7 Tools Of The Trade

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Indicators are used as a measure to gain further insight into to the supply and demand of securities within technical analysis. Those indicators (such as volume) confirm price movement, and the probability that the move will continue. The Indicators can also be used as a basis for trading, as they can form buy-and-sell signals.

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On-Balance Volume - OBV

The on-balance volume indicator (OBV) is used to measure the positive and negative flow of volume in a security, relative to its price over time. It is a simple measure that keeps a cumulative total of volume by adding or subtracting each period's volume, depending on the price movement. This measure expands on the basic volume measure by combining volume and price movement. The idea behind this indicator is that volume precedes price movement, so if a security is seeing an increasing OBV, it is a signal that volume is increasing on upward price moves. Decreases mean that the security is seeing increasing volume on down days.


What Does On-Balance Volume - OBV Mean?
A method used in technical analysis to detect momentum, the calculation of which relates volume to price change. OBV provides a running total of volume and shows whether this volume is flowing in or out of a given security. This indicator was developed by Joe Granville.


OBV attempts to detect when a financial instrument (stock, bond, etc.) is being accumulated by a large number of buyers or sold by many sellers. Traders will use an upward sloping OBV to confirm an uptrend, while a downward sloping OBV is used to confirm a downtrend. Finding a downward sloping OBV while the price of an asset is trending upward can be used to suggest that the "smart" traders are starting to exit their positions and that a shift in trend may be coming.

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Accumulation/Distribution Line

One of the most commonly used indicators to determine the money flow of a security is the accumulation/distribution line (A/D line). It is similar to on-balance volume indicator but, instead of only considering the closing price of the security for the period, it also takes into account the trading range for the period. This is thought to give a more accurate picture of money flow than of balance volume. The line trending up is a signal of increasing buying pressure, as the stock is closing above the halfway point of the range. The line is trending downward is a signal of increasing selling pressure in the security.


What Does Accumulation/Distribution Mean?
A momentum indicator that attempts to gauge supply and demand by determining whether investors are generally "accumulating" (buying) or "distributing" (selling) a certain stock by identifying divergences between stock price and volume flow. It is calculated using the following formula:

Acc/Dist = ((Close – Low) – (High – Close)) / (High – Low) * Period's volume

Accumulation/Distribution
For example, many up days occurring with high volume in a downtrend could signal that the demand for the underlying is starting to increase. In practice, this indicator is used to find situations in which the indicator is heading in the opposite direction as the price. Once this divergence has been identified, the trader will wait to confirm the reversal and make his or her transaction decisions using other technical indicators.


Money Flow
What Does Money Flow Mean?
Calculated by averaging the high, low, and closing prices, and multiplying by the daily volume. Comparing that result with the number for the previous day tells you whether money flow was positive or negative for the current day.

Money Flow
When a stock is purchased at a higher price (an uptick), this is considered positive money flow. When the next trade is at a lower price (a downtick), this is considered to be negative money flow.

If more shares were bought throughout the day on the uptick than the downtick, net money flow is positive because more investors were willing to pay a premium for the stock. If money flow is negative when a stock's price is rising, this could spell trouble.

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Average Directional Index

The average directional index (ADX) is a trend indicator used to measure the strength and momentum of an existing trend. This indicator's main focus is not on the direction of the trend, but with the momentum. When the ADX is above 40, the trend is considered to have a lot of directional strength - either up or down, depending on the current direction of the trend. Extreme readings to the upside are considered to be quite rare compared to low readings. When the ADX indicator is below 20, the trend is considered to be weak or non-trending.


Average Directional Index - ADX
What Does Average Directional Index - ADX Mean?
An indicator used in technical analysis as an objective value for the strength of trend. ADX is non-directional so it will quantify a trend's strength regardless of whether it is up or down. ADX is usually plotted in a chart window along with two lines known as the DMI (Directional Movement Indicators). ADX is derived from the relationship of the DMI lines.

Average Directional Index - ADX
Analysis of ADX is a method of evaluating trend and can help traders to choose the strongest trends and also how to let profits run when the trend is strong.





