The Technical Edge Page 1

The Technical Edge

INDICATORS

Technical analysis relies on the study of a range of indicators. These come in many specific

types, based on calculations or price patterns. For those using charting services, the calculations

are built in to charts automatically.

A tremendous advantage in charting is that many signals provide not only pattern signals,

but highly visible tendencies, trends and patterns. The combined observation of price indicators

with other, non-price indicators, strengthens the reliability and timing of the entire process.

Part 1. Indicator types: price, volume, and moving averages and momentum

There are four broad classes of indicators. These are based on price, volume. moving average

and momentum.

Price indicators identify cause and effect of price patterns. While many charting

techniques in both Western technical and Eastern (candlestick) analysis identify reversal or

continuation, many non-price indicators are helpful in providing overview and confirmation of

the signals first identified in price.

Volume indicators reveal changes in the price trend based on averaging of volume trends

and separation between buyer-dominated or seller-dominated volume trends. Volume signals

often precede price movement, so noticing a change in volume levels may signal coming reversal

in price. This includes the easily spotted volume spike as well as several calculated volume-

based indicators.

Moving averages tend to lag behind price, since they are no more than a smoothing of

recent price trends. However, moving average patterns may lead at times, and at the very least

provide confirmation of price signals.

Momentum oscillators measure the speed and strength of change in trends, but not a

trend’s direction. Many oscillators provide confirmation of what price and volume trends

forecast.

The range of price indicators

Some indicators are hybrids between price and volatility, or between price and volume. These

include the average true range (ATR) and accumulation/distribution (A/D).

Average true range measures volatility as a primary test of price stability. This is an

alternative to the isolated analysis of only the price trend. Other signals can be used to track trend

direction and momentum, with ATR as a confirmation signal for the price volatility (risk) within

the trend. ATR is a reliable confirming indicator in many situations in which price appears to be

signaling reversal, but lacking confirmation in volume signals or momentum.

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ATR is an exponential moving average (EMA) of a specified number of trading sessions

based on a stock’s “true range.” The default period is 14 days.

True range is broadly defined as an extended trading breadth from the previous day’s

close to the current day’s close (as opposed to a single session’s trading range). The “true range”

is the current session’s high price minus low price:

high – low = TR

This TR net price change is used to update average true range, for which the full calculation is:

( ( prior ATR x 13 ) + current TR ) ÷ 14 = ATR

The focus on ranges is central to ATR analysis. Range summarizes activity and participation

among traders, representing volatility within the price pattern. This is the key to ATR’s value.

Changes in price, whether directional or range-bound, only reflect the current trending and price

tendencies. ATR further measures a degree of volatility in the price, providing the averaged true

range not only from open to close, but from high to low over a period of time. The greater the

ATR, the greater the assumed level of enthusiasm among buyers (in an uptrend) or sellers (in a

downtrend). So the ATR trend has to be viewed in this context. It does not imply bullish or

bearish movement, but does measure the level of strength on one side or the other.

If the range begins to decline as the trend evolves, it provides a forecast that the trend

may be slowing down. This “early warning” often precedes other reversal or momentum signals.

The chart of Aflac (AFL) demonstrates how ATR is used as a confirming price indicator,

and may actually precede changes in price direction. The initial downtrend did not signal any

specific weakening in a review of price. However, the ATR line began strengthening to the

upside well before the price downtrend concluded. This provided a divergence between the price

trend and ATR. The downtrend ending and reversed to the upside. The reversal point occurred

with the triple volume spike starting at the end of January. This significant volume signal was the

true turning point in the trend. However, as a reversal, confirmation did not occur until ATR

began its descent. This created a second divergence period, with the price uptrend in

contradiction to declining strength in ATR.

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Based on price alone, no obvious signals revealed a coming change in the price trend.

However, ATR weakened throughout the bullish period. This was a cautionary signal that the

uptrend could end suddenly. In fact, by mid-April, momentum revealed overbought conditions,

and by May (beyond the period of this chart), price stopped advanced and moved into a

consolidation trend.

