended, which usually results in a trend reversal.

The slow stochastic is usually plotted below the price movement on a chart.

The following three aspects of the slow stochastic are worth your attention:

How the Slow Stochastic is Constructed

The slow stochastic consists of two lines–%K dan %D – that oscillate in a range between 0 and 100.

%K reflects the most recent closing price of a share or CFD in relation to the range of historical closing prices.

%D is a moving average of %K.

If the closing price is near to the peak of historical closing prices, then the %K line (followed by the %D line) will rise.

If the closing price is near the bottom of the range of historical closing prices, the %K line (followed by the %D line) will move lower (see Figure 7 ).

Figure 7–Slow Stochastic

Slow Stochastic Trading Signal

The slow stochastic produces trading signals as it enters its upper and lower reversal zones.

The upper reversal zone is the area of the indicator that is above 80. When %K exceeds 80, the share or CFD may be overbought and could suffer a reversal soon.

The lower reversal zone is the area of the indicator that is below 20. When %K is below 20, the share or CFD may be oversold and could suffer a reversal soon.

Entry signal – when %K dips below 80, you can sell knowing that investor sentiment is shifting from being bullish to bearish.

When %K rises above 20, you can buy knowing that investor sentiment is shifting from being bearish to bullish.

Exit signal – when %K reverses direction after having risen above 20 or fallen below 80, and crosses over %D, you can sell knowing that investor sentiment is changing direction again.

Strengths of the Slow Stochastic

Weaknesses of the Slow Stochastic

The Relative Strength Index (RSI) is an oscillator that measures a particular financial instrument’s current relative strength compared to its own price history. The RSI should not be confused with relative strength which rates a financial instrument in relation to a market such as the S&P index.

The RSI is plotted on a vertical scale numbered from 0 to 100. The formula to calculate the RSI is 100-[100/(1+A)] where A is the average of the "up" closes over the calculation period divided by the average of the "down" closes over the calculation period. Recognia uses the popular 14-bar period in the calculation of the RSI. The "A" for a 14-day period is calculated by dividing the 14-day "up" close average by the 14-day "down" close average. An "up" close or a "down" close is defined as the absolute change in price from close to close.

Trading Considerations

The RSI sometimes shows more clearly than the price chart itself the support and resistance lines for a financial instrument. Failure Swings which are also known as support or resistance penetrations or breakouts can be detected by using the RSI. Failure swings occur when the RSI passes a previous high or falls below a recent low.

Divergences (when market trends go in a different direction than market indicators predicted, usually signifying the onset of a trend change) occur when the price makes a new high (or low) that is not confirmed by a new high (or low) in the RSI. Prices usually correct and move in the direction of the RSI.

A financial instrument is considered to be oversold when its RSI falls below 30 and overbought when its RSI rises over 70.

*Figure 8 – Relative Strength Index (RSI)*

Volume indicators provide a very different kind of indicator because, instead of relying solely on the price, they take volume into account.

Prices tell you in which direction an investment is moving, but volume can tell you what kind of support is influencing the price. For instance, if you see a price rise accompanied by high volume, then you know that there are a lot of traders who have confidence in this investment. Seeing this support may give you confidence too. On the other hand, if you see the price of a share of CFD rise on low volume, you know that there are only a few investors pushing the price. This may discourage you from buying yourself.

There are two volume indicators that you ought to know about:

Developed by Joe Granville, on balance volume is a volume indicator that demonstrates positive and negative volume flow. It can also show you when price movement is not reflected in increasing volume, which usually results in a trend reversal.

On-balance-volume is usually plotted below the price movement on a chart.

There are four aspects of on balance volume which you ought to know about:

How On balance volume is constructed

On balance volume involves a calculation that utilizes today’s volume and the previous trading day’s on-balance-volume level.

If today’s closing price is higher than yesterday’s, you add today’s volume to yesterday’s on balance volume level. You then record the resultant value below the price chart.

Alternatively, if today’s closing price is lower than yesterday’s, you subtract today’s volume from yesterday’s on balance volume level. You then record the resultant value below the price chart.

Connecting each on balance volume value gives you a smooth line that illustrates how volume has, or has not, supported the price movement of the share (see *Figure 9*).

