In the realm of technical indicators, moving averages are extremely popular with market technicians and with good reason.Moving averages smooth the price action and make it easier to spot the underlying trends. Precise trend signals can be obtained from the interaction between a price and an average or between two or more averages themselves. Since the moving average is constructed by averaging several days’ closing prices, however, it tends to lag behind the price action.The shorter the average (meaning the fewer days used in its calculation), the more sensitive it is to price changes and the closer it trails the price action. A longer average (with more days included in its calculation) tracks the price action from a greater distance and is less responsive to trend changes. The moving average is easily quantified and lends itself especially well to historical testing.Mainly for those reasons,it is the mainstay of most mechanical trend-following systems.
Popular Moving Averages
In stock market analysis, the most popular moving average lengths are 50 and 200 days. [On weekly charts, those daily values are converted into 10 and 40-week averages.] During an uptrend, prices should stay above the 50-day average. Minor pullbacks often bounce off that average, which acts as a sup-port level.A decisive close beneath the 50-day average is usually one of the first signs that a stock is entering a more severe
correction. In many cases, the breaking of the 50-day average signals a further decline down to the 200-day average. If a market is in a normal bull market correction,it should find new support around its 200-day average. [For short-term trading purposes, traders will employ a 20-day average to spot short-term
trend changes].
Bollinger Bands
These are trading bands plotted two standard deviations above and below a 20-day moving average. When a market touches (or exceeds) one of the trading bands, the market is considered to be over-extended. Prices will often pull back to the moving average line.
Moving Average Convergence Divergence (MACD)
The MACD is a popular trading system. On your computer screen, you’ll see two weighted moving averages (weighted moving averages give greater weight to the more recent price action).Trading signals are given when the two lines cross.
Monday, July 26, 2010
Monday, July 19, 2010
11. USING A TOP-DOWN MARKET APPROACH
The idea of beginning one’s analysis with a broader view and gradually narrowing one’s focus has another important application in the field of market analysis.That has to do with utilizing a “top-down” approach to analyzing the stock market. This approach utilizes a three-step approach to finding winning stocks. It starts with an overall market view to determine whether the stock market is moving up or down, and whether this is a good time to be investing in the market. It then breaks the stock market down into market sectors and industry groups to determine which parts of the stock market look the strongest. Finally, it seeks out leading stocks in those leading sectors and groups.
THE FIRST STEP: The Major Market Averages
The intent of the first step in the “top-down” approach is to determine the trend of the overall market. The presence of a bull market (a rising trend) is considered a good time to invest funds in the stock market. The presence of a bear market (a falling trend) might suggest a more cautious approach to the stock market. In the past, it was possible to look at one of several major market averages to gauge the market’s trend. That was because most major averages usually trended in the same direction. That hasn’t always been the case in recent history however. For that reason, it’s important to have some familiarity with the major market averages, and to know what each one actually measures.
Different Averages Measure Different Things
The traditional blue chip averages—like the Dow Jones Industrial Average, the NYSE Composite Index, and the S&P 500—generally give the best measure of the major market trend.The Nasdaq Composite Index,by contrast, is heavily influenced by technology stocks.While the Nasdaq is a good barometer of trends in the technology sector, it’s less useful as a measure of the overall market trend.The Russell 2000 Index measures the performance of smaller stocks. For that reason, it’s used mainly to gauge the performance of that sector of the market. The Russell is less useful as a measure of the broader market which is comprised of larger stocks. Since most of these market averages are readily available in the financial press and on the Internet,it’s usually a good idea to keep an eye on all of them.The strongest signals about market directions are given when all or most of the major market averages are trending in the same direction (See Figure 11-1).
THE SECOND STEP: Sectors and Industry Groups
The stock market is divided into market sectors which are subdivided further into industry groups. There are ten market sectors, which include Basic Materials, Consumer Cyclicals,
Consumer Non-Cyclicals, Energy, Financial, Healthcare, Industrial, Technology, Telecommunications, and Utilities. Each of those sectors can have as many as a dozen or more industry groups. For example, some groups in the Technology sector are
Computers, the Internet, Networkers, Office Equipment, and Semiconductors. The Financial sector includes Banks, Insurance, and Securities Brokers. The recommended way to approach this group is to start with the smaller number of market sectors. Look for the ones that seem to be the strongest.During most of 1999 and into the early part of 2000, for example, technology stocks represented the strongest market sector. Once you’ve isolated the preferred sector, you can then look for the strongest industry groups in that sector.Two leading candidates during the period of time just described were Internet and Semiconductor stocks. The idea is to be in the strongest industry groups within the strongest market sectors (See Figure 11-2). For many investors, the search can stop there.The choice to be in a market sector or industry group can easily be imple-
mented through the use of mutual funds that specialize in specific market sectors or industry groups.
