Trading without indicators is like running blind and it encourages emotional trading that is the bane of successful investment and speculation. It is hard to know what to buy or sell, let alone just when to do prudently. Thank goodness there are indicators available that provide information of stock and index movement of a more immediate nature, making life during these times somewhat more bearable.
There are over 80 such indicators divided into six categories. The most popular indicators, and also available for use free at online charting service such as stockcharts.com and bigcharts.com, are the trend, momentum, market strength and volatility categories. This article will deal with the six most popular momentum indicators.
At its most fundamental level, momentum is a means of assessing the relative levels of greed and fear in the market at any given point in time. Securities ebb and flow, surge and retreat, and such action is measured by oscillators which are powerful leading indicators of the security's immediate direction and its speed.
Oscillators are most useful and issue the most valid trading signals when their readings diverge from prices. A bullish divergence occurs when prices fall to a new low while an oscillator fails to reach a new low. This situation demonstrates that bears are losing power, and that the bulls are ready to control the market for the stock or index again. Such divergence often marks the end of a downtrend. Bearish divergences signify up-trends, when prices rally to a new high while the oscillator refuses to reach a new peak. In this situation, bulls are losing their grip on the security, prices are rising only as a result of inertia, and the bears are ready to take control again.
Stochastic Oscillator (SO)
SO compares a security's closing price to its price range over a given period of time. The theory behind this indicator is that in an upward-trending market, prices tend to close near their high, and during a downward-trending market, prices tend to close near their low.
There are two components to the SO: the %K which is the main line indicating the number of time periods (usually 14), and the %D which is a three-period moving average of the %K. Buy/sell signals occur when the %K crosses above/below the %D. A %K result of 70 (or 30), for example, is interpreted to mean that the price of the security closed above 70% (or below 30%) of all prior closing prices that have occurred over the past 14 days and assumes that the security's price will trade at the top (or at the bottom) of the range in a major uptrend (or downtrend). A move above 80 suggests that the security is overbought and therefore should be sold while a move below 20 suggests that the stock or index is oversold and, as such, is a buying signal.
The SO, which ignores market jolts, is an ideal companion to the MACD [moving average convergence-divergence] to provide an enhanced and more effective trading experience. Using the two together gives traders an opportunity to hold out for a better entry point on an up-trending security or to be more sure that any down-trend is truly reversing itself when bottom-fishing for long-term holds. However, on the downside, because the stock or index generally takes a longer time to line up in the best buying position, the actual trading of the security occurs less frequently, so you may need a larger basket of stocks to watch.
Relative Strength Index (RSI)
RSI compares the magnitude of recent gains in price to recent losses in an attempt to determine overbought and oversold conditions of a security.
The RSI, on a scale of 0-100, indicates that a stock is overbought when it is over 70 and oversold when it is below 30. Because large surges and drops in the price of a security will create false buy or sell signals the RSI works best when it is used in conjunction with short-term moving average crossovers such as the Stochastic Oscillator to confirm a directional shift.
StochRSI was created by applying the Stochastic Oscillator to the Relative Strength Index values rather than standard price data thereby giving the trader a better idea of whether the current RSI value is overbought or oversold - a measure that becomes specifically useful when the RSI value is confined between its signal levels of 30 and 70.
TRIX displays the percent rate-of-change of a triple exponentially smoothed moving average of a security's closing price and is designed to filter out stock movements that are insignificant to the larger trend of the security.
The user selects a number of periods (such as 15) with which to create the moving average, and those cycles that are shorter than that are filtered out. TRIX is also a leading indicator and can be used to anticipate turning points in a trend through its divergence with the security's price.
Commodity Channel Index (CCI)
CCI is an oscillator which quantifies the relationship between the security's price, a moving average of the security's price, and normal deviations from that average to determine when a security has been overbought or oversold.
The CCI, when used in conjunction with other oscillators, can be a valuable tool to identify potential peaks and valleys in the security's price, and thus provide investors with reasonable evidence to estimate changes in the direction of price movement of the security.
Price Rate of Change (ROC)
ROC measures the percentage rate of change, indicating the strength of the momentum, between the most recent price and the price over "x" periods (the narrower the better) thereby identifying bullish or bearish divergences. As such, the ROC is able to forecast sooner than almost any other indicator an upcoming reversal of a trend and whether or not a security's price action is created by those over-buying or over-selling it. A number other than zero (a personal choice) can be used to indicate an increase in upward momentum and a number less than zero to indicate an increase in selling pressure.
There you have it - an assessment of how to evaluate when you should be buying or selling particular stocks, warrants, ETFs, gold, silver or any other type of security.