Average True Range (ATR)

Introduction

Developed by J. Welles Wilder and introduced in his book, New Concepts in Technical Trading Systems (1978), the Average True Range (ATR) indicator measures a security's volatility. As such, the indicator does not provide an indication of price direction or duration, it simply shows the degree of price movement or volatility.

As with most of his indicators, Wilder designed ATR with commodities and daily prices in mind. In 1978, commodities were frequently more volatile than stocks. They were (and still are) often subject to gaps and limit moves. (A limit move occurs when a commodity opens up or down its maximum allowed move for the session.) The resulting bar or candlestick would simply be a small dash.) In order to accurately reflect the volatility associated with commodities, Wilder sought to account for gaps, limit moves, and small high-low ranges in his calculations. A volatility formula based on only the high-low range would fail to capture the actual volatility created by the gap or limit move.

True Range

Wilder started with a concept called True Range (TR), which is defined as the greatest of the following:

• Current High less the current Low
• Current High less the previous Close (absolute value)
• Current Low less the previous Close (absolute value)

Absolute values are used to insure positive numbers. After all, we are interested in measuring the distance between these two points. If the current high-low range is large, chances are it will be used as the True Range. If the current high-low range is small, one of the other two methods would likely be used to calculate the True Range. The last two possibilities usually arise when the previous close is greater than the current high (signaling a potential gap down or limit move) or the previous close is lower than the current low (signaling a potential gap up or limit move). The high-low range is used as the TR for day one because it is impossible to use the previous close for the first day.

Example A: A small high/low range formed after a gap up. The TR equals the absolute value of the difference between the current high and the previous close.

Example B: A small high/low range formed after a gap down. The TR equals the absolute value of the difference between the current low and the previous close.

Example C: Even though the current close is within the previous high/low range, the current high/low range is quite small. In fact, it is smaller than the absolute value of the difference between the current high and the previous close, which is used to value the TR.

Calculation

Typically, the Average True Range (ATR) is based on 14 periods and can be calculated on an intraday, daily, weekly or monthly basis. For this example, the ATR will be based on daily data. Because there must be a beginning, the first TR value in a series is simply the High minus the Low, and the first 14-day ATR is the average of the daily TR values for the last 14 days. After that, Wilder sought to smooth the data set, by incorporating the previous period's ATR value.

             
Current ATR = [(Prior ATR x 13) + Current TR] / 14

- Multiply the previous 14-day ATR by 13.
- Add the most recent day's TR value.
- Divide the total by 14

Click here for an Excel Spreadsheet showing the start of an ATR calculation for QQQQ.

In the Spreadsheet example, the first True Range value (.91) equals the High minus the Low (yellow cells). The first 14-day ATR value (.56)) was calculated by finding the average of the first 14 True Range values (blue cell). Subsequent ATR values were smoothed using the formula above. The spreadsheet values correspond with the yellow area on the chart below. Notice how ATR surged as QQQQ plunged in May with many long candlesticks.

For those trying this at home, a few caveats apply. First, ATR values depend on where you begin. The first True Range value is simply the current High minus the current Low and the first ATR is an average of the first 14 True Range values. The real ATR formula does not kick in until day 15. Even so, the remnants of these first two calculations linger and slightly affect ATR values. Spreadsheet values for a small subset of data may not match exactly with what is seen on the price chart. Decimal rounding can also slightly affect ATR values.

Absolute ATR

ATR is based on the True Range, which uses absolute price changes. As such, ATR reflects volatility as absolute level. In other words, ATR is not shown as a percentage of the current close. This means low priced stocks will have lower ATR values than high price stocks. For example, a $20-30 security will have much lower ATR values than a $200-300 security. Because of this, ATR values are not comparable. Even large price movements for a single security, such as a decline from 70 to 20, can make long-term ATR comparisons impractical. Chart 4 shows Google with double digit ATR values and chart 5 shows Microsoft with ATR values below 1. Despite different values, their ATR lines have similar shapes.

Conclusions

ATR is not a directional indicator, such as MACD or RSI. Instead, ATR is a unique volatility indicator that reflects the degree of interest or disinterest in a move. Strong moves, in either direction, are often accompanied by large ranges, or large True Ranges. This is especially true at the beginning of a move. Uninspiring moves can be accompanied by relatively narrow ranges. As such, ATR can be used to validate the enthusiasm behind a move or breakout. A bullish reversal with an increase in ATR would show bullish enthusiasm and reinforce the reversal. A bearish support break with an increase in ATR would show strong selling pressure and reinforce the support break.

Source:http://stockcharts.com/

Average Directional Index (ADX)

Introduction

J. Welles Wilder developed the Average Directional Index (ADX) to evaluate the strength of a current trend, be it up or down. It's important to determine whether the market is trending or trading (moving sideways), because certain indicators give more useful results depending on the market doing one or the other.

The ADX is an oscillator that fluctuates between 0 and 100. Even though the scale is from 0 to 100, readings above 60 are relatively rare. Low readings, below 20, indicate a weak trend and high readings, above 40, indicate a strong trend. The indicator does not grade the trend as bullish or bearish, but merely assesses the strength of the current trend. A reading above 40 can indicate a strong downtrend as well as a strong uptrend.

ADX can also be used to identify potential changes in a market from trending to non-trending. When ADX begins to strengthen from below 20 and moves above 20, it is a sign that the trading range is ending and a trend is developing.

When ADX begins to weaken from above 40 and moves below 40, it is a sign that the current trend is losing strength and a trading range could develop.

Positive/Negative Directional Indicators

The ADX is derived from two other indicators, also developed by Wilder, called the Positive Directional Indicator (sometimes written +DI) and the Negative Directional Indicator (-DI).

When the ADX Indicator is selected, SharpCharts plots the Positive Directional Indicator (+DI), Negative Directional Indicator (-DI) and Average Directional Index (ADX). With the Default color scheme on SharpCharts, ADX is the thick black line with less fluctuation, +DI is green and -DI is red. +DI measures the force of the up moves and -DI measures the force of the down moves over a set period. The default setting is 14 periods, but users are encouraged to modify these settings according to their personal preferences.

In its most basic form, buy and sell signals can be generated by +DI/-DI crosses. A buy signal occurs when +DI moves above -DI and a sell signal when -DI moves above the +DI. Be careful, though; when a security is in a trading range, this system may produce many whipsaws. As with most technical indicators, +DI/-DI crosses should be used in conjunction with other aspects of technical analysis.

The ADX combines +DI with -DI, and then smooths the data with a moving average to provide a measurement of trend strength. Because it uses both +DI and -DI, ADX does not offer any indication of trend direction, just strength. Generally, readings above 40 indicate a strong trend and readings below 20 a weak trend. To catch a trend in its early stages, you might look for stocks with ADX that advances above 20. Conversely, an ADX decline from above 40 might signal that the current trend is weakening and a trading range is developing.

Source:http://stockcharts.com/

Aroon

Introduction

Developed by Tushar Chande in 1995, Aroon is an indicator system that can be used to determine whether a stock is trending or not and how strong the trend is. "Aroon" means "Dawn's Early Light" in Sanskrit and Chande chose that name for this indicator since it is designed to reveal the beginning of a new trend.

