Computerised Technical Analysis

Trading is an information game. Computers allow us to use complex indicators that equips us with relevant information to spot opportunities.

Disclaimer: content is summarised from Part 4 (Chapter 21 - 27) of 'The New Trading for a Living: Psychology, Discipline, Trading Tools and Systems, Risk Control, Trade Management' by Alexander Elder

Contents:

1. Computers in Trading

• Toolboxes

• Computers

• Market Data

• 3 Major Groups of Indicators

2. Moving Averages

• EMA

• Choosing Length of MA

• Trading Rules

• Filtering

• More on MAs

• Dual EMAs

• MA & Channels

• Prices, Value, & Value Zone

• Dual EMAs

3. Moving Average Convergence-Divergence

• Creating MACD

• Market Psychology

• Trading Rules for MACD Lines

• MACD-Histogram

• Market Psychology

• Trading Rules

• More on MACD-H

• Divergences

• The Hound of the Baskervilles

4. The Directional System

• Constructing the Directional System

• Crowd Behaviour

• Trading Rules

• Average True Range - Help from Volatility

5. Oscillators

• Overbought & Oversold

6. Stochastic

• Crowd Psychology

• Trading Rules

• Line Direction

• More on Stochastic

7. Relative Strength Index

• Mass Psychology

• Trading Rules

1. Computers in Trading

Computerised technical analysis are more objective than classical charting. E.g. presence of S/R line can be argued but not about an indicator’s direction.

Toolboxes

Toolboxes provide a set of electronic tools for processing market data. Select your market, type of charts & indicators used. A good toolbox is available at all price levels. It may include popular indicators like moving averages, channels, MACD, Stochastic, Relative Strength Index, etc. You can modify indicators & even make your own. Compare any 2 markets & analyse their spreads. For options, your toolbox must include an options valuation model. Some allow you to backtest trading systems. Some can scan for specific stocks (e.g. find all stocks among Nasdaq 100 with rising EMA, with price <1% above EMA)

Decide what package to use & have user of said package to set it up to save time. Disable equity gains / losses in real time indicator as seeing dollars fluctuate at every tick is stressful & distracting.

Computers

Technical analysis software does not require excessive processing power. Use multiple screens for a multidimensional view of markets & watch several trading vehicles at once.

Market Data

Swing & position traders enter & exit within days / weeks hence, end-of-day data is sufficient for them. Day traders enter & exit in a hours / minutes hence they need real time data. 2 bull-and-bear-market cycles are approximately ~10 years. 10-12 year window is assess if stocks are cheap / expensive will suffice as patterns from say 1 year would be unreliable. Prioritise quality over quantity for collection & analysis of data. Focus on a few stocks & familiarise with their behaviour patterns.

Beginners should avoid day-trading due to demands of instant decision making. Instead, learn to trade in a slower environment & perhaps start as swing trader: hold positions for a few days, select stocks with good swings on good volume & use real time data for timing of entry & exit.

3 Major Groups of Indicators

Indicators are more objective than charting and they identify trends & reversals. Select a few & combine them. However, they may contradict one another. Most indicators are based on 5 data points: open, high, low, close, & volume

Trend-Following

These are best for moving markets however, quality of signals decreases as markets go flat. They are lagging indicators: they only turn after trends reverse. E.g. moving averages (MA), moving average convergence-divergence lines (MACD), the Directional System, On-Balance Volume, Accumulation/Distribution (AD), etc.

Oscillators

They identify turning points in flat markets but give premature & dangerous signals when markets begin to trend. They are leading indicators that often turn ahead of prices. E.g. MACD-Histogram, Force Index, Stochastic, Rate of Change, Momentum, Relative Strength Index, Elder-ray, Williams %R etc

Miscellaneous

Insight into mass psychology & shows intensity of bullish / bearish camps. They can be leading / lagging indicators. E.g. New High–New Low Index, the Put-Call Ratio, Bullish Consensus, Commitments of Traders, etc

Triple screen trading system combines indicators. Trade only if signals from indicator is clear-cut. If you find yourself squinting at a chart, trying to understand its signals, do not trade.