THE THIRD STEP: Individual Stocks
For those investors who deal in individual stocks, this is the third step in the “top-down”market approach. Having isolated an industry group that has strong upside potential, the trader can then look within that group for winning stocks. It’s been estimated that as much as 50% of a stock’s direction is determined by the direction of its industry group. If you’ve already found a winning group, your work is half done. Another advantage of limiting your stock search to winning sectors and groups is that it narrows the search considerably.
There are as many as 5,000 stocks that an investor can choose from. It’s pretty tough doing a market analysis of so many mar-
kets.Some sort of screening process is required.That’s where the three-step process comes in.By narrowing your stock search to a small number of industry groups, the number of stocks you have to study is dramatically reduced.You also have the added comfort of knowing that each stock you look at is already part of a winning group (See Figure 11-3).
THE FIRST STEP: The Major Market Averages
The intent of the first step in the “top-down” approach is to determine the trend of the overall market. The presence of a bull market (a rising trend) is considered a good time to invest funds in the stock market. The presence of a bear market (a falling trend) might suggest a more cautious approach to the stock market. In the past, it was possible to look at one of several major market averages to gauge the market’s trend. That was because most major averages usually trended in the same direction. That hasn’t always been the case in recent history however. For that reason, it’s important to have some familiarity with the major market averages, and to know what each one actually measures.
Different Averages Measure Different Things
The traditional blue chip averages—like the Dow Jones Industrial Average, the NYSE Composite Index, and the S&P 500—generally give the best measure of the major market trend.The Nasdaq Composite Index,by contrast, is heavily influenced by technology stocks.While the Nasdaq is a good barometer of trends in the technology sector, it’s less useful as a measure of the overall market trend.The Russell 2000 Index measures the performance of smaller stocks. For that reason, it’s used mainly to gauge the performance of that sector of the market. The Russell is less useful as a measure of the broader market which is comprised of larger stocks. Since most of these market averages are readily available in the financial press and on the Internet,it’s usually a good idea to keep an eye on all of them.The strongest signals about market directions are given when all or most of the major market averages are trending in the same direction (See Figure 11-1).
THE SECOND STEP: Sectors and Industry Groups
The stock market is divided into market sectors which are subdivided further into industry groups. There are ten market sectors, which include Basic Materials, Consumer Cyclicals,
Consumer Non-Cyclicals, Energy, Financial, Healthcare, Industrial, Technology, Telecommunications, and Utilities. Each of those sectors can have as many as a dozen or more industry groups. For example, some groups in the Technology sector are
Computers, the Internet, Networkers, Office Equipment, and Semiconductors. The Financial sector includes Banks, Insurance, and Securities Brokers. The recommended way to approach this group is to start with the smaller number of market sectors. Look for the ones that seem to be the strongest.During most of 1999 and into the early part of 2000, for example, technology stocks represented the strongest market sector. Once you’ve isolated the preferred sector, you can then look for the strongest industry groups in that sector.Two leading candidates during the period of time just described were Internet and Semiconductor stocks. The idea is to be in the strongest industry groups within the strongest market sectors (See Figure 11-2). For many investors, the search can stop there.The choice to be in a market sector or industry group can easily be imple-
mented through the use of mutual funds that specialize in specific market sectors or industry groups.
THE THIRD STEP: Individual Stocks
For those investors who deal in individual stocks, this is the third step in the “top-down”market approach. Having isolated an industry group that has strong upside potential, the trader can then look within that group for winning stocks. It’s been estimated that as much as 50% of a stock’s direction is determined by the direction of its industry group. If you’ve already found a winning group, your work is half done. Another advantage of limiting your stock search to winning sectors and groups is that it narrows the search considerably.
There are as many as 5,000 stocks that an investor can choose from. It’s pretty tough doing a market analysis of so many mar-
kets.Some sort of screening process is required.That’s where the three-step process comes in.By narrowing your stock search to a small number of industry groups, the number of stocks you have to study is dramatically reduced.You also have the added comfort of knowing that each stock you look at is already part of a winning group (See Figure 11-3).