TrendWhat Does Trend Mean?
The general direction of a market or of the price of an asset. Trends can vary in length from short, to intermediate, to long term. If you can identify a trend, it can be highly profitable, because you will be able to trade with the trend.

Trend
As a general strategy, it is best to trade with trends, meaning that if the general trend of the market is headed up, you should be very cautious about taking any positions that rely on the trend going in the opposite direction.

A trend can also apply to interest rates, yields, equities and any other market which is characterized by a long-term movement in price or volume.

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Aroon Indicator

The Aroon osciallatro is a technical indicator used to measure if a security is in a trend, and the magnitude of that trend. The indicator can also be used to identify when a new trend is set to begin. The indicator is comprised of two lines: an Aroon-up line and an Aroon-down line. A security is considered to be in an uptrend when the Aroon-up line is above 70, along with being above the Aroon-down line. The security is in a downtrend when the Aroon-down line is above 70 and also above the Aroon-up line.



Aroon IndicatorWhat Does Aroon Indicator Mean?
A technical indicator used for identifying trends in an underlying security and the likelihood that the trends will reverse. It is made up of two lines: one line is called "Aroon up", which measures the strength of the uptrend, and the other line is called "Aroon down", which measures the downtrend. The indicator reports the time it is taking for the price to reach, from a starting point, the highest and lowest points over a given time period, each reported as a percentage of total time.


Aroon Indicator
The Aroon indicator was developed by Tushar Chande in 1995. Both the Aroon up and the Aroon down fluctuate between zero and 100, with values close to 100 indicating a strong trend, and zero indicating a weak trend. The lower the Aroon up, the weaker the uptrend and the stronger the downtrend, and vice versa. The main assumption underlying this indicator is that a stock's price will close at record highs in an uptrend, and record lows in a downtrend.

This indicator is very similar to the directional movement index (DMI) that was developed by Welles Wilder, which is also a very popular indicator used to measure the strength of a given trend.


Indicator

What Does Indicator Mean?
Statistics used to measure current conditions as well as to forecast financial or economic trends. Indicators are used extensively in technical analysis to predict changes in stock trends or price patterns. In fundamental analysis, economic indicators that quantify current economic and industry conditions are used to provide insight into the future profitability potential of public companies.

In the context of technical analysis, an indicator is a mathematical calculation based on a securities price and/or volume. The result is used to predict future prices. Common technical analysis indicators are the moving average convergence-divergence (MACD) indicator and the relative strength index (RSI).

In an economic context, an indicator could be a measure such as the unemployment rate, which can be used to predict future economic trends. Common general economic indicators are the unemployment rate, new housing starts and the consumer price index (CPI).

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MACD

The moving average convergence divergence (MACD) is one of the most well-known and used indicators in technical analysis. It is used to signal both the trend and momentum behind a security. The indicator is comprised of two exponential moving averages (EMA), covering two different time periods, which help to measure momentum in the security. The idea behind this momentum indicator is to measure short-term momentum compared to long-term momentum to help determine the future direction of the asset. The MACD is simply the difference between these two moving averages, which (in practice) are generally a 12-period and 26-period EMA.




Moving Average Convergence Divergence - MACD
What Does Moving Average Convergence Divergence - MACD Mean?
A trend-following momentum indicator that shows the relationship between two moving averages of prices. The MACD is calculated by subtracting the 26-day exponential moving average (EMA) from the 12-day EMA. A nine-day EMA of the MACD, called the "signal line", is then plotted on top of the MACD, functioning as a trigger for buy and sell signals.



Moving Average Convergence Divergence - MACD
There are three common methods used to interpret the MACD:

1. Crossovers - As shown in the chart above, when the MACD falls below the signal line, it is a bearish signal, which indicates that it may be time to sell. Conversely, when the MACD rises above the signal line, the indicator gives a bullish signal, which suggests that the price of the asset is likely to experience upward momentum. Many traders wait for a confirmed cross above the signal line before entering into a position to avoid getting getting "faked out" or entering  into a position too early, as shown by the first arrow.