The Aroon indicator system consists of two lines, 'Aroon(up)' and 'Aroon(down)'. It takes a single parameter which is the number of time periods to use in the calculation. Aroon(up) is the amount of time (on a percentage basis) that has elapsed between the start of the time period and the point at which the highest price during that time period occurred. If the stock closes at a new high for the given period, Aroon(up) will be +100. For each subsequent period that passes without another new high, Aroon(up) moves down by an amount equal to (1 / # of periods) x 100.

Technically, the formula for Aroon(up) is:

[ [ (# of periods) - (# of periods since highest high during that time) ] / (# of periods) ] x 100

For example, consider plotting a 10-period Aroon(up) line on a daily chart. If the highest price for the past ten days occurred 6 days ago (4 days since the start of the time period), Aroon(up) for today would be equal to ((10-6)/10) x 100 = 40.

Aroon(down) is calculated in just the opposite manner, looking for new lows instead of new highs. When a new low is set, Aroon(down) is equal to +100. For each subsequent period that passes without another new low, Aroon(down) moves down by an amount equal to (1 / # of periods) x 100.

The formula for Aroon(down) is :

[ [ (# of periods) - (# of periods since lowest low during that time) ] / (# of periods) ] x 100

Continuing the example above, if the lowest price in that same ten-day period happened yesterday (i.e. on day 9), Aroon(down) for today would be 90.

Aroon Oscillator

A separate indicator called the Aroon Oscillator can be constructed by subtracting Aroon(down) from Aroon(up). Since Aroon(up) and Aroon(down) oscillate between 0 and +100, the Aroon Oscillator will oscillate between -100 and +100 with zero as the center crossover line.

Interpretation Guidelines

Chande states that when Aroon(up) and Aroon(down) are moving lower in close proximity, it signals that a consolidation phase is under way and no strong trend is evident. When Aroon(up) dips below 50, it indicates that the current trend has lost its upward momentum. Similarly, when Aroon(down) dips below 50, the current downtrend has lost its momentum. Values above 70 indicate a strong trend in the same direction as the Aroon (up or down) is under way.

The Aroon Oscillator signals an upward trend is underway when it is above zero and a downward trend is underway when it falls below zero. The farther away the oscillator is from the zero line, the stronger the trend.

In some ways, Aroon is similar to Wilder's DMI system (and the Aroon Oscillator is similar to Wilder's ADX line) however the Aroon is constructed in a completely different manner. Divergences between the two systems may be very instructive.

Source:http://stockcharts.com/

Accumulation/Distribution Line

Introduction - Volume and the Flow of Money

There are many indicators available to measure volume and the flow of money for a particular stock, index or security. One of the most popular volume indicators over the years has been the Accumulation/Distribution Line. The basic premise behind volume indicators, including the Accumulation/Distribution Line, is that volume precedes price. Volume reflects the amount of shares traded in a particular stock, and is a direct reflection of the money flowing into and out of a stock. Many times before a stock advances, there will be period of increased volume just prior to the move. Most volume or money flow indicators are designed to identify early increases in positive or negative volume flow to gain an edge before the price moves. (Note: the terms "money flow" and "volume flow" are essentially interchangeable.)

Methodology

The Accumulation/Distribution Line was developed by Marc Chaikin to assess the cumulative flow of money into and out of a security. In order to fully appreciate the methodology behind the Accumulation/Distribution Line, it may be helpful to examine one of the earliest volume indicators and see how it compares.

In 1963, Joe Granville developed On Balance Volume (OBV), which was one of the earliest and most popular indicators to measure positive and negative volume flow. OBV is a relatively simple indicator that adds the corresponding period's volume when the close is up and subtracts it when the close is down. A cumulative total of the positive and negative volume flow (additions and subtractions) forms the OBV line. This line can then be compared with the price chart of the underlying security to look for divergences or confirmation.

In developing the Accumulation/Distribution Line, Chaikin took a different approach. OBV uses the change in closing price from one period to the next to value the volume as positive or negative. Even if a stock opened on the low and closed on the high, the period's OBV value would be negative as long as the close was lower than the previous period's close. Chaikin chose to ignore the change from one period to the next and instead focused on the price action for a given period (day, week, month). He derived a formula to calculate a value based on the location of the close, relative to the range for the period. We will call this value the "Close Location Value" or CLV. The CLV ranges from plus one to minus one with the center point at zero. There are basically five combinations:

( ( (C - L) - (H - C) ) / (H - L) ) = CLV

1. If the stock closes on the high, the top of the range, then the value would be plus one.
2. If the stock closes above the midpoint of the high-low range, but below the high, then the value would be between zero and one.
3. If the stock closes exactly halfway between the high and the low, then the value would be zero.
4. If the stock closes below the midpoint of the high-low range, but above the low, then the value would be negative.
5. If the stock closes on the low, the absolute bottom of the range, then the value would be minus one.

The CLV is then multiplied by the corresponding period's volume, and the cumulative total forms the Accumulation/Distribution Line.

The daily chart of Ciena (CIEN) gives a breakdown of the Accumulation/Distribution Line, and shows how different closing levels affect the value. The top section shows the price chart for CIEN. The closing level relative to the high-low range is clearly visible. The second section with a black histogram is the Closing Location Value (CLV). The CLV is multiplied by volume, and the result appears in the green histogram. Finally, at the bottom, is the Accumulation/Distribution Line.

1. The close is on the low and the CLV = -1. Volume, however, was relatively light, so the Accumulation/Distribution Value for that period is only moderately negative.
2. The close is very near the high and the CLV = +.9273. Volume is relatively high, so the resulting Accumulation/Distribution Value is high.
3. The close is near the low and the CLV = -.75. Volume is moderately high, so the resulting Accumulation/Distribution Value is moderately high as well.
4. The close is about half way between the mid-point of the high-low range and the high, and the CLV = +.51. Volume is very heavy, so the Accumulation/Distribution Value is also very high.

Accumulation/Distribution Line Signals

The signals for the Accumulation/Distribution Line are fairly straightforward and center around the concepts of divergence and confirmation.

Bullish Signals

A bullish signal is given when the Accumulation/Distribution Line forms a positive divergence. Be wary of weak positive divergences that fail to make higher reaction highs or those that are relatively young. The main issue is to identify the general trend of the Accumulation/Distribution Line. A two-week positive divergence may be a bit suspect. However, a multi-month positive divergence deserves serious attention.

On the chart for Alcoa, Inc. (AA), the Accumulation/Distribution Line formed a huge positive divergence that was over 4 months in the making. Even though the stock fell from above 35 to below 30, the Accumulation/Distribution Line continued on a relentless march north. If one did not know better, it would seem that the two plots did not belong together. However, the stock finally caught up with the Accumulation/Distribution Line when it broke resistance in November.

Another means of using the Accumulation/Distribution Line is to confirm the strength or sustainability behind an advance. In a healthy advance, the Accumulation/Distribution Line should keep up or, at the very least, move in an uptrend. If the stock is moving up at a rapid clip, but the Accumulation/Distribution Line has trouble making higher highs or trades sideways, it should serve as an indication that buying pressure is relatively weak.