2. Moving Averages

MA reflects average value of data in its time window. E.g. 5-day simple MA shows average price for the past 5 days. However, simple MAs do not represent the market well.

MA represents average consensus of value for the period of time in its window. The slope of MA is most important: upwards is bullish, downwards is bearish

EMA

More weight given to latest data (e.g. last day of 10-day EMA is 18% of value). Moreover, EMA does not drop old data like simple MA as old data slowly fades away instead.

Choosing Length of MA

Whipsaws refer to rapid reversal of a trading signal. With narrow time frames, EMAs are more sensitive to price changes thus they catch new trends sooner, but this leads to more whipsaws. With wider windows, fewer whipsaws occur but turning points are missed by a wider margin. Length of MA should be half length of dominant market cycle/price cycle however, cycles keep changing and disappearing. EMAs are mostly 10-30 days. MA must be ≥ 8 days to be a trend-following tool. 22 is a good numbers as it is the approx. no.of trading days in a month or choose 26, half no. of weeks in a year. Set your parameters for indicators and do not change them to conserve objectivity.

Trading Rules

1. EMA rises → long

Buy when prices dip near EMA. Place protective stop below latest minor low & move it to breakeven point as prices close higher

2. EMA falls→ short

Sell short when prices tally toward EMA. Place protective stop above latest minor high & lower stop to breakeven as prices drop

3. EMA is flat → tradeless

Since it is trendless, do not trade

Filtering

Filtering whipsaws with rules reduces profits & losses. E.g. of filter: a rule states that prices must close on the other side of MA not once, but twice, or to penetrate MA by a certain margin. However, this reduces losses & ability to lock onto trends early.

More on MAs

MAs identify & follow trends, but lead to whipsaws in trading ranges. MAs also serve as S/R: a rising MA is a floor below prices, a falling MA is a ceiling above prices. Hence, buy near rising MA, sell short near falling MA.

If volume falls below MA, public interest in minor trend decreases, hence trend may reverse. If volume overshoots MA, public interest in trend is strong, confirming the trend.

Weighted MA (WMA) allows you to assign weight to any day, but traders are better off using EMAs to keep things easier.

Dual EMAs

Shorter EMAs are for short-term consensus of value, longer EMAs are for Long-term consensus of value. Alexander Elder uses a 2:1 ratio (e.g. 13-day EMA + 26-day EMA) Value “lives” between these two EMA lines, the value zone.

MA & Channels

Channels are 2 lines drawn parallel to a MA. Height / width is the distance between upper & lower channel lines. A good channel contains approximately 95% of all prices that occurred the past 100 bars. Longer-term markets & volatile markets have wider channels as prices would cover greater distances. Channels are useful for trading & performance tracking.

Prices, Value, & Value Zone

Prices are different from values. Buy when we feel that the current price < true value (undervalued). Sell when we feel that the current price > true value (overvalued). Fundamental Analysts define value by studying balance sheets & annual reports, but such sources are not objective as companies often 'massage' their financial data. Thus, long + short term EMAs that defines value is important.

DIS daily, 26- and 13-day EMAs. (Chart by Stockcharts.com)

Short EMA (faster reacting one) hugs prices more closely, long EMA moves slowly. Slow EMA identifies trend, fast EMA sets boundary of value zone. Buy when in value zone, short when waiting till it rallies to the value zone. During uptrend shown, pullbacks to value offers attractive buying opportunities at (1)(2)(3)(4). Downward reversal of slow EMA marks end of uptrend. Right edge shows that the trend is down, while pullback to value at (5) offers a shorting opportunity.

3. MA Convergence-Divergence (MACD), MACD-Histogram & Divergence

MA identifies trends & reversals. MACD consists of 3 EMA & is shown as 2 lines whose crossovers give trading signals.

Creating MACD

Solid line shows the fast MACD line (2 EMA) which responds to changes in prices relatively quickly. Dashed line shows the slow signal line which smooths the MACD line with another EMA & responds to changes in prices slower. Personalise your MACD line using other MA than standard 12, 26, 9. A ‘Quicky-and-dirty’ method uses only 2 EMAs: crossover of 2 EMA as a proxy for MACD & Signal lines

Market Psychology

Price is the consensus of value at the moment of trade. MA is the average consensus of value for selected period of time. Crossovers of MACD & Signal lines shows shifts in balance of power of bears & bulls. Fast MACD line shows consensus over shorter time period. Slow signal line shows consensus over longer time period. If fast MACD rises above slow signal: bulls > bears hence, long. If fast MACD falls below slow signal: bulls < bears hence, short.