2. Divergence - When the security price diverges from the MACD. It signals the end of the current trend.

3. Dramatic rise - When the MACD rises dramatically - that is, the shorter moving average pulls away from the longer-term moving average - it is a signal that the security is overbought and will soon return to normal levels.

Traders also watch for a move above or below the zero line because this signals the position of the short-term average relative to the long-term average. When the MACD is above zero, the short-term average is above the long-term average, which signals upward momentum. The opposite is true when the MACD is below zero. As you can see from the chart above, the zero line often acts as an area of support and resistance for the indicator.

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Relative Strength Index

The relative strength index (RSI) is used to signal overbought and oversold conditions in a security. The indicator is plotted between a range of zero-100, where 100 is the highest overbought condition and zero is the highest oversold condition. The RSI helps to measure the strength of a security's recent up moves, compared to the strength of its recent down moves. This helps to indicate whether a security has seen more buying or selling pressure over the trading period.



Relative Strength Index - RSIWhat Does Relative Strength Index - RSI Mean?
A technical momentum indicator that compares the magnitude of recent gains to recent losses in an attempt to determine overbought and oversold conditions of an asset. It is calculated using the following formula: RSI = 100 -  100 
______
1 + RS 

RS = Average of x days' up closes / Average of x days' down closes 

As you can see from the chart below, the RSI ranges from 0 to 100. An asset is deemed to be overbought once the RSI approaches the 70 level, meaning that it may be getting overvalued and is a good candidate for a pullback. Likewise, if the RSI approaches 30, it is an indication that the asset may be getting oversold and therefore likely to become undervalued.




Relative Strength Index - RSI
A trader using RSI should be aware that large surges and drops in the price of an asset will affect the RSI by creating false buy or sell signals. The RSI is best used as a valuable complement to other stock-picking tools.


Overbought
What Does Overbought Mean?
1. A situation in which the demand for a certain asset unjustifiably pushes the price of an underlying asset to levels that do not support the fundamentals.

2. In technical analysis, this term describes a situation in which the price of a security has risen to such a degree - usually on high volume - that an oscillator has reached its upper bound. This is generally interpreted as a sign that the price of the asset is becoming overvalued and may experience a pullback.
1. An asset that has experienced sharp upward movements over a very short period of time is often deemed to be overbought. Determining the degree in which an asset is overbought is very subjective and can differ between investors.

2. Technicians use indicators such as the relative strength index, the stochastic oscillator or the money flow index to identify securities that are becoming overbought.

An overbought security is the opposite of one that is oversold.


Oversold
What Does Oversold Mean?
1. A condition in which the price of an underlying asset has fallen sharply, and to a level below which its true value resides. This condition is usually a result of market overreaction or panic selling.

2. A situation in technical analysis where the price of an asset has fallen to such a degree - usually on high volume - that an oscillator has reached a lower bound. This is generally interpreted as a sign that the price of the asset is becoming undervalued and may represent a buying opportunity for investors.
1. Assets that have experienced sharp declines over a brief period of time are often deemed to be oversold. Determining the degree to which an asset is oversold is very subjective and could easily differ between investors.

2. Identifying areas where the price of an underlying asset has been unjustifiably pushed to extremely low levels is the main goal of many technical indicators such as the relative strength index, the stochastic oscillator, the moving average convergence divergence and the money flow index.

Oversold is the opposite of overbought.

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Stochastic Oscillator

The stochastic oscillator is another well-known momentum indicator used in technical analysis. In an upward trend, the price should be closing near the highs of the trading range. In a downward trend, the price should be closing near the lows of the trading range. When this occurs, it signals continued momentum and strength in the direction of the prevailing trend. The stochastic oscillator is plotted within a range of zero-100, and signals overbought conditions above 80 and oversold conditions below 20.



Stochastic Oscillator
What Does Stochastic Oscillator Mean?
A technical momentum indicator that compares a security's closing price to its price range over a given time period. The oscillator's sensitivity to market movements can be reduced by adjusting the time period or by taking a moving average of the result. This indicator is calculated with the following formula:

%K = 100[(C - L14)/(H14 - L14)]

C = the most recent closing price
L14 = the low of the 14 previous trading sessions
H14 = the highest price traded during the same 14-day period.