*Figure 9 – On-Balance-Volume*

On balance volume Confirmations

Traders need to know whether a trend will sustain its momentum. On balance volume can help you decide if there is enough momentum behind a price to sustain it or continue pushing it higher

Positive confirmation – on balance volume can provide positive confirmations of both upward and downward trends. If the on balance volume line is in an upward trend while the price is likewise rising, you know there is strong buying support. If the on balance volume line is in a downward trend whilst the price is also falling, you know there is strong selling support.

Negative confirmation – on balance volume can provide negative confirmations of both upward and downward trends. If the on balance volume line is in a downward trend while the price is in an upward trend, you know there is only weak buying support underpinning the upward trend. If the on balance volume line is in an upward trend whilst the price is in a downward trend, you know there is weak selling support underpinning the downward trend.

Strengths of on balance volume

Weaknesses of on balance volume

Accumulation/distribution line is a volume indicator that reveals the cumulative flow of money into and out of a share or CFD. The accumulation/distribution line can also indicate when price rises are not mirrored by increasing volume, which usually results in a trend reversal.

The accumulation/distribution line is usually plotted below the price movement on a chart.

There are four aspects of the accumulation/distribution line which need to be examined:

How the Accumulation/Distribution Line is constructed

The accumulation/distribution line is similar to the on balance volume line, but the calculation has one distinct difference. It does not compare the current trading period’s price movement in relation to the previous period’s price movement. Whereas the on balance volume line is calculated based on the closing price in the current period compared to that in the previous period, the accumulation/distribution line shows where the price closed in relation to the mid-point of that period's price movement.

If the share price closes above the mid-point, you must add a value between 0 and 1 to the cumulative value of the accumulation/distribution line. If the share price closes below the midpoint, you subtract a value between 0 and -1 from the cumulative value of the accumulation/distribution line.

Therefore, if the share price closed at the high for that trading period, you would add 1 to the cumulative value of the accumulation/distribution line. Conversely, if the share price closed at the low for that trading period, you would subtract 1 from the cumulative value of the accumulation/distribution line.

Connecting each accumulation/distribution data point gives you a smooth line that illustrates how volume has, or has not, supported the price movement (see *Figure 10*).

*Figure 10 –Accumulation/Distribution*

Accumulation/Distribution Line Confirmations

Traders are always eager to know whether a trend can sustain its momentum. The accumulation/distribution line can help you decide if the momentum behind a price rise is sufficient to continue pushing the price up

Positive confirmation – the accumulation/distribution line generates 'positive' confirmations of both upward and downward trends. If the accumulation/distribution line is soaring whilst the share price is doing likewise, you know there is strong buying support. If the accumulation/distribution line is on a downward trend whilst the price is doing likewise, you know there is strong selling support.

Negative confirmation – the accumulation/distribution line generates 'negative' confirmations of both upward and downward trends. If the accumulation/distribution line is diving whilst the share price is rising, you know there is only weak buying support. If the accumulation/distribution line is on an upward trend whilst the price is on a downward trend, you know there is weak selling support.

Strengths of the Accumulation/Distribution Line

Weaknesses of the Accumulation/Distribution Line

Traders vote with their cheque books. If they believe a share or CFD is going to move higher, they will buy it. If they believe a share or CFD is going to move lower, they will sell it. When their money is at stake, they will do whatever it takes to be profitable. Often, their actions form quite distinctive price patterns on the charts, and it is well worth your while to learn to recognize these.

Price patterns provide an insight into what share and CFD traders are thinking and feeling. Learning to recognize various price patterns will give you an advantage over traders who only use fundamentals or technical indicators.

Imagine having the ability to precisely identify the optimum moment to buy as a share or CFD surges as well as the ability to accurately project how far a share or CFD is going to rise.

Price patterns can give you this ability.

Price patterns are divided into the following two categories:

Share and CFD traders continually ask themselves whether a trend can continue. Deciding whether to invest in the middle of a trend or whether to take your profits is difficult. You can never know if a share or CFD is going to turn around and start moving in the opposite direction.

Continuation patterns give you advanced warning of when a share or CFD is likely to resume its trend after a short consolidation period, and they can also tell you how far the share or CFD is likely to move in that direction. Of course, continuation patterns are not infallible, but they do put the odds of success in your favor.

Take some time to become acquainted with the following price continuation patterns:

Pennants

Pennants are continuation patterns that form as the price of a share or CFD moves into a tighter and tighter consolidation range. Pennants can be either bullish or bearish, depending on what the trend was before the pennant began to form. If a share or CFD was on an upward trend before the pennant began to form, then it is a bullish continuation pattern.

