Chapter 2

Popular Trading Indicators

Robert M. Melancon, RIA

Technical analysis is based on the premise that human nature remains more or less constant and that people will respond to changing economic, monetary, and psychological factors in the future in much the same way as they have responded in the past. The challenge for the technical analyst, then, is to identify the prevailing psychological trend in the market, recognize when changes in that trend are at hand, and attempt to profit from the new trend for as long as it remains in effect. Technical indicators are tools that have been developed over time to assist the technician in identifying these changes in the prevailing trend.

With the advent of the personal computer, technical indicators are now limited only by the bounds of ones imagination. There are price-based indicators, volume-based indicators, breadth-based indicators, sentiment-based indicators, and the like. There are also seasonally based indicators, celestial-based indicators, Super Bowl-based indicators and even indicators based on the length of womens skirt hems. The purpose of this chapter, however, is not to examine every indicator imaginable, but rather to acquaint the reader with the development, application, and limitations of a few of the more popular and reliable ones in use.

Trend Identification

Before setting about the task of identifying trends and trend reversals, it is first necessary to understand what a price trend is. Around the turn of the century, Charles Dow, considered the father of technical analysis, observed that during a market advance prices tended to move upward in a series of steps or waves, with each new high and low progressively higher than the one preceding it (see Figure 2.1). As long as this pattern of progressively higher peaks and valleys remained uninterrupted, the primary trend of the market was considered to be positive. Conversely, during market declines prices tended to move lower in a series of progressively lower highs followed by progressively lower lows.

Dow further observed that once a trend was established (either upward or downward), it tended to stay in effect until it was broken. Once violated, though, it

Figure 2.1 Uptrends and downtrends.

Uptrend

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usually meant an end to the prevailing trend and the likelihood of a reversal in direction. As simplistic as it may seem, this elementary concept of peak-and-valley progression paved the way for the earliest forms of technical analysis: pattern recognition.

Chart Pattern Recognition

When a primary trend comes to an end, prices usually enter a sideways consolidation period before either resuming the preceding trend or reversing direction. The price patterns resulting from this consolidation phase frequently give the analyst highly profitable clues as to future price direction. Some patterns, such as wedges, pennants, and flags, are considered continuation patterns and can be useful in preventing a premature exit from a position. Others, such as the double or triple top (bottom) and "head and shoulders" formations are considered highly reliable reversal patterns and can be invaluable in giving advance warning of an impending trend reversal. Still other patterns, such as right-angled and symmetrical triangles (sometimes called coils), can be either continuation or reversal formations and thus serve as a valuable caution flag for the investor. Besides their usefulness as a barometer of future trend direction, chart patterns also serve a highly useful role in projecting the extent of an ensuing price move. While beyond the scope of this chapter, a thorough understanding of chart pattern recognition cannot be overemphasized as a basic requirement for the serious technical analyst.

Moving Averages

Another of the early price based indicators is the moving average. The purpose of moving averages is to smooth out the fluctuations of incremental price movement, and provide the technician with a sort of moving trend. Although there are a number of different kinds of moving averages, the most common are the simple, weighted, and exponential moving averages. A simple moving average is nothing more than a summation of a number of periods of data, divided by the number of periods. Each time a new increment of data is added, the first or initial increment of data is dropped. Thus the moving average "moves" or changes along with the price data it is averaging.

Weighted moving averages are similar in concept to simple moving averages except that additional weight is given to the more recent data. Exponential moving averages are similar in construction and give similar results to weighted moving averages, but are far more simple (and faster) to calculate. Thus they are frequently the moving average of choice in technical analysis. With the advent of the personal computer, however, virtually any form of moving average, including advanced and centered moving averages, can be calculated in a flash with the touch of a button. But because they are used extensively in most technical indicators, a thorough understanding of the various types of moving averages is essential before proceeding further.

Technical Indicators

Due in large part to the power and broad accessibility of the personal computer, technical analysis has taken a quantum leap from the early study of chart patterns and moving averages to a formidable array of technical indicators and trading systems. For the most part, these indicators fall into four major categories: sentiment indicators, monetary indicators, market structure indicators, and other indicators.

Sentiment Indicators

Based primarily on crowd psychology, sentiment indicators measure the buy and sell expectations of the various market participants. Unlike most other indicators, though, their interpretation is contrary in nature. For example, according to the well known Advisory Sentiment Index, the more investment advisors that are bullish, the more likely it is that they are already fully invested, and therefore there is less new money available to drive the market higher! Without liquidity to drive prices higher, the most likely course for stocks is down as those already fully invested begin taking profits. Therefore, the more bullish investment advisors are as a group, the more bearish the outlook for stocks.

As the popularity of sentiment indicators has taken hold, it has become more and more difficult to know whether the emotions being measured are the actual opinions of those surveyed or the opposite of their true feelings, based on contrary opinion.