Trading Rules for MACD Lines

Trading in the direction of a crossover is to go with the flow of the market. This system generates fewer trades & whipsaws than mechanical systems based on 1 MA.

If fast MACD rises above slow signal, go long & place a protective stop below the latest minor low.

If fast MACD falls below slow signal, go short & place a protective stop above the latest minor high.

ABX weekly, 26- and 13-week EMAs, 12-26-9 MACD Lines. (Chart by Stockcharts.com)

Black curve shows fast MACD Line, red curve shows slow signal line. Notice the sell signal from red vertical arrow once fast MACD line falls below signal line. Signal reversed later when fast goes above slow signal line at green arrow. Notice that for new low (B), MACD lines refused to confirm (did not fall to a new low but traced a double bottom) which was a false breakout, a bullish sign. Bears' last attempt to drive ABX lower (C), wasn't confirmed by MACD Lines, which maintained a steady uptrend. At the right edge, MACD Lines reached a new high, indicating strength. Both EMAs are rising, confirming the bullish trend.

MACD-Histogram

MACD-H provides a deeper insight into balance of power between bulls & bears. It shows whether bulls / bears are in control & if they strengthen /weaken

MACD-H = MACD line - Signal line

Computer plots difference of lines as bars to fill the screen. MACD-H is positive when fast is above slow, vice versa

DJIA daily, 26- and 13-day EMAs, 12-26-9 MACD Lines. (Chart by Stockcharts.com)

Buy & sell signals of MACD lines, marked by green & red arrows respectively. (D) & (F) are bottoms. (F) turned out to be a false downside breakout). MACD-H bottom became more shallow than the first, suggesting that bears weakened & an upside reversal was likely to occur.

Market Psychology

MACD-H reveals difference between long-term & short-term consensus of value. Rising MACD-H suggests bulls are getting stronger hence, long. Falling MACD-H suggests bears are getting stronger hence, short. Trend is safe when the slope of MACD-H moves in same direction as price. Trend is questionable when slope moves in opposite direction as price.

Best buy signals occur when MACD-H is below the center-line but the slope turns up, showing that bears have become exhausted (opposite for best sell signals). When prices go one way but MACD-H moves opposite, the dominant crowd is losing enthusiasm & the trend is weaker than it appears.

Trading Rules

Buy when MACD-H stops falling & ticks up. Place a protective stop below the latest minor low.

Sell short when MACD-H stops rising & ticks down. Place a protective stop above the latest minor high.

Impulse system = EMA + MACD-H

When MACD-H reaches a new high during a rally, uptrend is healthy & you can expect the next rally to retest / exceed its previous peak (likewise for downtrends)

More on MACD-H

Works for all timeframes. Signals in longer timeframes lead to greater price moves (applies to all technical indicators). Monitor weekly charts on a daily basis as trends may turn in the middle of the week.

Divergences

Divergence is among the most powerful signals in technical analysis. Divergences between MACD-H & prices are infrequent. They do not occur at every important top / bottom, but when they do, a big reversal is likely to occur.

Bullish divergences occur towards the ends of downtrends—they identify market bottoms. Divergences occur when prices (P) & oscillator (O) fall to a new low, then rally, with O turning positive, then both fall again. But this time, P drops to an even lower low, whilst O traces a smaller bottom.

DJIA weekly, 26- and 13-day EMAs, 12-26-9 MACD Lines and MACD-Histogram. (Chart by TC2000 from the book Two Roads Diverged: Trading Divergences)

Record low of MACD-H (A) suggests that bears were extremely strong & thus (A) was to be retested / exceeded. MACD-H rallied above center-line at (B). Prices reach a lower low at (C) & MACD-H traced a shallower low. Uptick completes bullish divergence, giving a strong buy signal. MACD-H has to cross above that line before skidding to its 2nd bottom. Notice that MACD-H gives a buy signal when it ticks up from the 2nd bottom. It does not have to cross above the center-line for a 2nd time. Buy signal occurs when MACD-H, still below zero, simply stops declining & traces out a bar that is less negative than its preceding bar. Notice that we cannot call area after (C) a divergence. Despite lowering tops, it has to cross & recross its zero line.