Monday, July 12, 2010
10. USING DIFFERENT TIME FRAMES FOR SHORT- AND LONG-TERM VIEWS
Bar chart analysis is not limited to daily bar charts.Weekly and monthly charts provide a valuable long-term perspective on market history that cannot be obtained by using daily charts alone.The daily bar chart usually shows up to twelve months of price history for each market.Weekly charts show almost five years of data, while the monthly charts go
back over 20 years (See Figure 10-1).
By studying these charts,the chartist gets a better idea of longterm trends,where historic support and resistance levels are located, and is able to obtain a clearer perspective on the more recent action revealed in the daily charts. These weekly and monthly charts lend themselves quite well to standard chart analysis described in the preceding pages. The view held by some market observers that chart analysis is useful only for short-term analysis and timing is simply not true.The principles of chart analysis can be used in any time dimension.
Using Intraday Charts
Daily and weekly charts are useful for intermediate- and longterm analysis. For short-term trading, however, intraday charts
are extremely valuable. Intraday charts usually show only a few days of trading activity. A 15-minute bar chart, for example, might show only three or four days of trading.A 1-minute or a 5-minute chart usually shows only one or two days of trading respectively, and is generally used for day-trading purposes. Fortunately, all of the chart principles described herein can also be applied to intraday charts (See Figure 10-2).
Going From the Long Term to the Short Term
As indispensable as the daily bar charts are to market timing and analysis, a thorough chart analysis should begin with the monthly and weekly charts—and in that order.The purpose of
that approach is to provide the analyst with the necessary longterm view as a starting point. Once that is obtained on the 20-year monthly chart, the 5-year weekly chart should be consult-
ed.Only then should the daily chart be studied. In other words, the proper order to follow is to begin with a solid overview and then gradually shorten the time horizon. (For even more microscopic market analysis, the study of the daily chart can be followed by the scrutiny of intraday charts.)
back over 20 years (See Figure 10-1).
By studying these charts,the chartist gets a better idea of longterm trends,where historic support and resistance levels are located, and is able to obtain a clearer perspective on the more recent action revealed in the daily charts. These weekly and monthly charts lend themselves quite well to standard chart analysis described in the preceding pages. The view held by some market observers that chart analysis is useful only for short-term analysis and timing is simply not true.The principles of chart analysis can be used in any time dimension.
Using Intraday Charts
Daily and weekly charts are useful for intermediate- and longterm analysis. For short-term trading, however, intraday charts
are extremely valuable. Intraday charts usually show only a few days of trading activity. A 15-minute bar chart, for example, might show only three or four days of trading.A 1-minute or a 5-minute chart usually shows only one or two days of trading respectively, and is generally used for day-trading purposes. Fortunately, all of the chart principles described herein can also be applied to intraday charts (See Figure 10-2).
Going From the Long Term to the Short Term
As indispensable as the daily bar charts are to market timing and analysis, a thorough chart analysis should begin with the monthly and weekly charts—and in that order.The purpose of
that approach is to provide the analyst with the necessary longterm view as a starting point. Once that is obtained on the 20-year monthly chart, the 5-year weekly chart should be consult-
ed.Only then should the daily chart be studied. In other words, the proper order to follow is to begin with a solid overview and then gradually shorten the time horizon. (For even more microscopic market analysis, the study of the daily chart can be followed by the scrutiny of intraday charts.)
Friday, July 9, 2010
9. THE INTERPRETATION OF VOLUME
Chartists employ a two-dimensional approach to market analysis that includes a study of price and volume. Of the two,price is the more important.However,volume provides important secondary confirmation of the price action on the chart and often gives advance warning of an impending shift in trend (See Figure 9-1).
Volume is the number of units traded during a given time period,which is usually a day.It is the number of common stock shares traded each day in the stock market.Volume can also be
monitored on a weekly basis for longer-range analysis.
When used in conjunction with the price action,volume tells us something about the strength or weakness of the current price trend.Volume measures the pressure behind a given price
move. As a rule, heavier volume (marked by larger vertical bars at the bottom of the chart) should be present in the direction of the prevailing price trend. During an uptrend, heavier
volume should be seen during rallies, with lighter volume (smaller volume bars) during downside corrections. In downtrends, the heavier volume should occur on price selloffs. Bear
market bounces should take place on a lighter volume.