Wal-Mart Stores (WMT) began a sharp advance in August that was accompanied by an equally strong move in the Accumulation/Distribution Line. In fact, the Accumulation/Distribution Line was stronger than the stock in early September. After a bit of a consolidation, both again started higher and recorded new reaction highs in early October. Volume flows were behind this advance from the very beginning and continued throughout. The stock ended up advancing from 40 to 60 in about 3 months. Interestingly, as of this writing (December 1999) the Accumulation/Distribution Line has started to move sideways and is indicating that buying pressure is beginning to wane.

Bearish Signals

The same principles that apply to positive divergences apply to negative divergences. The key issue is to identify the main trend in the Accumulation/Distribution Line and compare it to the underlying security. Young negative divergences, or those that are relatively flat, should be looked upon with a healthy dose of skepticism.

The Wal-Mart chart shows a relatively flat negative divergence that is just over a month old. This negative divergence has yet to make a lower low, and should probably be given a little more time to mature. The relative weakness in the Accumulation/Distribution Line should serve as a sign that buying pressure is diminishing while the stock remains at lofty levels.

The Delta Air Lines (DAL) chart shows a negative divergence that developed within the confines of a clear downtrend. The stock had clearly broken down, and the Accumulation/Distribution Line was declining in line with the stock. A deteriorating Accumulation/Distribution Line confirmed weakness in the stock. During the June-July rally, the stock recorded a new reaction high, but the Accumulation/Distribution Line failed, thus setting up the negative divergence.

Source:http://stockcharts.com/

ZigZag

Introduction

The ZigZag feature on SharpCharts is not an indicator per se, but rather a means to filter out random noise and compare relative price movements. The ZigZag can be set to acknowledge minimum price changes and ignore those that do not fit the criteria. The minimum price movements are set in percentage terms and can be based on either the close or high/low range.

A ZigZag set at 10% with OHCL bars would yield a line that only reverses after a change from high to low of 10% or greater. All movements less than 10% would be ignored. If a stock traded from a low of 100 to a high of 109, the ZigZag would not draw a line because the move was less than 10%. If the stock advanced from a low of 100 to a high of 110, then the ZigZag would draw a line from 100 to 110. If the stock continued on to a high of 112, this line would be extended to 112 (100 to 112). The ZigZag would not reverse until the stock declined 10% or more from its high. From a high of 112, a stock would have to decline 11.2 points (or to a low of 100.8) for the ZigZag to reverse and display another line.

The ZigZag has zero predictive power and draws lines base on hindsight. Any predictive power will come from applications such as Elliott Wave or Fibonacci retracements and projections.

Uses

Filter:

Volatility and daily price fluctuations can produce erratic movements or noise. The ZigZag can be used to filter this noise. If price movements smaller than 5% are deemed insignificant, then the ZigZag can be set at 5% and all movements less than 5% will be ignored.

Elliott Wave

The ZigZag can be used to identify waves for Elliott Wave counts. (Note: The object of this article is not Elliott Wave Theory, but simply to illustrate methods of using the ZigZag.)

(ZigZag Chart for HPQ)

The HPQ example set the ZigZag at 15%. All moves 15% or greater were drawn and those less that 15% ignored. A large advance began in Oct-99 and formed a 5-wave structure that lasted until mid 2000. Within this larger structure, other smaller waver counts can also be deciphered.

Retracements

The ZigZag can be used to measure retracements. After an advance, it is common for a security to retrace a portion of its advance with a correction. After a decline, it is common for a security to retrace part of its decline with a reaction rally. According to Dow Theory, 1/3, 1/2 and 2/3 retracements are most likely. Based on Fibonacci numbers, 38.2% or 61.8% retracement levels are deemed significant.

(ZigZag Chart for HAL)

During the advance from 34 to 55, HAL corrected twice (waves 2 and 4) and fulfilled two Fibonacci retracement targets: .618 and .786. Perhaps the most important Fibonacci number is .618, which is the golden mean. The square root of .618 is .786 (78.6%), another Fibonacci number used frequently by Scott Carney. In Mar-00, HAL retraced 79.8% of its wave 1 advance (red oval). From the Mar-00 low, the stock advanced 1.70 times its previous decline to form wave 3, which is close to a Fibonacci 1.618. The correction on wave 4 retraced 67.6% of the wave 3 advance. While 67.6% and 79.8% are not exact Fibonacci retracements, they are close enough to 61.8% and 78.6% to warrant attention.

Projections

The ZigZag can be used to measure primary price movements. As opposed to a correction or reaction rally, a primary price movement is in the direction of the underlying trend. Instead of retracing a portion of the previous move, primary moves extend past the previous reaction high or low. Many analysts that use Elliott Wave and Fibonacci sequences project the length of an advance or decline by multiplying a ratio to the previous retracement. If the previous decline (correction) was 50 points and a Fibonacci specialist was looking for new highs on the subsequent advance, the projection might be 1.618 times the previous move, or 81 points (50 x 1.618 = 81). The 81 points would be added to the beginning of the advance for a price target.

Examples

ZigZag (Basic)

(ZigZag Chart for IBM)

The percentage price change for the ZigZag can be changed with the first box to the right. The default setting is 5%. In the example, the indicator was set at 12, or 12 percent. All price movements greater than or equal to 12% will produce a ZigZag line. All price movements less than 12% will be ignored. The ZigZag is plotted as a thick line on top of the price plot.

ZigZag w/Retracements

(ZigZag Chart for IBM)

The ZigZag w/Retracements includes ratios of adjacent price movements. For the IBM example, the ZigZag w/Retracements was set at 12% to filter out all price movements less than 12%. Three pairs of price movements were compared from the Jun-00 to Nov-00. Dotted lines connect the relevant highs or relevant lows and the ratio is labeled in the middle of the dotted line. The first ratio is 1.566, representing an advance that was 156.6% of the previous decline. The formula is calculated in three steps:

• First Price Move - Decline: 122.31 - 100 = 22.31
• Second Price Move - Advance: 134.94 - 100 = 34.94
• Advance/Decline Ratio: 34.94/22.31 = 1.566

Calculations for the other two ratios (1.374 and .309) are shown on the corresponding chart.

The final line for the ZigZag is subject to change. On the IBM example above, the current ZigZag high is 104.38. Because of the recent decline, the ZigZag continued down from 104.38. However, the current decline is well short of the 12% minimum. Should the current decline fail to exceed 12% and should IBM advance above 104.38, then the line from 86.94 would be extended to the new high and the ratio (.363) would change. The red line in the example above provides an idea of what would happen should IBM turn up from current levels and move to 110. The green lines extending from the October low would be replaced by a line extending straight up to 110.

Source:http://stockcharts.com/

Volume by Price

introduction

"Volume by Price" is a horizontal histogram that overlays a price chart. The histogram bars stretch from left to right starting at the left side of the chart. The length of each bar is determined by the cumulative total of all volume bars for the periods during which the closing price fell within the vertical range of the histogram bar. Example

In the chart below, each volume-by-price bar covers a vertical range of 5 points. The longest bar covers the range from 27.5 to 32.5. The length of that bar was determined by adding up all of the volume bars on the days during which the price closed anywhere between 27.5 and 32.5.

