Indicators And Oscillators
Indicators are those calculations, done primarily using the price and volume of stocks to gain further insight into the price movement of a security. They help a technical analyst to confirm trends, judge a chart quality, understand volumes and thus derive BUY/SELL signals. Indicators fall in two categories
1. Oscillators: These indicators mainly show value in a range between 0-100 i.e. they oscillate between oversold (0) and overbought (100).
2. Other Indicators: These indicators do not fall in a range. They do no generate a number like an oscillator but still help an analyst in generating BUY/SELL signals.
Indicators can also be classified as:
1) A leading indicator which moves ahead of the price and is used to predict the next price movement
2) A lagging indicator lags (follows) the price movement and is used to confirm the verdict given by the leading indicator.
Note: A good analyst should not rely on a single indicator. He should derive his verdict by using other indicators, chart patterns, trends, and volumes collectively. Only then the accuracy of the verdict could be higher.
Common and useful indicators:
RSI (Relative Strength Index):
This momentum indicator is used to indicate if a stock has generated an unreasonable demand (overbought) or an unreasonable supply (oversold). It reflects a value between 0-100. It shows an overbought when it is above 70 and shows an oversold if it is below 30. This indicator was developed by J Welles Wilder who articulated that when a stock moves up rapidly it will come to an overbought point. Similarly when it falls rapidly, it will come to an oversold point. In either case, a trend reversal can be expected soon. Thus, this indicator is used by analysts to indicate a probable trend reversal. It is mostly plotted on a 14 day time frame.
Warning: RSI above 70 does not conclude a SELL. It can very well be a BUY. The same applies to RSI below 30 as well. Any conclusions based on a single indicator can be misleading and may result in missed opportunities.
This indicator is similar to RSI where it indicates an overbought above 80 and oversold below 20. The only difference between RSI and stochastic is that, a RSI reacts to price changes a lot faster than a stochastic. Thus it can predict a trend reversal quickly. The disadvantage being that since the reaction is fast, it could have an error attached to it. Stochastic is slow in its reaction, and is delayed in its verdict, but it filters the market error and provides a less distorted picture. Both the indicators have their own benefits and their usage is mostly a personal choice. RSI is mostly used by long timeframe traders while stochastic is mostly used by swing traders.
Warning: A stochastic above 80 does not conclude a SELL. It can very well be a BUY. The same applies to stochastic below 20 as well. Any conclusions based on a single indicator can be misleading and may result in missed opportunities.
MACD (Moving Average Convergence Divergence):
It is used to measure momentum in a stock and thus predict a trend reversal. It consists of two exponential moving averages(EMA) of two different time periods namely the 12-day EMA and 26-day EMA. Technically the MACD is calculated by subtracting 26-day EMA from 12-day EMA. It is plotted mostly along a signal line of 9-day EMA of MACD line. At the center line (0) the two moving averages are equal. As the moving averages fluctuate, the MACD moves above and below the zero line. In most cases a signal line crossover or a zero line crossover is used to generate buy and sell signals.
MACD Line: 12-day EMA – 26-day EMA
Signal Line: 9-day EMA of MACD Line
Warning: 90% of the people who understand a bit of technical analysis use this indicator (signal level crossover) to enter into a position. Investors are advised not to rely solely on this indicator for taking a position. It could mostly result in losses.
On-Balance Volume (OBV):
Unlike the basic volume measure, this leading indicator is a combination of price and volume and indicates the flow of money into a stock. It maintains a cumulative total of volumes by adding volumes on up days (positive volumes) and subtracting volumes on down days (negative volumes).
• A volume is considered positive when the security closes higher on that day compared to its previous close. Therefore Current OBV will be Previous OBV + Current Volume.
• Similarly a volume is considered negative when the security closes below the previous close.
• Therefore Current OBV will be Previous OBV – Current Volume.
The OBV thus tells an analyst if there is more demand or supply coming in a security and is a trend reversal in sight. Demand is evident when the OBV line is rising. Supply is evident when the OBV line falls. OBV is not a standalone indicator and should always be used in conjunction with other indicators.
Accumulation/Distribution Line (ADL):
This is a volume based indicator and is similar to the OBV with a slight difference that unlike OBV which considers only the closing price of a security, this one also considers the day’s High and Low for its calculation.
1. It derives the following multiplier PosNegVol (positive or negative volume as in OBV) as
PosNegVol = [ (Days close – Days low) – (Days high – Days close)] / (Days high – Days low)
2. This multiplier will be positive or negative. It is multiplied with volume which eventually becomes a positive or a negative volume (as seen in OBV) forming ‘Current Volume’
3. ADL is calculated as previous ADL + Current Volume.
Average Directional Index (ADX):
The focus of this indicator is on measuring the strength of a trend. It doesn’t really care about the actual direction of the trend. ADX is comprised of +DI (positive directional indicator) and -DI (negative directional indicator). Calculations of these +-DI’s are complex. The ADX is plotted on a scale between 0-100. ADX value greater than 40 indicates a lot of strength in the trend. The trend can be up or down, and it doesn’t matter. Similarly a value less than 20 indicates weakness in the trend. When +DI is greater than –DI it also shows that bulls are in control of this security at the moment. ADX is mostly used along with the +-DI indicators as it alone doesn’t provide sufficient insights to the analysts. Usage of this indicator requires a lot of skill and experience.
Aroon indicator is used by analysts to understand and predict trends, their strength and also trend reversals. It is also used to identify phases of consolidation and corrections in stocks. It comprises of two indicators i.e
1. A X-day Aroon-Up indicator which calculates the numbers of days it has been since a X day high.
2. A X-day Aroon-Down indicator which calculates the numbers of days it has been since a X day low.
X can be any timeframe which an anlysts wishes to analyse.
The above two indicators fluctuate between 0-100. An uptrend trend can be signaled when Aroon-Up is above 50 while Aroon-Down is below 50. Conversely, a downtrend trend can be signaled if Aroon-Up is below 50 and Aroon-Down is above 50. An Aroon-Up between 70-100 and Aroon-Down between 0-30 would indicate and extremely bullish trend. Conversely, An Aroon-Up between 0-30 and Aroon-Down between 70-100 would indicate and extremely bearish trend. A consolidation can be signaled when both the indicators are below 30.
The Aroon Oscillator is plotted between a range of 0-100 and is calculated as the difference between Aroon-Up and Aroon-Down. It thus combines the two indicators into a single indicator and portrays the stronger of the two.
A positive reading on the oscillator indicates a bullish or an uptrend and a negative reading indicates a bearish trend. The higher the value above zero, the more is the strength in the uptrend. Conversely, the lower the value below zero, the more is the strength in downtrend.