Alternatively, if a share or CFD was on a downward trend before the pennant began to form, then it is a bearish continuation pattern.

Pennants usually form over short periods of time. All have the following five characteristics (see *Figure 11* ):

*Figure 11 – Pennant*

Flags

Flags are continuation patterns that form as the price of a share or CFD pulls back from the predominant trend in a parallel channel. Flags can be either bullish or bearish, depending on what the trend was before the flag began to form. If a share or CFD was on an upward trend before the flag began to form, it is a bullish continuation pattern. If a share or CFD was on a downward trend before the flag began to form, it is a bearish continuation pattern. Flags usually form over short periods of time.

Flags all have the following five characteristics (see *Figure 12* ):

*Figure 12 – Flag*

Wedges

Wedges are continuation patterns that form as the price of a share or CFD pulls back from the predominant trend and moves into a tighter and tighter consolidation range. Wedges can be either bullish or bearish, depending on what the trend was before the wedge began to form. If a share or CFD was on an upward trend before the wedge began to form, it is a bullish continuation pattern. If a share or CFD was on a downward trend before the wedge began to form, it is a bearish continuation pattern. Wedges usually form over short periods of time.

Wedges all have the following five characteristics (see *Figure 13* ):

Triangles

Triangles are continuation patterns that form as the price of a share or CFD hits a flat level of support or resistance and begins moving into a tighter and tighter consolidation range. Triangles can be either bullish or bearish, depending on what the trend was before the wedge began to form. If a share or CFD was on an upward trend before the triangle began to form, it is a bullish continuation pattern. If a share or CFD was on a downward trend before the triangle began to form, it is a bearish continuation pattern. Triangles usually form over long periods of time.

Triangles all have the following five characteristics (see *Figure 14* ):

Share and CFD traders continually ask themselves the question whether a trend can continue. Deciding whether a trend is over is difficult. You can never know for sure if a share or CFD is going to turn around and start moving in the opposite direction.

Reversal patterns give you advanced warning when a share or CFD is likely to turn around and begin a new trend. They also indicate how far the share or CFD is likely to move in the opposite direction. Of course, reversal patterns are not infallible, but they do increase the likelihood of you correctly anticipating the market.

Take some time to become familiar with the following price reversal patterns:

Double-Tops/Bottoms

Double-tops and double-bottoms are reversal patterns that form as the price of a share or CFD hits a support or resistance level two times before the share or CFD turns around and moves in the opposite direction. Double-tops are bearish reversal patterns and double-bottoms are bullish reversal patterns. If a share or CFD is on an upward trend, it will form a double-top. If ashare or CFD is on a downward trend, it will form a double-bottom. Double-tops and double-bottoms both usually form over long periods.

Double-tops and bottoms all have the following four characteristics (see *Figure 15* ):

*Figure 15 – Double-top*

Triple-Tops/Bottoms

Triple-tops/bottoms are reversal patterns that form as the price of a share or CFD hits a support or resistance level three times before the share or CFD turns around and moves in the opposite direction. Triple-tops are bearish reversal patterns and triple-bottoms are bullish reversal patterns. If a share or CFD is on an upward trend, it will form a triple-top. If a share or CFD is on a downward trend, it will form a triple-bottom. Triple-tops and triple-bottoms usually form over long periods.

Triple-tops and bottoms all have the following four characteristics (see *Figure 16* ):

*Figure 16 – Triple-top*

Head-and-Shoulders Tops/Bottoms

Head-and-shoulders tops are reversal patterns that form as the price of a share or CFD hits a resistance level (forming the first shoulder), then breaks through the first resistance level and hits a higher resistance level (forming the head) and then hits the first resistance level again (forming the second shoulder)

Head-and-shoulders bottoms are reversal patterns that form as the price of a share or CFD hits a support level (forming the first shoulder), then breaks through the first support level and hits a lower support level (forming the head) and then hits the first support level again (forming the second shoulder).

Head-and-shoulders tops are bearish reversal patterns and head-and-shoulders bottoms are bullish reversal patterns. If a share or CFD is on an upward trend, it will form a head-and-shoulders top. If a share or CFD is on a downward trend, it will form a head-and-shoulders bottom. Head-and-shoulders tops/bottoms usually form over long periods.

Head-and-shoulders tops/bottoms all have the following five characteristics (see *Figure 17*):

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