Know Your Indicators

7/31/2019 Know Your Indicators

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KNO W YO UR

INDICATORS

MACD RSIPUNEET JAIN

Quick, Accurate & Effective Methodology of Using Indicator



MACD (Moving Average Conf irmation & Diverg ence)

Mo ving aver ag es ar e the ea siest a nd most p op ular technical indicato rs. But they a re tr end-f ollowingindicat ors that wor k b est in strong trending p eriod s; in f act, moving avera ge tr ad ing systems tend to losemoney d uring period s of choppy trad ing.

Since mar kets and individual securities will, at some po int, enter a pe riod of sidewa ys or choppy tra dingwhere rices move u and down without an sense of direction ou ma want to turn to an indicator that

is more sensitive and responsive to that kind o f tra d ing b ehavio r. O scillato rs f it this b ill.

Technicians use oscillato rs in a var iety of ways— to d eter mine overbought a nd over sold condit ions, tod etermine the momentum of a security or index , as well as to identif y diver gences be tween pr ice a nd theindicator.

MACD is one indica tor t hat comb ines the be st of bot h world s— the trend-f ollowing chara cteristics ofmoving averages, and oscillator characteristics that help indicate whether a security is overbought oroversold a nd that help p inpoint potential diverg ences. The indicator is ca lled moving avera geconverg ence/ d ivergence, more commonly known as MACD.



CALCULATING THE MACD

The MACD is a trend-f ollowing momentum indicator developed by G era ld Ap pel that shows therelationship between two moving averages of price (normally the close). The MACD line is calculated bytaking the difference

betw een a longer-p eriod and shorter-period exp onential moving a verag e. It is the interaction of these twomoving averages that gives the indicator its name. Over time, the two moving averages are constantly.

to changes in price, since more weight is placed on the most recent price compared to the earlier prices.

A “ signal” or tr igg er line is also used, w hich is the nine-period exponential moving a verag e of the M ACDline.

You ca n use any l ength of p erio d you wish when cal cula ting the var ious exp onentia l moving a vera ge s,although the 12, 2 6, a nd nine p eriod avera ges are most f requently used.

Per iod can be a ny lengt h you choose— days, weeks, months, etc.

In the exa mples used f urther, the MACD line is calcula ted using the 26 and 12 moving a vera ges, while thesignal line is a nine da y moving a verag e of the MACD.



NOW WE’LL SEE HOW WE USE MACD AS GENERATING SIGNALS AND REVERSAL WARNINGS FOR US

Bef ore we proceed I want you to understa nd f ew te rms :-

Cla ssic Divergence

Reverse Diverg ence/ Hidden Diverg ence

Super Divergence

Okey lets start with Divergence firstDiver ence, which is a term that technicians use when two or more avera es or indices fail t o show conf irmin trends, is one of

the mainstays of technical analysis Mo st technical indicator s mirror or conf irm p rice movement. W hen price moves up, the

indicator moves up; w hen p rice moves do wn, the indica tor moves d own. W hen pr ices pe ak, the indicator

p ea ks; a nd when prices bo ttom, the ind icator bo ttoms. Sometimes, however, a d iscrepa ncy occurs be tween p rice a nd

indicator movement. That d iscrepa ncy is known a s non confirmation and can be seen most clearly on overbought or oversold

indicators as well as on indicatorsthat move above or below a zero line. Ma ny tra der s only lear n to recognize the ty pe of non confirmation that occurs at

market t op s and bo ttoms, which is the cla ssic d iverg ence.



This is a clear example of a bullish divergence. The easiest wa y to id entify this is to f irst identify the lowest value of theMACD histog ra m on the char t (po int A). W e now can move for wa rd a nd locate t he lowest p rice on the chart (point B). Atpoint B a bullish divergence pattern is established because the MACD indicator is now higher than at point A, but thepr ice of Feed ers has continued to move lower. This is a clue that the be ar s may be running out of stea m and that thistrend may be ending. By itself I would call this a "bullish condition" in Feeder Cattle. Traders could now use otherindicators to trigg er a long p osition.



This process is reversed in a bearishdivergence pattern. We can easily see

that a bea rish divergence a pp eared

before the huge sell off this year. PointA is where the MACD peaked and

egan ea ng ower, w e um erextended it's pr ice g ains to p oint B.Astute traders would have been aware

that this suggested the bulls may berunning out of energy and could lookfor any reason to go short.