Bearish divergences occurs at uptrends—they identify market tops. Divergences occur when prices reach a new high, then pull back, with an oscillator turns negative. Prices stabilise & rally to a higher high, but an oscillator reaches a lower peak than in a previous rally.

DJIA weekly, 26- and 13-day EMAs, 12-26-9 MACD Lines and MACD-Histogram. (Chart by TC2000 from the book Two Roads Diverged: Trading Divergences)

DOW rallied to market high at (X) with MACD-H. Bulls were extremely strong, & peak (X) was likely to be retested / exceeded. MACD-H falls below centreline at (Y). DOW rallied to new high at (Z) but feeble MACD-H shows weakness in bulls. Downtick from (Z) completes a bearish divergence, giving a strong sell signal. Signs of bearish divergence is reinforced by MACD Lines that traced a bearish pattern between tops (X) & (Z)

“Missing right shoulder” divergences occur when 2nd peak fails to cross the zero line. They are quite rare, but produce very strong trading signals.

Best divergences occur when distance between 2 peaks / bottoms of MACD-H are 20 - 40 bars (the closer to 20, the better & 2nd top / bottom is no more than half of the 1st) 20 bars translates to 20 weeks on a weekly chart, 20 days on a daily chart.

Triple Bullish / Bearish Divergences consists of 3 price bottoms & 3 oscillator bottoms OR 3 price tops & 3 oscillator tops. They are stronger than regular divergences. To occur, a regular bullish / bearish divergence has to abort. 3rd top / bottom has to be more shallow than the 1st, but not necessarily the 2nd.

The Hound of the Baskervilles

"Hound of the Baskervilles" signal occurs when a reliable chart / indicator pattern (like divergence) causes prices move opposite to what one would expect. Market refuses to respond to a perfectly good signal & this shows that something is fundamentally changing below the surface. Hence, it is time to get in gear with the new powerful trend. On such rare occasions when a bearish divergence aborts you may choose to go long, & short when a bullish divergence aborts. (signal is named after the story by Sir Arthur Conan Doyle where Sherlock Holmes was called to investigate a murder. He found the essential clue when he realised that the family dog did not bark while the murder was being committed. This meant the dog knew the criminal & the murder was an inside job. A signal was given by the lack of expected action—by the lack of barking)

4. The Directional System

DS identifies trends & shows when a trend is moving fast enough to make it worth following. It helps traders by taking out chunks of the middle of important trends.

Constructing the Directional System

Directional Movement (DM) is the portion of today's range that is outside of the previous day's range. It checks whether today's range extends above / below the previous day's range & averages that data over a period.

1. Identify DM

Compare today’s high-low range with yesterday's. The largest part of today's range outside of yesterday's range. DM is always positive. Below, we have the 4 types of DM.

2. Identify True Range (TR)

TR is always a positive number & is the largest of the following: 1. Dist. from today’s high & today’s low 2. Dist. from today’s high & yesterday’s close 3. Dist. from today’s low & yesterday’s close

3. Calculate daily Directional Indicators (+DI & -DI)

Compare markets by expressing their DM as a % of each market's TR. +DI = 0 suggests no directional movement upwards. -DI = 0 suggests no directional movement downwards.

4. Calculate smoothed Directional Lines (+DI13 & -DI13)

They are created with MAs. Pick any period for smoothing, like 13-day MA. Both +DI13 & -DI13 numbers are positive & are usually plotted in different colours. The relationship between Directional lines identifies trends. When +DI13 is on top, trend is up. When -DI13 is on top, trend is down. Crossovers of the lines gives buy & sell signals.