Another indicator measuring buying and selling interest along with price, is

accumulation/distribution (A/D). This can be termed a volume indicator because its index value

is based on volume flow; however, it also tends to confirm price trends.

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A/D serves as a price measurement even though it contains elements of momentum and

volume. The A/D formula is:

( ( Close – Low ) - ( High – Close ) ) ÷ ( High – Low ) x Volume

This calculation is applied to each session and then added to or subtracted from the cumulative

index value. An analysis of the formula reveals how price, volume and momentum all come into

play in the A/D line.

The index moves between a range of +1 and -1. When the line moves into positive

territory, buying pressure is greater than selling pressure; and the opposite is in effect when the

index value moves into negative territory.

The chart of Motorola Solutions (MSI) demonstrates how the A/D line interacts with

price. Increasing sell pressure matches the price decline, confirming the likely continuation of

the downtrend. As the A/D line levels out, it signals the likely end of the downtrend and coming

reversal. This is confirmed by the bullish candlestick signal, the morning star.

Price next moves into a new bullish trend as anticipated by A/D and the candlestick. As

price advances, the continuation of the bull trend is confirmed by the A/D line.

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Volume indicators

Volume indicators confirm price direction and often precede a strong reversal. The most easily

spotted of these is the price spike.

A spike occurs when:

1. Volume jumps far above the average of typical trading sessions.

2. The volume level immediately returns to previously set levels and does not recur.

3. The significance of the spike is confirmed in price reversal.

An example of the volume spike is seen in the chart of Polo Ralph Lauren (RL). The prominent

spike is isolated and exceptional, and follows an uptrend. The reversal is confirmed by the

downward gap and long black candle session. Further confirmation is also seen in the movement

of momentum into oversold territory, in the Relative Strength Index (RSI) oscillator.

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These signals collectively point to a strong example of how the volume spike often is

found at the moment of reversal. The spike, price gap, candlestick, and momentum signals all

confirm the change in direction. Although the downtrend was short-term, it moved price down

25 points in only one week.

Several additional volume indicators are worth tracking, and both act as leading

indicators, signaling coming reversal before price confirms the change.

On-balance volume (OBV) is the calculated sum of total volume for a session, identified

as “up” or “down.” Up volume is given positive value and down volume is given negative value.

A flaw in this is that “up” or “down” are applied whether the dominance of one side is

fractional or very large. So when volume levels are very close on each side, the OBV trend can

be distorted. OBV measures buying and selling interest on a cumulative basis rather than in the

use of a set period of consecutive sessions.

The calculation adds volume when the price closes above the previous close, and

subtracts volume when price closes below:

Higher close:

Previous OBV + current session’s volume = Current OBV

or lower close:

Previous OBV – current session’s volume = Current OBV

When the price closes at the same level as the previous day, OBV is not changed.

The theory behind OBV is that volume precedes price, an observation shared by the Dow

Theory. When this is true, OBV should anticipate rising or falling prices based on the cumulative

direction. However, because no distinction is made between large or small differences in the

price movement or in levels of volume, OBV can become distorted.

OBV, as a cumulative indicator, lacks an absolute value. Its purpose is found in the

comparison between he OBV trend and the price trend. If OBV indicates a change in direction

before price, it could be an initial reversal indicator. Upon recognizing confirmation in other

indicators, traders can time trades in advance of the actual price reversal. However, this signal

should be used sparingly and requires confirmation. The distortion of OBV is especially likely if

a volume spike appears, as this could cause the OBV line to yield a false signal.

The chart of Kimberly Clark (KMB) shows how OBV interacts with price. This chart

revealed bullish movement in OBV before the price trend began. As prices advanced, OBV

stopped its upward movement and signaled a bearish reversal a full month before price dropped.

Although this set of signals appears to reliably anticipate price reversal in advance of price itself,

the indicator should be used only with strong confirmation from price reversal signals,

momentum, and other indicators.