Source:http://stockcharts.com/

Price Channels

Introduction

Similar to Bollinger Bands, price channels form boundaries above and below the price line and can be used as indicators of volatility. Price channels are created by specifying a number of periods that will chart an n-period high or low around the price line. For example, a 20-day price channel will chart the level of the highest high in the last 20 days above the price line, and will chart the level of the lowest low in the last 20 days below the price line. If the most recent price is a new n-period high or low, it will be charted outside of the price channel. Price channels differ from Bollinger Bands in that they use maximum and minimum price values instead of moving averages as boundaries.

Price channels can be used on daily, weekly, or monthly charts and can generate buy/sell signals at points of breakouts. When the price line breaks above or below the upper or lower price channel respectively, a new high or low becomes present. When the price breaks above a 20-day price channel, the price has reached a 20-day high and could potentially begin an uptrend. In this situation, the upper price channel breakout may signify that it is a good time to buy the stock.

Example

This chart for IBM illustrates a lower channel breakout (red arrow) followed by a downtrend. This new 20-day low represented a good time to sell the security, and the signal was not reversed until the price line crossed the upper price channel on June 9.

Source:http://stockcharts.com/

Parabolic SAR

Introduction

Developed by Welles Wilder, the Parabolic SAR refers to a price and time based trading system. Wilder called this the "Parabolic Time/Price System". SAR stands for "stop and reverse", which is the actual indicator used in the system. SAR trails price as the trend extends over time. The indicator is below the price when prices are rising and above the price when prices are falling. In this regard, the indicator stops and reverses when the price trend reverses and breaks above or below the indicator. Wilder introduced the indicator in his 1978 book, New Concepts in Technical Trading Systems. This book also includes RSI, Average True Range and the Directional Movement Concept (ADX). Despite being developed before the computer age, Wilder's indicators have stood the test of time and remain extremely popular.

Calculation

Calculation of SAR is complex with a few if/then variables that make it difficult to put in a spreadsheet. Feel free to skip to the interpretation section! These examples will provide a general idea of how SAR is calculated. Because of formula differentials, it is easier to divide the calculation into two parts. The first calculation covers rising SAR and the second covers falling SAR.

Rising SAR

Prior SAR: The SAR value for the previous period.

Extreme Point (EP): The highest high of the current uptrend.

Acceleration Factor (AF): Starting at .02, AF increases by .02 each
time the extreme point makes a new high. AF can reach a maximum
of .20, no matter how long the uptrend extends.

Current SAR = Prior SAR + Prior AF(Prior EP - Prior SAR)
9-Feb-10 SAR = 43.56 = 43.84 + .16(42.07 - 43.84)

The Acceleration Factor is multiplied by the difference between the
Extreme Point and the prior period's SAR. This is then added to the
prior period's SAR. SAR can never be above the prior period's low or
the current low. Should SAR be below one of these, use the lowest
of the two for SAR.

Falling SAR

Prior SAR: The SAR value for the previous period.

Extreme Point (EP): The lowest low of the current downtrend.

Acceleration Factor (AF): Starting at .02, AF increases by .02 each
time the extreme point makes a new low. AF can reach a maximum of .20,
no matter how long the downtrend extends.

Current SAR = Prior SAR - Prior AF(Prior SAR - Prior EP)
13-Apr-10 SAR = 48.28 = 48.13 - .14(48.13 - 49.20)

The Acceleration Factor is multiplied by the difference between the
Prior period's SAR and the Extreme Point. This is then subtracted
from the prior period's SAR. SAR can never be below the prior
period's high or the current high. Should SAR be below one of these,
use the highest of the two for SAR.

Interpretation

SAR follows price and can be considered a trend following indicator. Once a downtrend reverses and starts up, SAR follows prices like a trailing stop. The stop continuously rises as long as the uptrend remains in place. In other words, SAR never decreases in an uptrend and continuously protects profits as prices advance. The indicator acts as a guard against the propensity to lower a stop-loss. Once price stops rising and reverses below SAR, a downtrend starts and SAR is above the price. SAR follows prices lower like a trailing stop. The stop continuously falls as long as the downtrend extends. Because SAR never rises in a downtrend, it continuously protects profits on short positions.

Step Increments

The Acceleration Factor (AF), which is also referred to as the Step, dictates SAR sensitivity. SharpCharts users can set the Step and the Maximum Step. As shown in the spreadsheet example, the Step is a multiplier that influences the rate-of-change in SAR. That is why it is referred to as the Acceleration Factor. Step gradually increases as the trend extends until it hits a maximum. SAR sensitivity can be decreased by decreasing the Step. A lower step moves SAR further from price, which makes a reversal less likely. This will filter out smaller moves in favor of larger moves. Conversely, SAR sensitivity can be increased by increasing the step. A higher step moves SAR closer to the price action, which makes a reversal more likely. However, the indicator will fluctuate above and below the price too often if the step is set too high. This will produce whipsaws and fail to capture the trend. Chart 6 shows IBM with SAR (.01, .20). The step is .01 and the Maximum Step is .20. Chart 7 shows IBM with a higher Step (.03). SAR is more sensitive in chart 6 because there are more reversals. This is because the Step is higher in chart 6 than chart 7 (.01 versus .03).

Maximum Step

The sensitivity of the indicator can also be adjusted using the Maximum Step. While the Maximum Step can influence sensitivity, the Step carries more weight because it sets the incremental rate-of-increase as the trend develops. Also note that increasing the Step insures that the Maximum Step will be hit quicker when a trend develops. Chart 8 shows Best Buy (BBY) with a Maximum Step (.10), which is lower than the default setting (.20). This lower Maximum Step decreases the sensitivity of the indicator and produces fewer reversals. Notice how this setting caught a two month downtrend and a subsequent two month uptrend. Chart 9 shows BBY with a higher Maximum Step (.20). This higher reading produced extra reversals in early February and early April.

Conclusions

The Parabolic SAR works best with trending securities, which Wilder estimates occur roughly 30% of the time. This means the indicator will be prone to whipsaws over 50% of the time or when a security is not trending. After all, SAR is designed to catch the trend and follow it like a trailing stop. As with most indicators, the quality of the signals depends on the settings and the characteristics of the underlying security. The right settings combined with decent trends can produce a great trading system. The wrong settings will result in whipsaws, losses and frustration. There is no golden rule or one-size-fits-all setting. Each security should be evaluated based on its own characteristics. This means the Parabolic SAR should be used in conjunction with other indicators and technical analysis techniques. For example, Wilder's ADX can be used to estimate the strength of the trend. Click here for a live example of Parabolic SAR.

SharpCharts

The Parabolic SAR can be found as an Overlay in SharpCharts. The default parameters are .02 for the Step and .20 for the Maximum Step. As shown above, these can be changed to suit the characteristics of an individual security. The example below shows the indicator in pink with prices in black/white and the chart grid removed. This contrast makes it easier to see the indicator in action and compare with price action.