%D = 3-period moving average of %K



Stochastic Oscillator
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. Transaction signals occur when the %K crosses through a three-period moving average called the "%D".

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Tools Of The Trade: Conclusion

The goal of every short-term trader is to determine the direction of a given asset's momentum and to attempt to profit from it. There have been hundreds of technical indicators and oscillators developed for this specific purpose, and this has just revealed the tip of the iceberg. Now that you have been acquainted with a few of the basic indicators used in technical analysis, you can go forward and learn more - you are one step closer to being able to incorporate powerful technical indicators into your own strategies.


Momentum
What Does Momentum Mean?
The rate of acceleration of a security's price or volume, Momentum...
Once a momentum trader sees an acceleration in a stock's price, earnings, or revenues, the trader will often take a long or short position in the stock with the hope that its momentum will continue in either an upwards or downwards direction. This strategy relies more on short-term movements in price rather then fundamental particulars of companies, and is not recommended for novices.


Oscillator
What Does Oscillator Mean?
A technical analysis tool that is banded between two extreme values and built with the results from a trend indicator for discovering short-term overbought or oversold conditions. As the value of the oscillator approaches the upper extreme value the asset is deemed to be overbought, and as it approaches the lower extreme it is deemed to be oversold.
Oscillators are most advantageous when a clear trend cannot be easily seen in a company's stock such as when it trades horizontally or sideways. The most common oscillators are: the Stochastic oscillator, RSI,  ROC and MFI.

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Rate of change (ROC)

Stands alone as an important indicator used by many technicians interested in market momentum. ROC has a horizontal median called the equilibrium. It is this median that tells us everything we need to know about rate of change.

The normal time frame for ROC measurement is 10 days. The ratio to build the ROC indicator is as follows:

Rate of Change = 100 (Y/Yx)
"Y" represents the most recent closing price, and Yx represents the closing price a specific number of days ago. So, if the price of a stock closes higher today than it did 10 days ago, the ROC value point will be above the equilibrium, thus indicating to chartists that prices are rising in that particular issue. Conversely, if the price in today's session closes lower than it did 10 trading days ago, the value point will be below the equilibrium, indicating that prices are falling off. It is safe to say that if the ROC is rising, it gives a short-term bullish signal, and a bearish sign would have the ROC falling. Chartists pay great attention to the time period in the calculation of ROC. Long-term views of the market or a specific sector or stock will use perhaps a 26- to 52-week time period for Yx and a shorter view would use 10 days to around six months.



As you can see in this chart of Exxon Mobil, the events of Sept 11, 2001 saw the ROC fall off dramatically over the five trading sessions shown on this chart and rallying into the strong market Sept 24, 2001. You can see that the red line turned up sharply that day as the price of XOM jumped over $2. You can see that for the most part, the preceding summer months had Exxon Mobil falling off slightly in price from a level of about $47 in early June to $41 on Sept 10, and the ROC indicator traded below the median line for almost the entire three-month period.

Another important point is the bullish move at the end of the first week in April, when the stock price jumped from $38 to between $44 and $45 by the end of the month.




The second chart is that of Nortel Networks and shows the bearish trend from Sept 2000 through the next 12 months. There were a number of bullish signals over this same period of time that, for the most part, would have been acted upon by the short-term traders, but it is fairly safe to say that long-term investors would have stayed away from NT during this period of time. The fundamentals of the company coupled with the bearish indicators saw the "smart money" head for the sidelines. As you can see by the chart, there was not a strong bullish sign since the brief tech breakout in Apr 2001 that lasted just long enough to tease investors into thinking that the bear market for tech issues was over.

Conclusion
New technicians and veterans should look very closely at ROC when looking for plus/minus moves in indexes and stock issues alike, and use a number of different time spans to reconfirm their findings.