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A second important volume trend is money flow index (MFI). This expands on OBV by

calculating overbought or oversold conditions in price, making MFI an excellent indicator for

timing of entry and exit. The moving average of MFI is most often expressed over the most

recent 14 trading sessions.

As a volume-weighted version of the Relative Strength Index (RSI), money flow is

calculated as positive with rising prices, and negative with declining prices. The ratio between

positive and negative in then taken into a calculation, normally on a 21-day period, to set up an

oscillator with index value between zero and 100. While momentum oscillators generally track

the speed and strength of price trends, the money flow oscillator created by MFI tracks the

volume trend rather than price, based on 14 periods. This adjustment and calculation solves the

greatest problem of OBV, with its lack of distinction between large and small variations in

volume.

The calculation of MFI replies on four steps:

1. ( High + low + close ) ÷ 3 = Typical price

2. Typical price x volume = Raw money flow (RMF)

3. ( 14-period positive money flow ) ÷ ( 14-period negative money flow)

= Money flow ratio (MFR)

4. 100 – ( 100 ÷ ( 1 + MFR ) ) = MFI

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The raw money flow (RMF) is equivalent to dollar volume, since volume has been multiplied

by price.

Overbought/oversold levels highlight trend movement that is not likely to last. With

both RSI and MFI, movement of the index above 80 (overbought) or below 20 (oversold)

forecast a change back into mid-range between 20 and 80. These index values can be adjusted

to yield more signals by reducing the time period, or fewer signals by recognizing 90 and 10 in

place of 80 and 20.

For example, Southwest Gas (SWX) first signaled a likely change in the initial

downtrend with a strong move by the MFI into oversold territory. This preceded a price move,

and was immediately confirmed by a bullish engulfing signal. A bullish trend followed. During

the trend on this chart, no further indication from MFI signaled a reversal of the trend.

This lack of any MFI signal adds confidence in the bullish trend. The result: for those

holding SWX shares, there was no immediate indication to sell; and for those thinking of buying,

there was no indication that timing justified that decision. It made more sense to wait until price

once again fell to a point where the price per share would be a bargain.

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A related signal is the Chaikin Money Flow (CMF), a measurement of money flow

volume over 21 days. The indicator derived from this reveals movement above or below a zero

line, an oscillator of volume trends. The formula:

The calculation of CMF involves the following three steps:

1. ( ( Close – low ) - (High – close ) ) ÷ ( High – low ) = Multiplier

2. Multiplier x volume for the session = MF Volume

3. MF Volume for 21 sessions ÷ volume for 21 periods = CMF

The movement of the indicator across the zero line can be interpreted as the change in money

flow, with movement above zero pointing to a positive trend, and close below as a negative. As

a test of buying and selling pressure, CMF identifies the current bias or domination by either

buyers or sellers, so an extended trend in either direction is a strong signal. The CMF line tends

to cross frequently rather than setting longer-term trends favoring either buyers or sellers. This

is the consequence of applying a 21-period net change between up volume and down volume.

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An example of CMF was found on the chart of Big Lots (BIG). The pattern on this chart

demonstrates the tendency of CMF to cross the middle line often. However, in this case the

move from bearish to bullish seen in CMF precedes the actual price reversal by eight sessions.

The bullish crossover was confirmed by the double bottom occurring at the point where price

lagged and finally reversed to the upside.

Another indicator is the Chaikin oscillator, which is different than the Chaikin Money Flow

(CMF). This measures 3-day EMA changes in the A/D. It should anticipate changes in price

direction based on how the average shifts as anticipating a price change to follow. The

analytical base is the A/D line introduced earlier. The oscillator points to movement above or

below a zero line.

The first step in developing the oscillator is to calculate the A/D line. As explained in

the discussion of the A/D line, the initial calculation is:

( ( Close – Low ) - ( High – Close ) ) ÷ ( High – Low ) x Volume

This is added to or subtracted from the cumulative A/D previously calculated. The Chaikin

oscillator starts with this A/D line calculation and then makes a final additional calculation:

3-day EMA of A/D - 1-day EMA of A/D = Chaikin oscillator

This creates a separate oscillator that identifies the variation of A/D. It modifies A/D as a

cumulative indicator to identify the more immediate changes in the price trend. The indication is

positive when the oscillator closes in the top half of the high-low range, and negative when it

appears below.