Scans

Break above falling SAR: This scan starts with stocks that have an average price of $10 or greater over the last three months and average volume greater than 40,000. The scan then filters for stocks that have a bullish SAR reversal (Parabolic SAR (.01,.20)). This scan is just meant as a starter for further refinement.

Break below rising SAR: This scans starts with stocks that have an average price of $10 or greater over the last three months and average volume greater than 40,000. The scan then filters for stocks that have a bearish SAR reversal (Parabolic SAR (.01,.20)). This scan is just meant as a starter for further refinement.

Source:http://stockcharts.com/

Introduction to Technical Indicators and Oscillators

Introduction

This article is designed to introduce the concept of technical indicators and explain how to use them in your analysis. We will shed light on the difference between leading and lagging indicators, as well as look into the benefits and drawbacks. Many, if not most, popular indicators are shown as oscillators. With this in mind, we will also show how to read oscillators and explain how signals are derived. Later we will turn our focus to specific technical indicators and provide examples of signals in action.
What Is a Technical Indicator?

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A technical indicator is a series of data points that are derived by applying a formula to the price data of a security. Price data includes any combination of the open, high, low or close over a period of time. Some indicators may use only the closing prices, while others incorporate volume and open interest into their formulas. The price data is entered into the formula and a data point is produced.

For example, the average of 3 closing prices is one data point ( (41+43+43) / 3 = 42.33 ). However, one data point does not offer much information and does not an indicator make. A series of data points over a period of time is required to create valid reference points to enable analysis. By creating a time series of data points, a comparison can be made between present and past levels. For analysis purposes, technical indicators are usually shown in a graphical form above or below a security's price chart. Once shown in graphical form, an indicator can then be compared with the corresponding price chart of the security. Sometimes indicators are plotted on top of the price plot for a more direct comparison.
What Does a Technical Indicator Offer?

A technical indicator offers a different perspective from which to analyze the price action. Some, such as moving averages, are derived from simple formulas and the mechanics are relatively easy to understand. Others, such as Stochastics, have complex formulas and require more study to fully understand and appreciate. Regardless of the complexity of the formula, technical indicators can provide unique perspective on the strength and direction of the underlying price action.

A simple moving average is an indicator that calculates the average price of a security over a specified number of periods. If a security is exceptionally volatile, then a moving average will help to smooth the data. A moving average filters out random noise and offers a smoother perspective of the price action. Veritas (VRTS) displays a lot of volatility and an analyst may have difficulty discerning a trend. By applying a 10-day simple moving average to the price action, random fluctuations are smoothed to make it easier to identify a trend.

Veritas Software Corp. (VRTSE) SMA 10-day example chart from StockCharts.com
Why Use Indicators?

Indicators serve three broad functions: to alert, to confirm and to predict.

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An indicator can act as an alert to study price action a little more closely. If momentum is waning, it may be a signal to watch for a break of support. Or, if there is a large positive divergence building, it may serve as an alert to watch for a resistance breakout.
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Indicators can be used to confirm other technical analysis tools. If there is a breakout on the price chart, a corresponding moving average crossover could serve to confirm the breakout. Or, if a stock breaks support, a corresponding low in the On-Balance-Volume (OBV) could serve to confirm the weakness.
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Some investors and traders use indicators to predict the direction of future prices.

Tips for Using Indicators

Indicators indicate. This may sound straightforward, but sometimes traders ignore the price action of a security and focus solely on an indicator. Indicators filter price action with formulas. As such, they are derivatives and not direct reflections of the price action. This should be taken into consideration when applying analysis. Any analysis of an indicator should be taken with the price action in mind. What is the indicator saying about the price action of a security? Is the price action getting stronger? Weaker?

Even though it may be obvious when indicators generate buy and sell signals, the signals should be taken in context with other technical analysis tools. An indicator may flash a buy signal, but if the chart pattern shows a descending triangle with a series of declining peaks, it may be a false signal.

On the Rambus (RMBS) chart, MACD improved from November to March, forming a positive divergence. All the earmarks of a MACD buying opportunity were present, but the stock failed to break above the resistance and exceed its previous reaction high. This non-confirmation from the stock should have served as a warning sign against a long position. For the record, a sell signal occurred when the stock broke support from the descending triangle in March-01.

Rambus, Inc. (RMBS) MACD example chart from StockCharts.com

As always in technical analysis, learning how to read indicators is more of an art than a science. The same indicator may exhibit different behavioral patterns when applied to different stocks. Indicators that work well for IBM might not work the same for Delta Airlines. Through careful study and analysis, expertise with the various indicators will develop over time. As this expertise develops, certain nuances as well as favorite setups will become clear.

There are hundreds of indicators in use today, with new indicators being created every week. Technical analysis software programs come with dozens of indicators built in, and even allow users to create their own. Given the amount of hype that is associated with indicators, choosing an indicator to follow can be a daunting task. Even with the introduction of hundreds of new indicators, only a select few really offer a different perspective and are worthy of attention. Strangely enough, the indicators that usually merit the most attention are those that have been around the longest time and have stood the test of time.

When choosing an indicator to use for analysis, choose carefully and moderately. Attempts to cover more than five indicators are usually futile. It is best to focus on two or three indicators and learn their intricacies inside and out. Try to choose indicators that complement each other, instead of those that move in unison and generate the same signals. For example, it would be redundant to use two indicators that are good for showing overbought and oversold levels, such as Stochastics and RSI. Both of these indicators measure momentum and both have overbought/oversold levels.
Leading Indicators

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As their name implies, leading indicators are designed to lead price movements. Most represent a form of price momentum over a fixed look-back period, which is the number of periods used to calculate the indicator. For example, a 20-day Stochastic Oscillator would use the past 20 days of price action (about a month) in its calculation. All prior price action would be ignored. Some of the more popular leading indicators include Commodity Channel Index (CCI), Momentum, Relative Strength Index (RSI), Stochastic Oscillator and Williams %R.
Momentum Oscillators

Many leading indicators come in the form of momentum oscillators. Generally speaking, momentum measures the rate-of-change of a security's price. As the price of a security rises, price momentum increases. The faster the security rises (the greater the period-over-period price change), the larger the increase in momentum. Once this rise begins to slow, momentum will also slow. As a security begins to trade flat, momentum starts to actually decline from previous high levels. However, declining momentum in the face of sideways trading is not always a bearish signal. It simply means that momentum is returning to a more median level.
RSI

International Business Machines (IBM) RSI example chart from StockCharts.com

Momentum indicators employ various formulas to measure price changes. RSI (a momentum indicator) compares the average price change of the advancing periods with the average change of the declining periods. On the IBM chart, RSI advanced from October to the end of November. During this period, the stock advanced from the upper 60s to the low 80s. When the stock traded sideways in the first half of December, RSI dropped rather sharply (blue lines). This consolidation in the stock was quite normal and actually healthy. From these lofty levels (near 70), flat price action would be expected to cause a a decline in RSI (and momentum). If RSI were trading around 50 and the stock began to trade flat, the indicator would not be expected to decline. The green lines on the chart mark a period of sideways trading in the stock and in RSI. RSI started from a relatively median level, around 50. The subsequent flat price action in the stock also produced relatively flat price action in the indicator and it remains around 50.
Benefits and Drawbacks of Leading Indicators

There are clearly many benefits to using leading indicators. Early signaling for entry and exit is the main benefit. Leading indicators generate more signals and allow more opportunities to trade. Early signals can also act to forewarn against a potential strength or weakness. Because they generate more signals, leading indicators are best used in trading markets. These indicators can be used in trending markets, but usually with the major trend, not against it. In a market trending up, the best use is to help identify oversold conditions for buying opportunities. In a market that is trending down, leading indicators can help identify overbought situations for selling opportunities.