5. Calculate Average Directional Indicator (ADX)

ADX shows when a trend is worth following by measuring spread between Directional lines. ADX is calculated by smoothing DX with an MA, e.g. 13-day EMA

During a persistent trend, spread between smoothed Directional lines increases & ADX rises. ADX decreases when trend reverses / market enters trading range. Only use trend-following methods when ADX is rising.

Crowd Behaviour

DS tracks change in mass bull / bear behaviour by measuring capacity of bulls & bears to move prices outside of the previous day’s range. Uptrend when +DI13 is on top, downtrend when -DI13 is on top. When ADX rises, spread between directional lines increases, market leaders get stronger & trend is likely to continue (opposite is true for ADX decline)

ANV daily, 22-day EMA, Directional System (13). (Chart by Stockcharts.com)

Green curve shows +DI13 (bullish directional line), red curve (bearish directional line) shows -DI13 & black curve below is ADX.

Allied Nevada Gold Corp. (ANV) had a low (A) at $3.07, and further dropped to $3.01 at (B) & recoiled, leaving a false downside breakout. Support was retested at (C), $3.08 before the uptrend began, with EMA turning up. Directional system gave buy signal at vertical green arrow: +DI1 was above -DI13, while ADX moved above -DI13.

Near the right edge a pullback is seen, offering a good opportunity to long further.

Though one may find a similar shorting signal in the lettered areas (A)(B)(C), a discretionary trader does not trade every signal he sees as shorting a stock near $3 that declined from $45 would mean chasing a very old trend.

Trading Rules

1. If +Directional line is above, long. If -Directional line is above, short. The best time to trade is when ADX is rising as dominant group grows stronger.

2. If ADX declines, you do not use trend-following method. Market is becoming less directional & is likely to have many whipsaws.

3. If ADX falls below both directional lines, do not use trend-following system as it suggests a sleepy market. Prepare to trade as major trends emerge from such lulls. When ADX rallies from below both directional lines, it shows market is waking up from lull. A bull / bear market is born depending on what directional line is on top

4. If ADX rallies above both directional lines, pull away from trade as it suggests an overheated market. Major trend stumbles when it turns down after rallying above the directional lines. It is a good time to take profits on a directional trade. If you trade large positions, take partial profits.

5. Market indicators give hard & soft signals. E.g. when a moving average changes direction, it is a hard signal. Downturn of ADX is a soft signal &, you ought to be very careful about adding to positions when that happens. Look to get out.

Average True Range - Help from Volatility

ATR is an indicator that averages TR over a period of time. It tracks volatility by plotting a set of ATR lines above & below an MA. Helps to visualise current volatility. Plot 3 sets of lines around a MA: at 1,2 & 3 ATRs above & below an EMA. ATR is used for setting up entry points, stops & profit targets

Buy below value — below EMA. Normal pullbacks tend to bottom out near -1 ATR

Place stops at least 1 ATR away from entry as anything less would be within zone of normal market noise & anything more would make it more likely that only a real reversal can hit your stop.

After a buy, depending on how bullish the market is, place an order to take profits at +1, +2, or +3 ATRs. Get out of winning positions in several steps, placing orders for a 1/3 each at 1 ATR, 2 ATR & 3 ATR. Markets trading outside of its 3 ATRs, either up / down, can expect a pullback.

LULU daily, 21 EMA, volume with 8 EMA, ATR channels. (Chart by TradeStation)

Lululemon Athletica Inc. gapped down on a wide range bar on Sep 18 after an earnings announcement. There was no downside follow-through, & as stock rallied, horizontal line was drawn at the midpoint of its tall bar (A), tends to serve as short-term support.

As LULU pulled back, daily ranges narrowed, & volume dried up at (B). LULU was bought at $72.02 on Sep 30 (C) as it recovered from a false downside breakout. 1/3 of position profits were taken at $73.70 later that day, as LULU came within a few cents of +1 ATR. At (D), LULU hit its +2 ATR at $76.63 & another 1/3 position was closed. Final 1/3 was taken near mid range of (D)

5. Oscillators

Oscillators catch turning points. When masses are gripped by greed / fear, they surge, but after a while intensity fizzles out. Oscillators measure speed of any surges & shows when momentum starts to break. They identify emotional extremes of market crowds. Bet against extreme deviations & for a return to normalcy. E.g. When market rises & the crowd roars from greed, pros get ready to sell short.