I like using the MACD because it employs exponential moving averages in its calculation. Exponentialmoving avera ges smooth out price d ata so that a one-da y pr ice swing d oes not over inf luence theindicator (very important when looking for divergences). This is not the case with simple moving averages,

momentum or Rate of Change. I feel using it as a histogram makes it easier to identify divergences. Nowthat I have reviewed how to use d ivergence to esta blish a market condit ion, let me ta ke it a step furtherand show the uses of divergence as a system as well.

REVERSE DIVERG ENCE/ HIDDEN DIVERG ENCE

Just as classic divergence does not appear on every price chart, so it is withhidden divergence. But when they do appear, they are worthy of attention. Thetrick is to train your eye to recognize one when itpresents itself.



An unusual but normally reliablediscrepancy occurs when priceand momentum switch roles(where the price leads themomentum ind icator), theopposite of the normal situation

just described . That’s why I r ef er

Classic divergence.

Above you can see the price is going down but the oscillator is moving up (opp. Of classic

divergence)And you see the reversa l p rice mad e a small ra lly to correct it, this something you’ll see manytimes on intraday charts and day charts good point take some profits, below I've shown onemore exa mple of how to look at it.



you can see price is in the

consolation and momentum ispea king up, finally I’ve dra wna trendline to confirm thereversal.

The problem with divergences is that you never know how many to expect priorto the actua l trend r eversa l. Now we’ll d iscuss how to enter using d iverg ence asentry a rea.



You'll notice this is the same chart

used ab ove second ex amp le,with one exception. Af ter Iidentified the bearish divergencepoints A & B, I looked for thelowest va lue MACD rea chedduring this time (point C) andd rew a horizonta l line on mychart. My "sell signal" is

triggered when MACD breaksbelow the low of point C. If Iget filled; my stop loss is abovethe hig h of po int B. Notice thatthe M ACD preceded the top bya top a full month before a newtrend began. Most trendfollowing indicators are

"lagging", meaning they onlyemit a signal a fter a market hasmoved significantly in the newdirection



SUPER DIVERG ENCE ARE THO SE W HICH W E SEE O N HIG H TIME FRAMES



RSI (RELATIVE STRENG HT INDEX)

Now we’ll Study RSI

So far MACD is not a oscillator so we use RSI along with it for further confirmation,

’

Momentum-der ived oscillators ar e very po pular among f uture tr a der s, and increa sing ly stock tra d ers. The

first of the four most popular is; the Momentum Indicator that measures the change in the closing priceover time. The momentum indicator measures the absolute change in price by calculating, (present price)-(price ‘N’ time periods ago). The second most popular momentum indicator is the Rate of Change

Indicato r, which measures rela tive change by the formula, (present p rice)/ (price ‘N’ t ime period s ag o).



The third momentum-derived oscillator is the Stochastics Indicator developed by George Lane. Thisind icato r measures the rela tionship b etween the closing pr ice to the hig h, and low pr ice for the p eriodund er consider atio n. The for mula is [(closing p rice now – lowest low ‘N ’ time p eriod s a go)/ (highest high ‘N’

time p eriods ag o – lowest low ‘N’ time period s ag o)] * 10 0. The f ormula is a little bit more involved thanthe simple momentum indicator formula. The fourth most popular momentum-derived oscillator is theRelat ive Strength Indicator (RSI). Its f ormula is, 100 -[1 00 / [1 + (averag e of ‘N’ p eriod s of where the close

was hig her)/ (avera ge of ‘N’ p eriod s of where the close was lower)]].The prob lem wi th the fi rst three oscillators; Momentum, Ra te o f Change, and the Stochastics is that whenlarge price movements are dropped from the formula during the period under consideration, the indicator

.For exa mple, here is a current chart of the Ma rch 20 00 contract of Silver in which we look at twoconsecutive days for both Rate of Change and Momentum indicators:.



Silver had a larg e one-day ad vance (A),

at C1 when the 9 period Rate of Change(or theMomentum Indicator) is calculated it isba sed upon the closing p rice at (C1a ),and the current closing p rice a t (C1). Thenext d ay (C2) the closing p rice ba relychanges from (C1), however w hen thecalculations are

redone using the closing price of (A) andthe closing p rice of (C2 ) the la rg e upmove is dropped, and yet the value ofthe Rat e of Chang e or M omentumIndicator moves quite a bit as measuredby (E) – yet the price at (C1 & C2 )ba rely moved! This can b e ob ser ved a lsowith the large down move (B). Now

ob ser ve what hap pens when we cha ngethe look back period to 1 0 d ays.Immedia tely, we notice that the la rg emoves at (A & B) are still included in thelook b a ck calculated on the second d a y.