Volume Is an Important Part of Price Patterns
Volume also plays an important role in the formation and resolution
to diminish as price patterns form.The subsequent breakout that
On-Balance Volume (OBV)
Market analysts have several indicators to measure trading
sus downside volume.Each day that a market closes higher, that
is usually a bearish sign.
Plotting OBV
The OBV line is usually plotted along the bottom of the price
OBV line is flat or falling, that means there may not be enough
OBV Breakouts
During periods of sideways price movement, when the market
breakout in the OBV line should catch the trader’s eye and
volume is sometimes an early warning of an emerging uptrend
Other Volume Indicators
There are many other indicators that measure the trend of
they’re more complex in their calculations, they all have the
same intent —to determine if the volume trend is confirming,
or diverging from, the price trend.
Volume is the number of units traded during a given time period,which is usually a day.It is the number of common stock shares traded each day in the stock market.Volume can also be
monitored on a weekly basis for longer-range analysis.
When used in conjunction with the price action,volume tells us something about the strength or weakness of the current price trend.Volume measures the pressure behind a given price
move. As a rule, heavier volume (marked by larger vertical bars at the bottom of the chart) should be present in the direction of the prevailing price trend. During an uptrend, heavier
volume should be seen during rallies, with lighter volume (smaller volume bars) during downside corrections. In downtrends, the heavier volume should occur on price selloffs. Bear
market bounces should take place on a lighter volume.
Volume Is an Important Part of Price Patterns
Volume also plays an important role in the formation and resolution
of price patterns. Each of the price patterns described
previously has its own volume pattern.As a rule, volume tends
to diminish as price patterns form.The subsequent breakout that
resolves the pattern takes on added significance if the price
breakout is accompanied by heavier volume. Heavier volume
accompanying the breaking of trendlines and support or resistance
levels lends greater weight to price activity (See Figure 9-2).
On-Balance Volume (OBV)
Market analysts have several indicators to measure trading
volume. One of the simplest, and most effect, is on-balance volume
OBV). OBV plots a running cumulative total of upside ver-
sus downside volume.Each day that a market closes higher, that
day’s volume is added to the previous total. On each down day,
the volume is subtracted from the total. Over time, the on-balance
volume will start to trend upward or downward. If it
trends upward, that tells the trader that there’s more upside
than downside volume, which is a good sign.A falling OBV line
is usually a bearish sign.
Plotting OBV
The OBV line is usually plotted along the bottom of the price
chart. The idea is to make sure the price line and the OBV line
are trending in the same direction. If prices are rising, but the
OBV line is flat or falling, that means there may not be enough
volume to support higher prices. In that case, the divergence
between a rising price line and a flat or falling OBV line is a negative
warning (See Figure 9-3).
OBV Breakouts
During periods of sideways price movement, when the market
trend is in doubt, the OBV line will sometimes break out
first and give an early hint of future price direction.An upside
breakout in the OBV line should catch the trader’s eye and
cause him or her to take a closer look at the market or stock in
question.At market bottoms, an upside breakout in on-balance
volume is sometimes an early warning of an emerging uptrend
(See Figure 9-4).
Other Volume Indicators
There are many other indicators that measure the trend of
volume—with names like Accumulation Distribution, Chaikin
Oscillator, Market Facilitation Index, and Money Flow. While
they’re more complex in their calculations, they all have the
same intent —to determine if the volume trend is confirming,
or diverging from, the price trend.
8. PERCENTAGE RETRACEMENTS
Market trends seldom take place in straight lines.Most trend pictures show a series of zig-zags with several corrections against the existing trend.These corrections usually fall into certain predictable percentage parameters. The best-known example of this is the fifty-percent retracement. That is to say, a secondary, or intermediate, correction against a major uptrend often retraces about half of the prior uptrend before the bull trend is again resumed. Bear market bounces often recover about half of the prior downtrend.
A minimum retracement is usually about a third of the prior trend. The two-thirds point is considered the maximum retracement that is allowed if the prior trend is going to resume. A retracement beyond the two-thirds point usually warns of a trend reversal in progress. Chartists also place importance on retracements of 38% and 62% which are called Fibonacci retracements.
A minimum retracement is usually about a third of the prior trend. The two-thirds point is considered the maximum retracement that is allowed if the prior trend is going to resume. A retracement beyond the two-thirds point usually warns of a trend reversal in progress. Chartists also place importance on retracements of 38% and 62% which are called Fibonacci retracements.
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