Common chart indicators
Congrats on moving forward to Advanced Learning. As you progress, you
continue to add more and more tools to your trader’s toolbox. “What’s a
trader’s toolbox?” you say… Simple!
Your trader’s toolbox is what you will use to “build” your trading account.
The more tools (education) you have in your trader’s toolbox (Your Brain),
the easier it will be for you to build.
So for this lesson, as you learn each of these indicators, think of them as
a new tool that you can add to that toolbox of yours. You might not
necessarily use all of these tools, but it’s always good to have the option.
So, let’s get started!
We
will
be
discussing
in this section about
5
major
indicators:
Bollinger Bands
| MACD
|
Parabolic SAR |
Stochastics |
Relative
Strength Index
Bollinger bands are used to measure a market’s volatility. Basically, this
little tool tells us whether the market is quiet or whether the market is
LOUD! When the market is quiet, the bands contract; and when the market is
LOUD, the bands expand. Notice on the chart below that when the price was
quiet, the bands were close together, but when the price moved up, the bands
spread apart.
That’s all there is to it. Yes, we could go on by going into the
history of the Bollinger band, how it is calculated, the mathematical
formulas behind it, and so on and so forth, but you don’t need to know any
of that details. It’s more important that we show you some ways you can
apply the Bollinger bands to your trading.
Note: If you really want to learn about the calculations of a Bollinger
band, then you can go to www.bollingerbands.com
The Bollinger Bounce
One thing you should know about Bollinger Bands is that price tends to
return to the middle of the bands. That is the whole idea behind the
Bollinger bounce. If this is the case, then by looking at the chart below,
can you tell us where the price might go next?
If you said down, then you are correct! As you can see, the price settled
back down towards the middle area of the bands.
That’s all there is to it. What you just saw was a classic Bollinger
bounce. The reason these bounces occur is because Bollinger Bands act like
mini support and resistance levels. The longer the time frame you are in,
the stronger these bands are. Many traders have developed systems that
thrive on these bounces, and this strategy is best used when the market is
ranging and there is no clear trend.
Now let’s look at a way to use Bollinger Bands when the market
does trend.
Bollinger Squeeze
The Bollinger squeeze is self explanatory. When the bands “squeeze”
together, it usually means that a breakout is going to occur. If the
candles start to break out above the top band, then the move will usually
continue to go up. If the candles start to break out below the lower band,
then the move will usually continue to go down.
Looking at the chart above, you can see the bands squeezing together. The
price has just started to break out of the top band. Based on this
information, where do you think the price will go?
If you said up, you are correct! This is how a typical Bollinger Squeeze
works. This strategy is designed for you to catch a move as early as
possible. Setups like these don’t occur everyday, but you can probably spot
them a few times a week if you are looking at a 15 minute chart.
So now you know what Bollinger Bands are, and you know how to use them.
There are many other things you can do with Bollinger Bands, but these are
the 2 most common strategies associated with them. So now you can put this
in your trader’s toolbox, and we can move on to the next indicator.
MACD is an acronym for Moving
Average
Convergence
Divergence. This tool
is used to identify moving averages that are indicating a new trend, whether
it’s bullish or bearish. After all, our #1 priority in trading is being
able to find a trend, because that is where the most money is made.
With an MACD chart, you will usually see three numbers that are used for its
settings.
For example, if you were to see “12,26,9” as the MACD parameters (which is
usually the default setting for most charting packages), this is how you
would interpret it:
There is a common misconception when it comes to the lines of the MACD. The
two lines that are drawn are NOT moving averages of the price. Instead,
they are the moving averages of the DIFFERENCE between two moving averages.
In our example above, the faster moving average is the moving average of the
difference between the 12 and 26 period moving averages. The slower moving
average plots the average of the previous MACD line. Once again, from our
example above, this would be a 9 period moving average.
This means that we are taking the average of the last 9 periods of the
faster MACD line, and plotting it as our “slower” moving average. What this
does is it smoothes out the original line even more, which gives us a more
accurate line.
