Indicators – The What and How
We will be looking at some of the indicators I use and how I read them. To do that, we will need a typical chart to look at. I will use the SPY ticker over the 1 year time frame. I use the 10 year weekly interval chart to determing bull (rising) vs bear (falling) markets. The 1 year daily interval chart tells me the local trade available inside that market trend. Whenever possible it is much better to trade with the trend rather than to take a counter trend trade. (The reason for it is pretty simple. In a flat market, prices wander up and down in a sort of sin wave.)
Tilt the right side upward and the “ups” are steeper while the “downs” are more shallow. Tilt the right side downward and the downs are deep and fast, while the “ups” are often more “flat” than “up”. It’s very hard to make money out of an “up trade” that never goes more “up” than flat – dead money. It becomes more like a set of stairs, with rises and flats, or falls and flats.
A Chart of the S&P 500
OK, so lets look at the SPY in two charts. The first will use simple moving averages, RSI, MACD, and DMI indicators. The second will use the momentum, Slow Stochasitic, and fast volatility indicators. Each of these will be explained after the chart.
This chart shows a little blue square with “D” in it. Those are dates when a dividend is paid. “All Events” includes earnings announcements, dividends, stock splits and related actions. It is nice on a chart of a single ticker, but just clutters up a “race” with many tickers. For stocks with a large dividend, it helps to be reminded when folks may be selling out just after the dividend is paid.
The SMA – Simple Moving Average
Notice that there are three thin lines near the colored price bars? Those are Simple Moving Averages. Price tends to bounce off one moving average or another. In rising markets, it tends to bounce off the top, in falling markets off the bottom. You can also very easily pick out market tops (price and moving average stack cross over to the downside) and bottoms (cross over the other way, to price on top).
The moving average has a time lag (for example, the 24 day moving average lags by about 12 days) but has more stability. Comparision of the price to the Simple Moving Average helps see changes of direction or changes of momentum and velocity of price movement. But the cost is that the information comes a bit after the move has started (and for very fast moves, when it is almost over or completely over. – That is the risk you must watch for with the SMA). Many traders watch the 50 day SMA. I like to use a “stack” of three moving averages: 25, 50, and 75 day. This lets me see something a bit earlier (25) yet still have the reminder of the longer trend (75) and a marker of what other folks often watch (50). Sometimes I pull this in to a 24 – 48 – 72 day stack, or even 23 – 46 – 69. This sometimes helps, and sometimes just has me trading too soon. Some folks prefer the “Exponential” moving average, the EMA. It weights the recent data more. I don’t see much difference in practical terms.
On 10 day Hourly interval charts, I use SMA3 with 8, 16, 24 hour SMA stack (SMA-3 8). On the 10 year Weekly interval charts, I use SMA3 with 20, 40, 60 week SMA stack (SMA-3 20). That works out to 100, 200, and 300 day SMAs since a stock market week has 5 trading days. Long term investors often watch the 200 day SMA for major shifts of market direction.
Prices on this chart are “candlestick” style. That means that they have a red color on days where the price ended down, and black on days price ended up. The maximum price is the top of the color (if prices closed at the top) or the top of the skinny line out the top if the price did not close at the top. Similarly, the low price of the day is the bottom of the bar. That might be a skinny line if prices closed above the lows, or the bottom of the color if the stock closed at its low (with no skinny bit). There is an art to reading tea leaves in the shapes of these candels, that I will cover later. I have not found it very useful yet.
Indicators Below the Price Chart
We will take them from bottom to top.
The DMI is the slowest. It is there to remind you where you are coming from and that it isn’t over until it’s over. There are three lines. Black, Blue, and Red. The black is the strength of a move. The blue is the positive strength, the red is the negative strength. Important information comes from the black line (more than 25 or so and the MACD is more useful, less than 25 the movement is weak and fast trades using the Slow Stochastic work well). Red on top means danger, this is a downdraft. Blue on top means the stock is moving up. Inflections (changes from upward slop to downward or from downward to upward) are important. They indicate a change of trend. Since DMI is a slow lagging indicator, you will see important changes in the inflection long before the red/blue crossover happens. DMI is used to keep you focused on what the longer trend really is and what the strength of that trend is (and how they are changing, inflecting). When the DMI is very low (black line near the bottom) the stock is flat – trendless. It will be hard to make money in the stock on either long or short sides. You could sell options against it (sell a call and a put hoping both expire worthless) but otherwise it’s “dead money”.