Overbought & Oversold

When market is too high & ready to turn down, it is overbought. Oscillator is overbought when it reaches a high level associated with tops in the past

When market is too low & ready to turn up, it is oversold. Oscillator is oversold when it reaches a low level associated with bottoms in the past

Oscillators can stay overbought / oversold for weeks before a new strong uptrend / downtrend begins, giving premature sell signals. A mature analyst knows when to use oscillators & when to rely on trend following indicators.

Mark overbought & oversold oscillator levels by horizontal reference lines. Place them such that they cut cross only highest peaks & lowest valleys of that oscillator from the past 6 months.

Alternatively, place them so that oscillator spends only ~5% of its time beyond each line, & readjust lines once every 3 months.

When oscillator rises / falls beyond its reference line an unsustainable extreme is shown, likely to precede a top / bottom. Oscillators work well in trading ranges, but give premature & dangerous signals when a new trend erupts from a range. E.g. of oscillators include MACD-H, Stochastic, Relative Strength Index (RSI).

6. Stochastic

Stochastic tracks relationship of each closing price to recent high-low range. It consists of 2 lines: Fast line %K & Slow line %D

The standard width of stochastic time window is 5 days though it is sometimes more. Narrow windows catch more turning points while wider windows identify more important turning points.

Stochastic is designed to fluctuate between 0 & 100. Reference lines are usually drawn at 20% & 80% levels to mark overbought & oversold areas.

2 ways to plot Stochastic: Fast & Slow.

Fast Stochastic consists of 2 lines, %K & %D. Though sensitive, it causes many whipsaws. %D of Fast Stochastic becomes %K of Slow Stochastic. Slow Stochastic is smoothed by repeating step 2 to obtain %D. It is better at filtering out market noise & leads to fewer whipsaws.

Crowd Psychology

Settlement of trading accounts relies on closing prices. Highs shows the max. power of bulls while lows shows max. power of bears. Stochastic measures capacity of bulls / bears to close the market near the upper / lower edge of the recent range. It identifies signs of weakness e.g. if trend is strong during day but can't be held down for closing, trade against it.

CVX daily, 26-day EMA. 5-day Slow Stochastic. (Chart by Stockcharts.com)

Chart of Chevron Corporation (CVX) illustrates helpful & dangerous aspects of

Stochastic. As stock stays in a sideways trading range, Stochastic keeps nailing down short-term tops & bottoms. It gives buy signals at green arrows, when it rises above its lower reference line. It gives sell signals at red arrows, when it sinks below its upper reference line. Signals are reinforced by broad, down-sloping Stochastic tops, at diagonal purple arrows.

Several instances of false breakouts reinforce Stochastic signals. Sharp downtrend near the right edge overrides the Stochastic buy signal.

A trader may rely on Stochastic in a trading range, but should use protective stops as the last trade in a range always creates a loss when a trend begins.

Trading Rules

3 trading signals in order of importance:

1. Divergence

Bullish divergence occurs when prices fall to a new low, but Stochastic traces a higher bottom than during its previous decline. It shows losing strength of bears, thus once Stochastic turns up from its 2nd bottom, go long & place a protective stop below the latest low in the market.

Bearish divergence occurs when prices rally to a new high, but Stochastic traces a lower high than the previous rally. It shows losing strength of bulls, thus, once Stochastic turns down from 2nd top, go short & place a protective stop above the latest peak of price.

2. Overbought & Oversold

When Stochastic rallies above its upper reference line market is overbought. When Stochastic falls below its lower reference line market is oversold. These signals work fine at trading ranges but not at trends (e.g. in uptrends, Stochastic quickly becomes overbought, giving sell signals while the market rallies)

It pays to combine Stochastic with a long-term trend-following indicator. Triple Screen trading system allows traders to take buy signals from daily Stochastic only when the weekly trend is up. When the weekly trend is down, traders take only sell signals from daily Stochastic.