With early signals comes the prospect of higher returns and with higher returns comes the reality of greater risk. More signals and earlier signals mean that the chances of false signals and whipsaws increase. False signals will increase the potential for losses. Whipsaws can generate commissions that can eat away profits and test trading stamina.
Lagging Indicators

As their name implies, lagging indicators follow the price action and are commonly referred to as trend-following indicators. Rarely, if ever, will these indicators lead the price of a security. Trend-following indicators work best when markets or securities develop strong trends. They are designed to get traders in and keep them in as long as the trend is intact. As such, these indicators are not effective in trading or sideways markets. If used in trading markets, trend-following indicators will likely lead to many false signals and whipsaws. Some popular trend-following indicators include moving averages (exponential, simple, weighted, variable) and MACD.

S&P 500 Large Cap Index () MA 20/100 example chart from StockCharts.com

The chart above shows the S&P 500 ($SPX)[$SPX] with the 20-day simple moving average and the 100-day simple moving average. Using a moving average crossover to generate the signals, there were seven signals over the two years covered in the chart. Over these two years, the system would have been enormously profitable. This is due to the strong trends that developed from Oct-97 to Aug-98 and from Nov-98 to Aug-99. However, notice that as soon as the index starts to move sideways in a trading range, the whipsaws begin. The signals in Nov-97 (sell), Aug-99 (sell) and Sept-99 (buy) were reversed in a matter of days. Had these moving averages been longer (50- and 200-day moving averages), there would have been fewer whipsaws. Had these moving average been shorter (10 and 50-day moving average), there would have been more whipsaws, more signals, and earlier signals.
Benefits and Drawbacks of Lagging Indicators

One of the main benefits of trend-following indicators is the ability to catch a move and remain in a move. Provided the market or security in question develops a sustained move, trend-following indicators can be enormously profitable and easy to use. The longer the trend, the fewer the signals and less trading involved.

The benefits of trend-following indicators are lost when a security moves in a trading range. In the S&P 500 example, the index appears to have been range-bound at least 50% of the time. Even though the index trended higher from 1982 to 1999, there have also been large periods of sideways movement. From 1964 to 1980, the index traded within a large range bound by 85 and 110.

Another drawback of trend-following indicators is that signals tend to be late. By the time a moving average crossover occurs, a significant portion of the move has already occurred. The Nov-98 buy signal occurred at 1130, about 19% above the Oct-98 low of 950. Late entry and exit points can skew the risk/reward ratio.
The Challenge of Indicators

For technical indicators, there is a trade-off between sensitivity and consistency. In an ideal world, we want an indicator that is sensitive to price movements, gives early signals and has few false signals (whipsaws). If we increase the sensitivity by reducing the number of periods, an indicator will provide early signals, but the number of false signals will increase. If we decrease sensitivity by increasing the number of periods, then the number of false signals will decrease, but the signals will lag and and this will skew the reward-to-risk ratio.

The longer a moving average is, the slower it will react and fewer signals will be generated. As the moving average is shortened, it becomes faster and more volatile, increasing the number of false signals. The same holds true for the various momentum indicators. A 14 period RSI will generate fewer signals than a 5 period RSI. The 5 period RSI will be much more sensitive and have more overbought and oversold readings. It is up to each investor to select a time frame that suits his or her trading style and objectives.
Oscillator Types

An oscillator is an indicator that fluctuates above and below a centerline or between set levels as its value changes over time. Oscillators can remain at extreme levels (overbought or oversold) for extended periods, but they cannot trend for a sustained period. In contrast, a security or a cumulative indicator like On-Balance-Volume (OBV) can trend as it continually increases or decreases in value over a sustained period of time.

MACD, OBV chart example from StockCharts.com

As the indicator comparison chart shows, oscillator movements are more confined and sustained movements (trends) are limited, no matter how long the time period. Over the two year period, Moving Average Convergence Divergence (MACD) fluctuated above and below zero, touching the zero line about 18 times. Also notice that each time MACD surpassed +80 the indicator pulled back. Even though MACD does not have an upper or lower limit on its range of values, its movements appear confined. OBV, on the other hand, began an uptrend in March 2003 and advanced steadily for the next year. Its movements are not confined and long-term trends can develop.

There are many different types of oscillators and some belong to more than one category. The breakdown of oscillator types begins with two types: centered oscillators which fluctuate above and below a center point or line, and banded oscillators which fluctuate between overbought and oversold extremes. Generally, centered oscillators are best suited for analyzing the direction of price momentum, while banded oscillators are best suited for identifying overbought and oversold levels.
Centered Oscillators

Centered oscillators fluctuate above and below a central point or line. These oscillators are good for identifying the strength or weakness, or direction, of momentum behind a security's move. In its purest form, momentum is positive (bullish) when a centered oscillator is trading above its center line and negative (bearish) when the oscillator is trading below its center line.

MACD is an example of a centered oscillator that fluctuates above and below zero. MACD is the difference between the 12-day EMA and 26-day EMA of a security. The further one moving average moves away from the other, the higher the reading. Even though there is no range limit to MACD, extremely large differences between the two moving averages are unlikely to last for long.
MACD

MACD is unique in that it has lagging elements as well as leading elements. Moving averages are lagging indicators and would be classified as trend-following or lagging elements. However, by taking the differences in the moving averages, MACD incorporates aspects of momentum or leading elements. The difference between the moving averages represents the rate of change. By measuring the rate-of-change, MACD becomes a leading indicator, but still with a bit of lag. With the integration of both moving averages and rate-of-change, MACD has forged a unique spot among oscillators as both a lagging and a leading indicator.
ROC

Rate-of-change (ROC) is a centered oscillator that also fluctuates above and below zero. As its name implies, ROC measures the percentage price change over a given time period. For example: 20 day ROC would measure the percentage price change over the last 20 days. The bigger the difference between the current price and the price 20 days ago, the higher the value of the ROC Oscillator. When the indicator is above 0, the percentage price change is positive (bullish). When the indicator is below 0, the percentage price change is negative (bearish).