The histogram simply plots the difference between the fast and slow moving
average. If you look at our original chart, you can see that as the two
moving averages separate, the histogram gets bigger. This is called
divergence, because the faster moving average is “diverging” or moving away
from the slower moving average.
As the moving averages get closer to each other, the histogram gets
smaller. This is called convergence because the faster moving average is
“converging” or getting closer to the slower moving average. And that is how
it gets the name, Moving
Average
Convergence
Divergence!
Ok, so now you know what MACD does. Now I’ll show you what MACD can do for
YOU.
MACD Crossover
Because there are two moving averages with different “speeds”, the faster
one will obviously be quicker to react to price movement than the slower
one. When a new trend occurs, the fast line will react first and eventually
cross the slower line. When this “crossover” occurs, and the fast line
starts to “diverge” or move away from the slower line, it often indicates
that a new trend has formed.
From the chart above, you can see that the fast line crossed under the slow
line and correctly identified a new downtrend. Notice that when the lines
crossed, the histogram temporarily disappears. This is because the
difference between the lines at the time of the cross is 0. As the
downtrend begins and the fast line diverges away from the slow line, the
histogram gets bigger, which is good indication of a strong trend.
There is one drawback to MACD. Naturally, moving averages tend to lag
behind price. After all, it's just an average of historical prices. Since
the MACD represents moving averages of
other moving averages and
is smoothed out by another moving average, you can imagine that there is
quite a bit of lag. However, it is still one of the most favored tools by
many traders.
Up until now, we’ve looked at indicators that mainly focus on catching the
beginning of new trends.
And although it is important to be able to identify new trends, it is
equally important to be able to identify where a trend ends. After all, what
good is a well-timed entry without a well-timed exit?
One indicator that can help us determine where a trend might be ending is
the Parabolic SAR (Stop
And
Reversal). A Parabolic
SAR places dots, or points, on a chart that indicate potential reversals in
price movement. From the chart above, you can see that the dots shift from
being below the candles during the uptrend, to above the candles when the
trend reverses into a downtrend.
Using Parabolic SAR
The nice thing about the Parabolic SAR is that it is really simple to use.
Basically, when the dots are below the candles, it is a buy signal; and when
the dots are above the candles, it is a sell signal. This is probably the
easiest indicator to interpret because it assumes that the price is either
going up or down. With that said, this tool is best used in markets that
are trending, and that have long rallies and downturns. You DON’T want to
use this tool in a choppy market where the price movement is sideways.
Stochastics are another indicator that helps us determine where a trend
might be ending. By definition, a stochastic is an oscillator that measures
overbought and oversold conditions in the market. The 2 lines are similar
to the MACD lines in the sense that one line is faster than the other.
How to Apply Stochastics
Like I said earlier, stochastics tells us when the market is overbought or
oversold. Stochastics are scaled from 0 to 100. When the stochastic lines
are above 70 (the red dotted line in the chart above), then it means the
market is overbought. When the stochastic lines are below 30 (the blue
dotted line), then it means that the market is oversold. As a rule of
thumb, we buy when the market is oversold, and we sell when the market is
overbought.
Looking at the chart above, you can see that the stochastics has been
showing overbought conditions for quite some time. Based upon this
information, can you guess where the price might go?
If you said the price would drop, then you are absolutely correct! Because
the market was overbought for such a long period of time, a reversal was
bound to happen.
That is the basics of stochastics. Many traders use stochastics in
different ways, but the main purpose of the indicator is to show us where
the market is overbought and oversold. Over time, you will learn to use
stochastics to fit your own personal trading style. Okay, let's move on to
RSI.
Relative Strength Index, or RSI, is similar to stochastics in that it
identifies overbought and oversold conditions in the market. It is also
scaled from 0 to 100. Typically, readings below 20 indicate oversold, while
readings over 80 indicate overbought.