When uptrend on a weekly chart is identified, wait for daily Stochastic lines to decline below lower reference line. Then, place a buy order above high of the latest price bar with protective stop below the low of the trade day / the previous day, whichever is lower

If Stochastic has a narrow / shallow bottom, bears are weak & the rally is likely to be strong. If it is deep & wide, bears are strong & rally is likely to be weak. (Only buy with narrow bottom)

When downtrend on a weekly chart is identified, wait for daily Stochastic lines to rally above their upper reference line. Then, place an order to sell short below the low of the latest price bar with protective stop above the high of the trade day / the previous day, whichever is higher.

If Stochastic has a narrow top, bulls are weak & a severe decline is likely. If Stochastic top is high & wide bulls are strong (only sell with narrow top)

3. Do not buy when Stochastic is overbought, & do not short when it is oversold.

This rule filters out most bad trades.

Line Direction

Lines in same direction confirms short-term trend e.g. When prices rise & both Stochastic lines rise, uptrend is likely to continue

More on Stochastic

If weekly Stochastic turns, MACD-H is likely to turn the next week hence, time to tighten stops / start taking profits. Shorter-term oscillators are more sensitive (preferable if Stochastic as part of a trading system, combined with trend-following indicators). Longer-term oscillators turn only at important tops & bottoms (preferable if Stochastic as a stand-alone oscillator)

7. Relative Strength Index (RSI)

RSI is an oscillator that measures any trading vehicle's strength by monitoring changes in closing prices. It is a leading / coincident indicator, never a laggard.

RSI fluctuates between 0 - 100. Pattern of RSI peaks & valleys does not change in response to width of its time window. Trading signals become more visible with shorter RSI, like 7 / 9 days. Overbought & oversold RSI levels vary from market. Horizontal reference lines drawn at 30% & 70%, some use 40% & 80% in bull markets / 20% & 60% in bear markets.

5% rule: draw each line at a level above where RSI spends less than 5% of its time in the past 4 - 6 months, then adjust reference lines once every 3 months.

CVX daily, 13-day RSI. (Chart by Stockcharts.com)

RSI & Stochastic works well in trading ranges, but give premature & dangerous signals when prices begin to trend. RSI, based exclusively on closing prices, is less noisy than Stochastic. It calls for rallies when it rises above its lower reference line, at vertical green arrows. It signals declines by sinking below its upper reference line, at vertical red arrows.

RSI signals emerge earlier. A powerful sell signal is given by a bearish divergence of RSI, at diagonal solid arrow & dashed red arrow. Chevron Corporation (CVX) stock rallied to a new high, while RSI could not reach its upper reference line, pointing to that rally’s hidden weakness. Sharp break near the right edge pushes prices lower despite the RSI buy signal.

Crowd Psychology

Traders pay most attention to closing prices. RSI shows whether bulls / bears are stronger at closing time.

Trading Rules

3 trading signals in order of importance:

1. Divergence

Divergences between RSI & prices tend to occur at important tops & bottoms. They show when trends are weak & ready to reverse.

Bullish divergence occurs when prices fall to a new low but RSI makes a higher bottom than during its previous decline. Buy when RSI turns up from its 2nd bottom, & place a protective stop below the latest minor price low. Buy signals are strong if 1st RSI bottom is below its lower reference line & the 2nd bottom is above line. Bearish D is opposite

2. Charting Patterns

RSI often breaks through S/R a few days ahead of prices, providing hints of likely trend changes. RSI trend lines are usually broken 1 / 2 days before price trend changes

1. When RSI breaks above its downtrend line, place an order to buy above the

latest price peak to catch an upside breakout.

2. When RSI breaks below its uptrend line, place an order to sell short below

the latest price low to catch a downside breakout.

3. RSI Levels

When RSI rises above its upper reference line, bulls are strong but market is overbought & entering its sell zone. When RSI declines below its lower reference line, bears are strong but market is oversold & entering its buy zone.

It pays to buy using overbought signals of daily RSI only when the weekly trend is up & sell short using sell signals of daily RSI only when the weekly trend is down.

Deal with only a few numbers— opening, high, low & closing prices for each bar, plus volume, & open interest for derivatives like futures & options

Always follow trends first before indicators. Do not use indicators to confirm your personal bias. Use a small number of indicators with a strict hierarchy for their analysis, including multiple timeframes.