ROC 20-period example chart from StockCharts.com

As with MACD, ROC is not bound by upper or lower limits. This is typical of most centered oscillators and can make it difficult to spot overbought and oversold conditions. This ROC chart indicates that readings above +20% and below -20% represent extremes and are unlikely to last for an extended period of time. However, the only way to gauge that +20% and -20% are extreme readings is from past observations. Also, +20% and -20% represent extremes for this particular security and may not be the same for other securities. Banded oscillators offer a better alternative to gauge extreme price levels.
Banded Oscillators

Banded oscillators fluctuate above and below two bands that signify extreme price levels. The lower band represents oversold readings and the upper band represents overbought readings. These set bands are based on the oscillator and change little from security to security, allowing the users to easily identify overbought and oversold conditions. The Relative Strength Index (RSI) and the Stochastic Oscillator are two examples of banded oscillators. (Note: The formulas and rationale behind RSI and the Stochastic Oscillator are more complicated than those for MACD and ROC. As such, calculations are addressed in separate articles.)
Stochastics/RSI

Stochastics/RSI example chart from StockCharts.com

For RSI, the bands for overbought and oversold are usually set at 70 and 30 respectively. A reading greater than 70 would be considered overbought and a reading below 30 would be considered oversold. For the Stochastic Oscillator, a reading above 80 is overbought and a reading below 20 oversold. Even though these are the recommended band settings, certain securities may not adhere to these ranges and might require more fine-tuning. Making adjustments to the bands is usually a judgment call that will reflect a trader's preferences and the volatility of the security.

Many, but not all, banded oscillators fluctuate within set upper and lower limits. The Relative Strength Index (RSI) is range-bound by 0 and 100 and will never go higher than 100 nor lower than zero. The Stochastic Oscillator is another oscillator with a set range and is bound by 100 and 0 as well. However, the Commodity Channel Index (CCI) is an example of a banded oscillator that is not range bound.
CCI

CCI example chart from StockCharts.com
Pros and Cons of Centered and Banded Oscillators

Centered oscillators are best used to identify the underlying strength or direction of momentum behind a move. Broadly speaking, readings above the center point indicate bullish momentum and readings below the center point indicate bearish momentum. The biggest difference between centered oscillators and banded oscillators is the latter's ability to identify extreme readings. While it is possible to identify extreme readings with centered oscillators, they are not ideal for this purpose. Banded oscillators are best suited to identify overbought and oversold conditions.
Oscillator Signals

Oscillators generate buy and sell signals in various ways. Some signals are geared towards early entry, while others appear after the trend has begun. In addition to buy and sell signals, oscillators can signal that something is amiss with the current trend or that the current trend is about to change. Even though oscillators can generate their own signals, it is important to use these signals in conjunction with other aspects of technical analysis. Most oscillators are momentum indicators and only reflect one characteristic of a security's price action. Volume, price patterns and support/resistance levels should also be taken into consideration.
Positive and Negative Divergences

Divergence is a key concept behind many signals for oscillators as well as other indicators. Divergences can serve as a warning that the trend is about to change or set up a buy or sell signal. There are two types of divergences: positive and negative. In its most basic form, a positive divergence occurs when the indicator advances and the underlying security declines. A negative divergence occurs when an indicator declines and the underlying security advances.

Merrill Lynch & Co., Inc (MER) MACD example chart from StockCharts.com

On the Merrill Lynch (MER)[Mer] chart, MACD formed a positive divergence in late October. While MER was trading below its previous reaction low, MACD had yet to penetrate its previous low (green arrows). However, MACD had not turned up and the positive divergence was still just a possibility. When MACD turned up and traded above its 9-day EMA, a positive divergence was confirmed. At this point, other signals came together to create a buy signal. Not only had the stock reached support and gapped up, but there was also a MACD positive divergence and a MACD bullish crossover. (Note: The thick line is the MACD and the thin line is the 9-day EMA of the MACD, which acts as a trigger line. A bullish crossover occurs when MACD moves above its 9-day EMA and a bearish crossover occurs when MACD moves below its 9-day EMA.) After these MACD signals, the stock gapped up the very next day on a huge increase in volume.

International Business Machines (IBM) ROC example chart from StockCharts.com

On the IBM[IBM] chart, the ROC Oscillator formed a negative divergence prior to the decline that began in January. When IBM recorded a high in mid January, the ROC Oscillator failed to surpass its previous high. The stock then began to decline and the ROC Oscillator turned lower as well, thus completing the lower high and the negative divergence. As there was little else to go on at the time, this negative divergence should have been taken as a warning signal. However, when the ROC Oscillator continued to deteriorate and broke below 0 (centerline), it was clear that the stock was weak and vulnerable to a further decline.
Overbought and Oversold Extremes

Banded oscillators are designed to identify overbought and oversold extremes. Since these oscillators fluctuate between extremes, they can be difficult to use in trending markets. Banded oscillators are best used in trading ranges or with securities that are not trending. In a strong trend, users may see many signals that are not really valid. If a stock is in a strong uptrend, buying on oversold conditions will work much better than selling on overbought conditions.

In a strong trend, oscillator signals against the direction of the underlying trend are less robust than those with the trend. The trend is your friend and it can be dangerous to fight it. Even though securities develop trends, they also fluctuate within those trends. If a stock is in a strong uptrend, buying when oscillators reach oversold conditions (and near support tests) will work much better than selling on overbought conditions. During a strong downtrend, selling when oscillators reach overbought conditions would work much better. If the path of least resistance is up (down), then acting on only bullish (bearish) signals would be in harmony with the trend. Attempts to trade against the trend carry added risk.

When the trend is strong, banded oscillators can remain near overbought or oversold levels for extended periods. An overbought condition does not indicate that it is time to sell, nor does an oversold condition indicate that it is time to buy. In a strong uptrend, an oscillator can reach an overbought condition and remain so as the underlying security continues to advance. A negative divergence may form, but a bearish signal against the uptrend should be considered suspect. In a strong downtrend, an oscillator can reach an oversold condition and remain so as the underlying security continues to decline. Similarly, a positive divergence may form, but a bullish signal against the downtrend should be considered suspect. This does not mean counter-trend signals won't work, but they should be viewed in proper context and considered with other aspects of technical analysis.

The first step in using banded oscillators is to identify the upper and lower bands that mark the extremities. For RSI, anything below 30 and above 70 represents an extremity. For the Stochastic Oscillator, anything below 20 and above 80 represents an extremity. We know that when RSI is below 30 or the Stochastic Oscillator is below 20, an oversold condition exists. By that same token, when RSI is above 70 and the Stochastic Oscillator is above 80, an overbought condition exists. Identification of an overbought or oversold condition should serve as an alert to monitor other technical aspects (price pattern, trend, support, resistance, candlesticks, volume or other indicators) with extra vigilance.

The simplest method to generate signals is to note when the upper and lower bands are crossed. If a security is overbought (above 70 for RSI and 80 for the Stochastic Oscillator) and moves back down below the upper band, then a sell signal is generated. If a security is oversold (below 30 for RSI and 20 for the Stochastic Oscillator) and moves back above the lower band, then a buy signal is generated. Keep in mind that these are the simplest methods.

Simple signals can also be combined with divergences and moving average crossovers to create more robust signals. Once a stock becomes oversold, traders may look for a positive divergence to develop in the RSI and then a cross above 30. With the Stochastic Oscillator overbought, traders may look for a negative divergence and combine that with a moving average crossover and a break below 80 to generate a signal. (Note: The Stochastic Oscillator is usually plotted with a 3-day simple moving average that acts as the trigger line. When the Stochastic Oscillator crosses above the trigger line it is a bullish moving average crossover, and when it crosses below it is bearish).