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Money Flow Index - MFI
What Does Money Flow Index - MFI Mean?
A momentum indicator that is used to determine the conviction in a current trend by analyzing the price and volume of a given security. The MFI is used as a measure of the strength of money going in and out of a security and can be used to predict a trend reversal. The MFI is range-bound between 0 and 100 and is interpreted in a similar fashion as the RSI.



The money flow index is calculated by using the following formula:

Typical Price = (High + Low + Close) / 3
Money Flow = Typical price * Volume
Money Ratio = Positive Money Flow/Negative Money Flow

Note: Positive money values are created when the typical price is greater than the previous typical price value. The sum of positive money over the number of periods used to create the indicator is used to create the positive money flow - the values used in the money ratio. The opposite is true for the negative money flow values.

Money Flow Index = 100 - (100/ (1 + Money Ratio)) this explains Money Flow Index - MFI
The money flow index is similar to the relative strength index (RSI). The fundamental difference is that the MFI also accounts for volume, whereas the RSI only incorporates price. Many traders watch for opportunities that arise when the MFI moves in the opposite direction as the price. This divergence can often be a leading indicator of a change in the current trend.


Money Flow
What Does Money Flow Mean?
Calculated by averaging the high, low, and closing prices, and multiplying by the daily volume. Comparing that result with the number for the previous day tells you whether money flow was positive or negative for the current day.
This explains Money Flow,
When a stock is purchased at a higher price (an uptick), this is considered positive money flow. When the next trade is at a lower price (a downtick), this is considered to be negative money flow.

If more shares were bought throughout the day on the uptick than the downtick, net money flow is positive because more investors were willing to pay a premium for the stock. If money flow is negative when a stock's price is rising, this could spell trouble.

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Tools Of The Trade: Conclusion

Oscillator
What Does Oscillator Mean?
A technical analysis tool that is banded between two extreme values and built with the results from a trend indicator for discovering short-term overbought or oversold conditions. As the value of the oscillator approaches the upper extreme value the asset is deemed to be overbought, and as it approaches the lower extreme it is deemed to be oversold.
Oscillators are most advantageous when a clear trend cannot be easily seen in a company's stock such as when it trades horizontally or sideways. The most common oscillators are: the Stochastic oscillator, RSI,  ROC and MFI.

Oscillators

Oscillators are indicators that are used when viewing charts that are non-trending. Moving averages (MA) and trends are paramount when studying the direction of a stock. A technician will use oscillators when the charts are not showing a definite trend in either direction. Oscillators are thus most beneficial when a company's stock either is in a horizontal or sideways trading pattern, or has not been able to establish a definite trend in a choppy market.

When the stock is in either an overbought or oversold situation, the true value of the oscillator is exposed. With oscillators a chartist can see when the stock is running out of steam on the upside, the point at which the stock moves into an overbought situation. This simply means that the buying volume has been diminishing for a number of trading days which means traders will then start to sell their shares. Conversely, when a stock has been sold by a greater number of investors for a consistent period of time ranging from one to six months or longer, the stock will enter an oversold situation.

The Relative Strength Index
In the example below, you can see Microsoft's (Nasdaq:MSFT) lower range of the relative strength index (RSI) is 30 and the upper range is 70. The midrange is 50. We now understand that the RSI becomes oversold at the 30 level and overbought at the 70 level. Some charts and theories would use 20/80 as the low/high boundary. For some technicians, these numbers may be far too conservative, causing the trader to be too late on the buy side and therefore miss out on capital gains. Also, if traders use the 80 high mark, they may miss the true selling point on the overbought side. 

Arrows are shown at the entry points at which the RSI bounces off the 30 level. By drawing a horizontal channel between the $66 and $72 price levels, we have marked the horizontal trading pattern. Notice that the RSI tends to remain well above 50 while the price action is inside this horizontal channel. Here the RSI shows a somewhat overbought situation, but no major selling pressure is evident.  Many investors believe Microsoft can be purchased at any level because they will hold it in their portfolios for the long-term and are not concerned with trading it short-term.




J. Welles Wilder, Jr. developed the RSI and first shared it with the technical community in his book "New Concepts in Technical Trading Systems." It's a must read for anyone planning to use oscillators to determine buy and sell points.