Next is the MACD – Moving Average Convergence Divergence, that gives a slightly time lagged trade indicator. It works best when trends are strong. When DMI is above 25 or so. Those SMA stacks that cross over each other on the price chart; this is a modified version of that using faster moving averages. It then takes their difference and plots them. That’s the red and blue lines. When they are above the zero line, it’s a bull run. Below the zero line, bear run. So when the colored lines are below the zero, shorts are better trades, when above the zero, owning the stock is better. Watch for crossovers of red/blue to tell you when to enter or exit a trade. The angle of the crossover gives you an idea of the strength. It is possible in a steady rising (or falling) trend for the two lines to go sideways and weave with the angles of the crossovers shallow. That can cause repeated trading in/out for no good reason, so watch for that. If the actual price action is stable, and RSI says no change soon, don’t over trade from MACD flutter! BTW, the black blob in the middle is just the difference between the blue and red line flattened to a zero reference. Called the MACD Histogram. Same information, different picture.
At the top is the RSI, that often gives an idea what is coming, but can say “down is weaking” and you take it as “buy now” and forget that DMI said “down may be weakening, but it’s still down.” This is something of a sentiment indicator. When it is approaching 80, a rising trend is getting tired. It calls this, typically, in advance of the fact. It tells you to “get ready” and watch the MACD for an exit signal. At bottoms, it approaches 20 to give an early indication of a bottom. Sometimes very early… Falling stocks have RSI oscillate between 20ish and 50ish. Rising stock oscillate between 50ish and 80ish. When the pattern of oscillation breaks, when that “next 80” is a 65 or that “next 20” is instead a 35 (or so) it is likely that the trend is going to reverse. Reduce your position (sell part, move some of the position into cash) and get ready to swap sides (shorts to long, or longs to short). Watch DMI / ADX -/+ for inflections and watch MACD for a red/blue crossover with a wide mouth between the lines and an interior angle pointing steeply into the new direction.
This is a good basic set, but what if you want more? There is a large zoo of indicators. Many, like the “Williams %R” give almost the same indications as the MACD but with a different “look’ about it. Others, like the “Ultimate Oscillator” or “Bollinger Bands” are rather hard to explain or use and are outside the scope of anyone who is not interested in being a professional stock trader. The set I use is generally limited to the 3 listed above, plus some basics:
So what are these indicators (and some words about some others that you might want to explore)
PSAR – This is an indicator on the price chart; those odd red dots. It reminds you where a stop loss order ought to be set and when maybe you ought to be getting ready to get out (when a trend is getting old). It essentially sets a price a ways away from the supposed trade price (when price touches the red dots, it assumes you bought / sold), then creeps it up slowly as the trend gets older. It works OK in medium trends. It can result in choppy trades at the wrong times in a choppy sideways stock.
Volume – How much stock sold today? When people are panicking out of stocks, volume can be quite high. When everyone has bought a stock and it’s getting tired near a top, volume dries up. Notice the high volume at the bottom of the crash? Look at some of the up runs; notice that volume gets light just before the price rolls over? Not enough people left buying, so the stock “market maker” moves the price down to generate some volume (and commisions) and people start to panic out…
Slow Stochastic – This is a fast trade indicator (despite the name) that is good for trading the ripples in a flat to slighly trending chart. If there is no strong trend to ride, I’ll use this in wobbly but flat trend stock for fast trades. Notice that in the plumit part of this chart, the SlowStoch goes a bit nuts with a choppy undecided character.
Momentum – Sometimes this indicator is more stable than MACD. If I’m not sure if the MACD is weaving or not, I’ll look at “momentum” and it’s first cousin, ROC for a second opinion. On this chart, it’s substantially below the zero line. It’s telling you this is still a bear market. If you are short, hold the short bias. If you want to trade long (buying the stock) you need to catch the inflections off the peaks of momentum probably using the MACD or SlowStoch.
Yet More Indicators
Other indicators I’ll just mention. You can play with them if you like. At bigcharts.com just pick the advanced chart and on the left side there will be 4 places to chose indicators. Some speak to different individuals more than others…
ROC – Rate Of Change. Much of the time it says exactly what “momentum” says, but sometimes it doesn’t. I’ve not settled on a good way to choose one over the other.
Volatility – How much does the price range over the time period? Did a $10 stock trade between $5 and $15 or between $9.80 and $10.10 today? Prices are more volatile at bottoms (or sometimes at drops from a top) and they become less volatile in steady rising markets. It says similar things to volume, but in a different way.
Williams %R – This tends to give the same indications as the MACD, but with a different graphic. Inflections from extreams (near zero or near 100) back across the 50 line tend to show a change of direction of prices. It seems to work best in steadly trending markets, but the price action alone works for that.