As we can see, the a mount the oscilla tor

changed (E & F) is much less when thelook ba ck period isextended to 1 0 day s. This is becausethe oscillator f or both consecutive d ay sis looking at the pr ice bef orethe la rg e move. Add itiona lly, theoscillator s continued to d rop a t (F),where in the 9 day look back the

oscillator s actually increa sed . It isinteresting that the price of silveractually drop ped a tenth of a cent! Thisis a major p rob lem with using thesesimple momentum oscillators.



The RSI due to the way it is constructed will

dampen, or smooth out these distortions. RSIwith a 9 , and 1 0-d ay look ba ck periodAs we can see, the vertical distance the RSI

moves (E1 vs. E2, and F1 vs. F2) regardless ifthe large move are included or not remainsbasically the same. This a llow s us to p la ce

more significance into the actual4 values of the RSI. In ad d ition, the RSIindicator is alway s contained within a vertical

ra nge rom o .

This saves us f rom consta ntly r ef err ing to the past indica tor va lues when de termining overbought oroversold levels. This problem of comparing past highs or lows occurs because typical momentumindicators a re not conta ined within a p red ef ined vertical r ange.



Most books on technical analysis when discussing RSI will typically use a 14-day look back period to

perform its calculation. The longer the time period, the less sensitive the RSI becomes to oscillate and thesmaller its amplitude changes. I pr ef er a look b ack per iod of 14 as it works the best in all time fra mes, andit is one half the lunar cycle. For intra-day time frames, some traders will use a nine period look back. Inthe gold , silver, crude a nd f inancial s a 25 -d ay look ba ck per iod p erf orms well. There seems to b e a 50 -d aycycle on these markets, and a 25-day look back is half the cycle length. It is important to realize the RSIformula r equires at least 9 0 pe riod s worth of da ta to p rovide va lid results. O therwise, the RSI formula willnot give accurate results f or trend a naly sis. W hen I look at d aily char ts, I pr ef er a t lea st 2 00 da ys worth of

da ta to ea rn my trust in the valid ity of the RSI da ta.Every book on technical a naly sis I have rea d when d iscussing the RSI will sta te tha t, any movement ab ove 7 0 isconsidered overbought, while any movement under 30 is oversold. An important fact to remember is that anyoscillator (RSI included) in a strongly trending market will become either oversold (bear market), or overbought(bull market), and consequently will remain oversold or overbought for quite a while. A few books on technicalanaly sis will ad just these levels. They recommend that in a strong b ull mar ket, the 80 level b ecomes theef fe ctive overbought level, and the 20 level becomes the eff ective oversold level in a bea r mar ket.W ild er sta tes in his op inion that the g rea test value of the RSI is in pointing out a d ivergence b etween thegraphs for the RSI and price behavior. Their graphical behavior reveals a bullish divergence (or as he calls it abottom f a ilure swing ) when the p rice makes a new low, while the RSI continues under 3 0 and f a ils to make anew low. W hen the RSI proceed s to exceed the p revious RSI pea k, a short-te rm b uy signal occurs accord ing toW ilder.



Similarly, the op po site event would a pp ly to a bea rish divergence (a top fa ilure swing), and would b e consider ed a

short-term selling opportunity! The typical trader continues to use the RSI to identify a bearish divergence when theRSI is over 70, and a bullish divergence when the RSI is under 30. This synopsis sums up public knowledge about RSI.However, what the avera ge investor comprehend s is a small p ar t of the dynamic overall p icture. For ex amp le, if thera nge eff ectively shifts in a b ull mar ket so that 8 0 is overb ought, then Andrew Card well rea lized that the supp ortlevel must also shift. Inversely if the oversold level in a bear market will shift down to 20, then the resistance level in abear market must also shift.