An example of the oscillator is seen on the chart of General Mills (GIS). The complexity

of the oscillator calculation is reduced to a single line tracking strength or weakness of the

prevailing trend.

The bullish trend beginning in February and ending in April is highlighted on the chart,

along with the Chaikin oscillator, also trending higher and remaining in the upper half of the zero

line. Only when this oscillator line descends to or below the line is a reversal confirmed.

However, this is a lagging indicator, which is demonstrated on the chart. The oscillator decline

begins only after price had peaked. So the oscillator in this case is not predictive, but it is

confirming.

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Part 2. Crossover and divergence

Any signal may exhibit crossover and divergence tendencies. A crossover is most likely seen

with the use of multiple moving averages, or with momentum oscillators involving more than

one averaging line. These include MACD and Stochastics.

A crossover is a flag that should not be ignored. It points to a change from bullish to

bearish or vice versa. It may also point to the emergence of a dynamic trend after a period of

consolidation.

The problem in analysis of crossovers is that the signals often are lagging indicators. So

relying on crossover to generate a trade is not effective. However, crossover is a strong form of

confirmation when a price, volume or moving average signal has been spotted, and crossover

confirms what is discovered.

Crossover may present a different situation, however. When a crossover points to a

reversal but price continues in the same direction or even in the direction opposite of the

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crossover, it is a moment of divergence. This is seen both in volume and momentum signals, and

knowing how to handle divergence is essential in order to manage the chart and identify both

risks and opportunities.

An example of divergence between price and OBV was seen on the chart of Colgate

Palmolive (CL). The price trend moved strongly upward over a period of three months.

However, the apparent strength of this trend was not reflected in OBV, which remained flat for

the first half of the bullish trend before finally moving upward to indicate strength.

Most analysts would point to this situation as a bearish divergence. OBV contradicts

price, pointing to a likely reversal over an extended period of time. That reversal did not occur.

In fact, as the bullish trend concluded after three months, OBV once again diverged, moving

gradually higher. This implies a growing level of strength in the uptrend, even though price did

not move from its level of approximately $70 per share on this chart for two months beyond.

This divergence analysis points out the weakness in lagging indicators. OBV in this

example was not responsive to the price trend, either while it developed or at its conclusion. For

this reason, divergence has to be confirmed by other indicators; or when no confirmation is

located, it should be ignored and acknowledged only as a misleading signal.

However, when divergence appears even without confirmation, it should lead to close

tracking of the prevailing price trend and analysis of any signals that might emerge over time.

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Because many volume and momentum signals are lagging, they are not reliable on their own as a

signal of immediate reversal. This also applies to moving average divergence. In a perfect situation, OBV and other signals behave exactly as they are predicted to. OBV does

tend to track price closely, but that only confirms the prevailing trend and does not predict a

change until OBV begins to slow down. The same cautionary point applies to all indicators in

comparison to price.

Part 3. Directional indicators

A directional indicator is intended to identify how movement of price predicts trend direction

and duration. The average directional index (ADX) tracks trend strength much like a momentum

oscillator, regardless of direction.

A positive signal is produced when the current session’s high minus the previous

session’s high, nets to a level greater than the previous low minus the current low:

CH – PH > PL – CL = +DI

when CH = current high

PH = previous high

PL = previous low

CL = current low

+DM = positive directional indicator

The opposite is true when the high comparison is lower than the low comparison:

PL – CL > CH – PR = -DI

when PL = previous low

CL = current low

CH = current high

PH = previous high

-DM = negative directional indicator

To calculate all of these tracking indicators, the starting point is true range (TR), introduced

earlier. TR formula is used to discover ATR, and the calculation of ADX is very similar. The

+DI and -DI can be included on the indicator for ADX, or ADX and be tracked as a solitary

line and compared to the price trend. For example, on the chart of Caterpillar, the clearly

identified downtrend and uptrend are accompanied by changing ADX levels. This indicator

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rises with the downtrend, indicating strength in that trend. However, as the bullish reversal

begins, ADX declines for the first half, indicating weakness in that trend.