Cisco Systems, Inc. (CSCO) Stochastics example chart from StockCharts.com

The Cisco (CSCO)[Csco] chart shows that the Stochastic Oscillator can change from oversold to overbought quite quickly. Much depends on the number of time periods used to calculate the oscillator. A 10-day Slow Stochastic Oscillator will be more volatile than a 20-day. The thin green lines indicate when the Stochastic Oscillator touched or crossed the oversold line at 20. The thin red lines indicate when Stochastic Oscillator touched or crossed the overbought line. CSCO was in a strong up trend at the time and experiencing little selling pressure. Therefore, trying to sell when the oscillator crossed back below 80 would have been against the uptrend and not the proper strategy. When a security is trending up or has a bullish bias, traders would be better off looking for oversold conditions to generate buying opportunities.

We can also see that much of the upside for the stock occurred after the Stochastic Oscillator advanced above 80 (thin red lines). The green circle in August shows a buy signal that was generated with three separate items: one, the oscillator moved above 20 from oversold conditions; two, the oscillator moved above its 3-day MA; and three, the oscillator formed a positive divergence. Confirmation from these three items makes for a more robust signal. After the buy signal, the oscillator was in overbought territory a mere 4 days later. However, the stock continued its advance for 2-3 weeks before reaching its high.

Microsoft Corp. (MSFT) chart from StockCharts.com

The Microsoft (MSFT)[Msft] chart reveals trading opportunities with the Relative Strength Index (RSI). Because a 14-period RSI rarely moved below 30 and above 70, a 10-period RSI was chosen to increase sensitivity. With the intermediate-term and long-term trends decidedly bearish, savvy traders could have sold short each time RSI reached overbought (black vertical lines). More aggressive traders could have played the long side each time RSI dipped below 30 and then moved back above this oversold level. The first two buy signals were generated with a positive divergence and a move above 30 from oversold conditions. The third buy signal came after RSI briefly dipped below 30. Keep in mind that these three signals were against the larger downtrend and trading strategies should be adjusted accordingly.
Centerline Crossovers

As the name implies, centerline crossover signals apply mainly to centered oscillators that fluctuate above and below a centerline. Traders have been also known to use centerline crosses with RSI in order validate a divergence or signal generated from an overbought or oversold reading. However, most banded oscillators, such as RSI and Stochastics, rely on divergences and overbought/oversold levels to generate signals. The middle ground is a bit of a no man's land for banded oscillators and is probably best left to other tools. For our purposes, the analysis of centerline crossovers will focus on centered oscillators such as Chaikin Money Flow, MACD and Rate-of-Change (ROC).

A centerline crossover is sometimes interpreted as a buy or sell signal. A buy signal would be generated with a cross above the centerline and a sell signal with a cross below the centerline. For MACD or ROC, a cross above or below zero would act as a signal.

Movements above or below the centerline indicate that momentum has changed from either positive to negative or negative to positive. When a centered momentum oscillator advances above its centerline, momentum turns positive and could be considered bullish. When a centered momentum oscillator declines below its centerline, momentum turns negative and could be considered bearish.

Intel Corp. (INTC) MACD, ROX example chart from StockCharts.com

On this Intel (INTC)[INTC] chart with MACD and ROC, there have been a number of signals generated from the centerline crossover. There were a couple of excellent signals, but there were also plenty of false signals and whipsaws. This highlights some of the challenges associated with trading oscillator signals. Also, it stresses the importance of combining various signals in order to create more robust buy and sell signals. Some traders also criticize centerline crossover signals as being too late and missing too much of the move.

A centerline crossover can also act as a confirmation signal to validate a previous signal or reinforce the current trend. If there were a positive divergence and bullish moving average crossover, then a subsequent advance above the centerline would confirm the previous buy signal. Failure of the oscillator to move above the centerline could be seen as a non-confirmation and act as an alert that something was amiss.

Intel Corp. (INTC) MACD example chart from StockCharts.com

On the Intel (INTC)[Intc] chart with MACD, the centerline crossover acts as the third in a series of bullish signals. Even after the third signal, Intel still has plenty of upside left.

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There was the higher low forming that signaled a potential positive divergence.
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There was the bullish moving average crossover to confirm the positive divergence.
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And finally, there was the bullish centerline crossover.

Some traders would worry about missing too much of the move by waiting for the third and final confirmation. However, this can be a more reliable signal and help to avoid whipsaws and false signals. It is true that waiting for the third signal will reduce profits, but it can also help reduce risk.

International Business Machines (IBM) CMF example chart from StockCharts.com

Chaikin Money Flow is an example of a centered oscillator that places importance on crosses above and below the centerline. Divergences, overbought levels and oversold levels are all secondary to the absolute level of the indicator. The direction of the oscillator's movement is important, but needs to be placed in the context of the absolute level. The longer the oscillator is above zero, the more evidence of accumulation. The longer the oscillator is below zero, the more evidence of distribution. Hence, Chaikin Money Flow is considered to be bullish when the oscillator is trading above zero and bearish when trading below zero.

On the IBM[IBM] chart, Chaikin Money Flow began to turn down in July. At this time, the stock was declining with the market and the decline in the oscillator was normal. However, in the second half of August, concerns began to grow when the oscillator failed to continue up with the stock and fell below zero. As the stock advanced further, Chaikin Money Flow continued to deteriorate. This served as a signal that something was amiss.
Pros and Cons of Oscillator Signals

Banded oscillators are best used to identify overbought and oversold conditions. However, overbought is not meant to act as a sell signal, and oversold is not meant to act as a buy signal. Overbought and oversold situations serve as an alert that conditions are reaching extreme levels and close attention should be paid to the price action and other indicators.

To improve the robustness of oscillator signals, traders can look for multiple signals. The criteria for a buy or sell signal could depend on three separate yet confirming signals. A buy signal might be generated with an oversold reading, positive divergence and bullish moving average crossover. Conversely, a sell signal might be generated from a negative divergence, bearish moving average crossover and bearish centerline crossover.

Traditional chart pattern analysis can also be applied to oscillators. This is a bit trickier, but can help to identify the strength behind an oscillator's move. Looking for higher highs or lower lows can help confirm previous analysis. A trend line breakout can signal that a change in the direction of the momentum is imminent.

It is dangerous to trade an oscillator signal against the major trend of the market. In bull moves, it is best to look for buying opportunities through oversold signals, positive divergences, bullish moving average crossovers and bullish centerline crossovers. In bear moves, it is best to look for selling opportunities through overbought signals, negative divergences, bearish moving average crossovers and bearish centerline crossovers.

And finally, oscillators are most effective when used in conjunction with pattern analysis, support/resistance identification, trend identification and other technical analysis tools. By being aware of the broader picture, oscillator signals can be put into context. It is important to identify the current trend or even to ascertain if the security is trending at all. Oscillator readings and signals can have different meaning in differing circumstances. By using other analysis techniques in conjunction with oscillator reading, the chances of success can be greatly enhanced.

Source:http://stockcharts.com/