Determining the RSI Range

An up trending market will typically find support at the 40 level, with effective resistance at the 80 level. A downtrending market will find resistance at 60, with effective support at the 20 level. Often times a primary indicationthat the trend has shifted from a bear trend to a possible bull market occurs when the RSI which previously wasrespecting the 60 level, ra llies up to 7 0 o r higher. W hen the inevitab le d ecline a rri ves, the RSI will respect the 40

level, bef ore rallying a gain. In an 8 0/ 40 ra nge (bull market), you will see the RSI make higher top s and higherbot toms – a classica l indicatio n of a bull ma rket! Likewise, in a 6 0/ 20 ra nge (be ar market) yo u will see the

RSI making lower bottoms and lower tops. Recognizing this RSI behavior is very useful when first looking at achart of a commodit y or stock. Inspecting the ra nge the RSI is in, is the f irst clue ind icating the trend. The RSIwil l a lso f ind r esista nce o r supp ort a t p revious top s, or b otto ms in the RSI values themselves. O ld resista nce

points could become new resistance points, and if broken a new support level upon a retracement.Likewise, old supp ort levels could pr ove to be ef fective suppor t a ga in, and if broken will p rove to beeffective resistance.



At (A) there is a small b ear ish diverge nce indicating that the p rior uptrend is ab out to take a d etour. Price

subsequently declines to (B) finding support at the 40 level. The rally to (C) is our first hint that a trendchange could be coming, as the 60 level proves to be effective resistance. The decline in prices to (D)violates the p revious sup por t line a t 4 0. At this p oint, we rea lize that w hat should have been sup por t f a iled,

that 60 was effective resistance at (C), and that the trend has probably changed. The price rallies a little bitaf ter (D) bef ore falt ering, and declining to a new low, however the RSI fa ils to make a new low. Instea d, itmakes a bullish divergence! At this point, we can safely say that the prior bull market died! The RSI level of 60

(C) proved to b e resistance b eca use the 40 level f aile d to p rovide suppo rt (decline C to D), and a bullishdiverg ence w as mad e. W here the b ulls got excited ab out the b ullish diverg ence, is where w e should be lookingfor a pla ce to g et short!

e ra y o respec s e eve aga n e ore ropp ng o . owever, e n s some suppor aindicating that the bulls might be getting re ad y to r ally pr ices. W hen the rally f alt ers at (G ) we cansafely assume that the bear market is still in effect. The low at (H) was not followed by a bullish

divergence; a minor indication that a trend change could be coming. This was somewhat confirmed at (I)as the RSI managed to rally above 60 to 64.93 before dropping. Our suspicion became more valid as thesubsequent decline to J found support at the 40 level. This was similar to the RSI finding resistance at the

60 level at (C). The rally to (K) violated the 60 -resista nce level, and the d ecline at (L) finding suppor t a tthe 60 level confirmed that we were now back in a bull market. In fact just as we were looking for a placeto get short prior to (E), we should also be looking for a place to get long prior to (L). Remember, RSI itself

tends to find support (L) at old resistance levels (C, E, G, H) in a bull market.



In any, case the ra lly to (M) found resistance a t the 80 level. The decline to (N) f ound supp ort

again at the 60 level. Notice that this is the second time that 60 acted as support. This behavior bythe RSI ind icates tha t we a re in a strong bull ma rket. In contrast, this would be similar to the 4 0level acting as resistance in a bear market. In fact, after the bear decline to (D) the market rallieda little b it f ind ing resistance a t the 40 level – six d ays later (a six p eriod bullish d ivergence).Following the ra lly f rom (N) we had a b ea rish divergence a t (O), followed by another d ivergencea f ewdays later. The subsequent decline in price to (P) was followed by a warning that the trend couldbe

changing came at (Q) as the RSI found resistance at the 60 level (with a small bear divergence)that led to a decline to (R). The explosive rally to (S) was a strong indication that the bull market isstill a live a nd well. It is interesting to note that (S) is itself a longer- term bea rish diverg enceag ainst (O).The first indication by the RSI that the bull market in Yen has ended will be the 60 level acting as

resistance followed by a violation of the 40 level – or the pr ice will negate the 40 support levelwithout f irst encountering resista nce at the 60 level.



USING MOVING AVERAGESAnother tools I prefer to use to indicate trend is moving averages, the standard workhorse used by most

technical traders. Moving averages are valuable, as they will remove the volatility from whatever they areca lculated f rom. For exa mple, ca lculating a moving aver ag e b ased on the RSI, ef f ectively r emoves thevolatility and g ives a smoother signal. In fa ct, the trend ca n be conf irmed by calculat ing a 9 p eriod simple

moving avera ge a nd a second 45 pe riod weig hted moving a vera ge on both the RSI and pr ice. W hen the:1. The 9 period on price is above the 45 period on price, andThe 9 period on RSI is above the 45 period on RSI the trend is up .