Bottom Line
You will begin to notice that one indicator looks very similar to others and using one indicator in conjunction with another is a very useful tool for determining the important entry/exit points. Using this indicator you can see how professional traders can be in and out of stocks long before the average investor, and you will also be able to find a comfortable trading range.

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Use This 'Unknown' Indicator to Accumulate Profits

It's incredibly important for investors to have a solid set of tools to help evaluate potential investments. Otherwise we're just following what other people say without using our own brains - a sure-fire way to lose money. Independent investors need to think for themselves, and act according to their own research. 

Technical analysis methods blended with fundamental research is the best combination of tools. Over the next couple of weeks I'll review a number of technical analysis tools that you can use to help time your buy and sell decisions.

Today we'll take a look at the relative strength indicator (RSI). The relative strength of a stock is a measure of a stock's price against its past performance. It helps to determine the internal strength of the stock.

It's a very easy indicator to turn on when using most finance charting websites such as Yahoo! Finance or StockCharts.com. On Yahoo! Finance, use the 'interactive chart' feature and look in the drop-down tab for 'technical indicators'. You can set the RSI to the period of your choice. Note that it will be in the same period as the one you select for your chart, days for a daily chart, weeks for a weekly chart, or minutes for a minute chart. I suggest sticking with 14 days and 3-month, 6-month, and one year charts until you become accustomed to using the index. 

RSI is a technical momentum indicator that quantifies the magnitude of gains and losses to determine whether the stock is overbought or oversold. The formula for relative strength is: RSI = 100 – (100 / (1 + RS)). In this formula, RS = (average of (x) days up closes) / (average of (x) days' down closes).

The RSI of a stock is useful only when the relative trend is observed over a period of time. The scale is set from 1 to 100, and when RSI rises to 70, it indicates that the stock could be getting overbought. Conversely, if the RSI drops below 30, the stock could be getting oversold and you may want to accumulate shares. The appeal of this barometer is that it enables you to apply a simple formula to draw a meaningful conclusion about the price strength of a single stock.

Take a look at the three month chart of Green Mountain Coffee Roaster (NasdaqGS:GMCR - News) below. This stock has been selling off and rallying due to fundamental reasons, but the RSI indicator has been fairly accurate in signaling when the stock should rise (RSI hits 30) and fall (RSI hits 70).



A key momentum indicator, the RSI can be used to time entry and exit decisions based on momentum. For example, a stock that has a low, but improving, RSI may begin to show signs of strengthening stock price. Momentum investors may see this change as an early sign that the stock is going to outperform the market in the future.   

Another advantage to using RSI is that it can be calculated over any time period. Very short-term traders may track RSI over just a few minutes, whereas traders willing to wait for longer time periods may want to use RSI over several months. As I mentioned earlier, start with using a 14-day period on 3-month, 6-month and one year charts and go from there depending on your preference. 

The key change in RSI, represented by strengthening or weakening trend lines or even crossover points (with other indicators like moving averages), is believed by many technicians to anticipate more specific signals like breakouts and strong price reversals. RSI, accompanied by observation of changes in the patterns of trading ranges and resistance or support tests, can serve as an important early indicator of new trends in a stock's price.

But be careful, the more indicators you use the more confusing things can become when first starting to use technical indicators. Ease into it by adding one, then two indicators and you'll learn faster than adding everything all at once. 

All technical indicators are generalizations, and none by themselves can be used reliably to make specific trading decisions. They can be used to confirm emerging fundamental trends in a company's ever-changing competitive stance. The best approach to studying a company is utilizing a wise combination of fundamental and technical indicators, and tracking both types over a period of time.

Just like most things, understanding technical analysis measures like the relative strength indicator takes practice. But to a trained eye, RSI can give the astute investor an idea where the stock price may go. Practice before you act, and gain confidence. You'll be glad you did when you start to make profitable investments and trades.

I've been using the RSI indicator to help time entry points for Small Cap Investor PRO recommendations. Right now our last seven recommendations are up an average of 46.4 percent, and two have returns over 100 percent!