Using RSI
RSI can be used just like stochastics. From the chart above you can see
that when RSI dropped below 20, it correctly identified an oversold market.
After the drop, the price quickly shot back up.
RSI is a very popular tool because it can also be used to confirm trend
formations. If you think a trend is forming, take a quick look at the RSI
and look at whether it is above or below 50. If you are looking at a
possible uptrend, then make sure the RSI is above 50. If you are looking at
a possible downtrend, then make sure the RSI is below 50.
In the beginning of the chart above, we can see that a possible uptrend was
forming. To avoid fakeouts, we can wait for RSI to cross above 50 to
confirm our trend. Sure enough, as RSI passes above 50, it is a good
confirmation that an uptrend has actually formed.
We've covered a good number of indicators, let's see how we can put all of
what you just learned together.
Putting It All Together
In a perfect world, we could take just one of these indicators and trade
strictly by what that indicator told us. The problem is that we DON’T live
in a perfect world, and each of these indicators has imperfections. That is
why many traders combine different indicators together so that they can
“screen” each other. They might have 3 different indicators and they won’t
trade unless all 3 indicators give them the same answer.
As you continue your journey as a trader, you will discover what indicators
work best for you. We can tell you that we like using MACD, Stochastics,
and RSI, but you might have a different preference. Every trader out there
has tried to find the “magic combination” of indicators that will always
give them the right signals, but the truth is that there is no such thing.
We urge you to study each indicator on its own until you know EXACTLY how it
reacts to price movement, and then come up with your own combination that
fits your trading
style. Later on in the course, we will show you a system that combines
different indicators to give you an idea of how they can compliment each
other.
In short,
Everything you learn about trading is like a tool that is being added to
your trader’s toolbox. Your tools will make it easier for you to “build”
your trading account.
Bollinger Bands
MACD
-
Used to
catch trends early and can also help us spot trend reversals
-
It consists
of 2 moving averages (1 fast, 1 slow) and vertical lines called a
histogram, which measures the distance between the 2 moving averages.
-
Contrary to
what many people think, the moving average lines are NOT moving averages
of the price. They are moving averages of other moving averages.
-
MACD’s
downfall is its lag because it uses so many moving averages.
-
One way to
use MACD is to wait for the fast line to “cross over” or “cross under” the
slow line and enter the trade accordingly because it signals a new trend.
Parabolic SAR
-
This
indicator is made to spot trend reversals; hence the name Parabolic
Stop
And
Reversal (SAR)
-
This is the
easiest indicator to interpret because it only gives bullish and bearish
signals.
-
When the
dots are above the candles, it is a sell signal.
-
When the
dots are below the candles, it is a buy signal.
-
These are
best used in trending markets that consist of long rallies and downturns.
Stochastics
-
Used to
indicate overbought and oversold conditions
-
When the
moving average lines are above 70, it means that the market is overbought
and we should look to sell.
-
When the
moving average lines are below 30, it means that the market is oversold
and we should look to buy.
Relative Strength Index (RSI)
-
Similar to
stochastics in that it indicates overbought and oversold conditions.
-
When RSI is
above 80, it means that the market is overbought and we should look to
sell.
-
When RSI is
below 20, it means that the market is oversold and we should look to buy.
-
RSI can
also be used to confirm trend formations. If you think a trend is
forming, wait for RSI to go above or below 50 (depending on if you’re
looking at an uptrend or downtrend) before you enter a trade.
Each indicator has its imperfections. This is why traders combine many
different indicators to “screen” each other. As you progress through your
trading career, you will learn which indicators you like the best and can
combine them in a way that fits
your trading style.
We know this has been a very very long lesson, and we do encourage you to go
back and read over anything you haven’t fully understood yet. Sometimes it
just takes a couple times of reading before you truly grasp something.
Once you understand the concepts of these indicators, go to a chart and
start trying and working with them. Really study how each indicator reacts
to the price movement.
When you fully understand an indicator, then it will become another tool for
your trader’s toolbox.
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