2. The 9 period on price is below the 45 period on price, and.

3. The 9 period on price is above the 45 period on price, and

The 9 period on RSI is below the 45 period on RSI the trend is sideways to up .4. The 9 period on price is below the 45 period on price, andThe 9 period on RSI is above the 45 period on RSI the trend is sideways to dow n .

Since the RSI is more volatile than the price, the 9 period simple moving average (SMA) on RSI will cross its

respective 4 5 period weighted moving average (W MA) b efor e the 9 p eriod (SMA) on price will cross itsresp ective 45 pe riod moving a verag e. I pla ce more emphasis on the moving avera ges ba sed on price than

those b a sed on RSI. Stay ing a wa re of what t he moving avera ges are d oing will help you to stay focused onthe overall tr end. W hen I am talking to another trad er, I will of ten say that the moving a verag e on price ispositive.



This implies that the short ter m, 9 p eriod SMA is, ab ove the longer ter m, 45 W MA. The larg est moves will fr eq uently comewhen both moving a vera ges ar e moving in the same d irection. One more thought on moving a vera g es. You will f ind the movingavera ge 45 W MA will p rove to b e support or resistance on both price and RSI. For exa mple, you will of ten see a bullishmarket retr ace to its respective 45 per iod moving avera ge (pr ice a nd/ or RSI). W hen this is observed it is another sign of whatthe trend a ctually is Here is an example of the U.S Trea sury 3 0 yea r b ond:



It is obvious that the trend ha s be en down since the beg inning of 19 9 9. However, by a pp lying the ab ove

rules we can see the f ollowing. At (1) (with the close a t: 1 24 ^1 4), the pr ice f ound resista nce a t the 4 5per iod moving avera ge (the red line). Also, notice that the 9 p eriod moving avera ge (the g reen line) on theRSI crossed under the 45 period moving average thereby resuming the downtrend. At point (2) (122^09)

the trend changed to side way s to d own, thus pr eventing us f rom looking for a pla ce to g et long. Instea d, itfor ced us to look f or a pla ce to g et short. This became ob vious at p oint (3) (12 0^ 04 ) where the trend w entback to down. The trend shifted back to sideways to up at point (4) (114^20). After the rally to (A), many

traders began to believe that the price would continue higher. At (A) several things are occurring. First,the tre nd is now up, as the moving a vera ge on pr ice, and the RSI a re positive. Second , the RSI is una b le toovercome the 60 -resistance level. Third, the p rice is not ab le to dista nce it self f rom the 4 5 pe riod moving

a ver ag e o n p r ce. s s n ca ng a e p ro a e r ec on w ou r ema n ow n. or eover, efollow ing decline into ear ly A ugust shows that the RSI broke p ossible suppor t a t 4 0 – indicat ing pr ob ab lelower prices. Shortly af terward s at (6) (11 1^ 03 ), the trend turned d own aga in. Between points 5 (114 ^2 6) &

6 (111^03) the moving average went positive, and negative a couple times. However, notice that the RSIcontinued to respect the 60-resistance level, and the moving average on price continued to be negative. Thenat p oint (6) (11 1^ 03 ) the trend resumed its downward trend. At p oint (7) (103 ^1 9) the trend b riefly went to

sid eway s to d ow n; however, it w as a f a lse move. This wa s evid ent b ecause the RSI was f inding resista nce a t the40 level – the fa ct that the 40 level a cted as suppo rt in late August wa s also signif icant. Remember that in abear market, what was support will often become resistance on a subsequent rally. This was signifying the

probability of a major downward move in price.



IN CO NCLUSIO N, W HAT I ASK MYSELF W HEN DETERMINING TREND IS:

1. W hat is the ra nge? Has there b een a ra nge shif t?2 . Is the marke t respecting f ormer suppor t, and resista nce a rea s, or is the marketviolatingthem, and reversing their roles?3. Have we broken an important trend line in the price, or RSI chart?4. W hat ty pe of d ivergences is pr esent?

5 . W hat is my moving a vera ges showing me?

This quick checklist is how I can accurately, and quickly determine the trend.

However, this short essay lays the foundation on how I determine what the trend is.

Know Your Indicators

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