Another version of the same charts adds in +DI (in green) and -DI (in red). This has the

effect of smoothing out the original ADX line, but also makes the overall indicator more

difficult to read and interpret. However, the +DI line (green) does appear to accurately track

the trend direction, notably the bullish trend.

A related secondary indicator can be taken from this more complex version of ADX

with all three versions on the same chart. The points of intersection between the three lines

appears to coincide with trend turning points and even to anticipate them in advance. As a

confirming indicator, this may be applied to anticipate reversal, assuming that strong

confirmation is also discovered. It is further noteworthy that these intersections are at or

above the index value of 25. This is the point considered strong enough to confirm the

directional indication.

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The 25 index level confirms a trending price pattern. whether bullish or bearish. Crossover is at

the core of this analysis. Using the 25 index value as the crossover point, the following

observations are applied in directional analysis: When +DI crosses above -DI, it is considered a

bullish signal. And when it crosses below it is viewed as bearish.

A very brief crossover in either direction should be overlooked and interpreted as a non-

signal. However, if crossover remains in place, then the crossover signal is confirmed. For

example, on the previous chart, +DI moves below -DI at the beginning of December in advance

of the bearish trend developed two weeks later. And +DI crosses above -DI in the beginning of

February, remaining above for the remainder of the chart and confirming a bullish tendency in

the price pattern.

In addition to recognizing brief and frequent crossovers as signal “chatter” versus

longer-term crossover as confirmed trend movements, additional confirmation should be

identified as well. This may occur in the form of candlesticks, Western technical signals, MA,

momentum, or volume signals.

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Part 4. Using indicators with candlestick chart reversal signals

In add types of indicators, a coordination between the signal and candlesticks is an essential

aspect of effective trade timing. No signal should be used by itself as a prompt for either entering

or exiting a trade; confirmation should be located as well.

A reliable system begins with identification of a candlestick signal, along with

confirmation in other signal forms. As an alternative, an initial non-price signal may be

confirmed by candlesticks. This observation does not mean that candlesticks are required as part

of a signal-generated system. However, it is often the case that candlesticks are the prominent or

leading initial signal.

For example, the emergence of wedges presents a particular challenge in chart analysis.

Wedges are very close in design to triangles, but the meaning of each is opposite. A rising wedge

is a bearish reversal, but the similar ascending triangle is a bullish continuation/. And a falling

wedge is a bullish reversal, compared to the descending triangle, which is a bearish continuation

signal. A slight adjustment of the pattern completely changes the meaning of the signal. So with

signals such as wedges, a candlestick confirmation signal is essential.

The similarity in the two signals is summarized in the graph below. Note the close design

of the rising wedge’s upper line and the flat upper line of the ascending triangle. The same

similarity is seen in the falling wedge’s bottom line and the bottom line of the descending

triangle.

An example of a Western reversal signal with candlestick confirmation is seen on the

chart of Chevron (CVX). The rising wedge consists of both resistance and support trending

higher but narrowing. This pattern appeared in the month of December. At the wedge concluded,

a double candlestick bearish signal confirmed the next move. Two three outside down signals

added great strength to the bearish rising wedge.

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A second example appeared with the bullish falling wedge. This is characterized by both

resistance and support declining while the range narrows. The likely bullish move was confirmed

by the bullish piercing lines. Immediately after this, the new bullish trend began.

Conclusion

Confirmation is essential to all indicators. Reversal may seem a certainty, but many false signals

can easily mislead traders.

This is why Western indicators, even exceptionally strong ones like double tops or

bottoms, head and shoulders, or gapping price patterns, need to be confirmed. Candlestick

reversal indicators are at the core of reversal and confirmation and using these as a starting point

will improve timing of trade entry and exit.