Technical Indicators and Trading Strategies PDF

The Corporate Finance Institute PART 03 The Complete Guide to Trading Technical Indicators and Trading Strategies corporatefinanceinstitute.com 69 The Corporate Finance Institute The Complete Guide to Trading Technical Indicators and Trading Strategies To learn more, please check out our on...

The Corporate Finance Institute PART 03 The Complete Guide to Trading Technical Indicators and Trading Strategies corporatefinanceinstitute.com 69 The Corporate Finance Institute The Complete Guide to Trading Technical Indicators and Trading Strategies To learn more, please check out our online courses Technical Analysis – A Basic Guide Technical analysis is a tool, or method, used to predict the probable future price movement of a security – such as a stock or cryptocurrency pair – based on market data. The theory behind the validity of technical analysis is the notion that the collective actions – buying and selling – of all the participants in the market accurately reflect all relevant information pertaining to a traded security, and therefore, continually assign a fair market value to the security through price action. Technical traders believe that current or past price action in the market is the most reliable indicator of future price action. Charting on Different Time Frames Technical traders analyze price charts to attempt to predict price movement. The two primary variables for technical analysis are the time frames considered and the particular technical indicators that a trader chooses to utilize. The time frames shown on charts range from one-minute to monthly, or even yearly, time spans. Popular time frames that technical analysts frequently examine include: • 5-minute chart • 15-minute chart • Hourly chart • 4-hour chart • Daily chart The time frame a trader selects to study is typically determined by that individual trader’s personal trading style. Intraday traders, traders who open and close trading positions within a single trading day, favor analyzing price movement on shorter time frame charts, such as the 5-minute or 15-minute charts. Long-term corporatefinanceinstitute.com 70 The Corporate Finance Institute The Complete Guide to Trading traders who hold market positions overnight and for long periods of time are more inclined to analyze markets using hourly, 4-hour, daily, or even weekly charts. Price movement that occurs within a 15-minute time span may be very significant for a trader who is looking for an opportunity to realize a profit from price changes occurring during one trading day. However, that same price movement viewed on a daily or weekly chart may not be particularly significant or indicative for long-term trading purposes. It’s simple to illustrate this by viewing the same price action on different time frame charts. The following daily chart for silver shows price trading within the same range, from roughly $16 to $18.50, that it’s been in for the past several months. A long-term silver investor might be inclined to look to buy silver based on the fact that the price is fairly near the low of that range. corporatefinanceinstitute.com 71 The Corporate Finance Institute The Complete Guide to Trading However, the same price action viewed on an hourly chart (below) shows a steady downtrend that has accelerated somewhat just within the past several hours. A silver investor interested only in making an intra-day trade would likely shy away from buying the precious metal based on the hourly chart price action. Candlestick Charting Candlestick charting is the most commonly used method of showing price movement on a chart. A candlestick is formed from the price action during a single time period for any time frame chart. Each candlestick on an hourly chart shows the price action for one hour, while each candlestick on a 4-hour chart shows the price action during each 4-hour time period. Candlesticks are “drawn” / formed as follows: The highest point of a candlestick shows the highest price a security traded at during that time period, and the lowest point of the candlestick indicates the corporatefinanceinstitute.com 72 The Corporate Finance Institute The Complete Guide to Trading lowest price during that time. The “body” of a candlestick (the respective red or blue “blocks”, or thicker parts, of each candlestick as shown in the charts above) indicates the opening and closing prices for the time period. If a blue candlestick body is formed, this indicates that the closing price (top of the candlestick body) was higher than the opening price (bottom of the candlestick body); conversely, if a red candlestick body is formed, then the opening price was higher than the closing price. The lines that extend above or below the candlestick body are referred to as wicks, tails, or shadows. Candlestick colors are arbitrary choices. Some traders use white and black candlestick bodies; other traders may choose to use green and red, or blue and yellow. Whatever colors are chosen, they provide an easy way to determine at a glance whether price moved up or down during a given time period. Technical analysis using a candlestick charts is often easier than using a standard bar chart, as the analyst receives clearer visual cues to price action during any given time period. Candlestick Patterns – Dojis Technical analysis using candlestick patterns, which are formed by either a single candlestick or by a succession of two or three candlesticks, are some of the most widely used technical indicators for identifying potential market reversals or trend changes. Doji candlesticks, for example, indicate indecision in a market that may be a signal for an impending trend change or market reversal. The singular characteristic of a doji candlestick is that the opening and closing prices are the same, so that the candlestick body is a flat horizontal line. The longer the upper and/or lower shadows, or tails, on a doji candlestick, the stronger the indication of market indecision and potential reversal is considered to be. There are several variations of doji candlesticks, each with their own distinctive name, as shown in the illustrations below. corporatefinanceinstitute.com 73 The Corporate Finance Institute The Complete Guide to Trading The typical doji is the long-legged doji, where price extends about equally in each direction, opening and closing in the middle of the price range for the time period. As the illustration notes, this indicates indecision in the market. When a doji like this appears at the end of an extended uptrend or downtrend in a market, it is commonly interpreted as signaling a possible market reversal, a trend change to the opposite direction. The dragonfly doji, when appearing after a prolonged downtrend, signals a possible upcoming reversal to the upside. Examination of the price action indicated by the dragonfly doji explains its logical interpretation. The dragonfly shows sellers pushing price substantially lower (the long lower tail), but at the end of the period price recovers to close at its highest point. The candlestick essentially indicates a rejection of the extended push to the downside. The gravestone doji’s name clearly hints that it represents bad news for buyers. The opposite of the dragonfly formation, the gravestone doji indicates a strong rejection of an attempt to push market prices higher, and thereby suggests a potential downside reversal may follow. The extremely rare four price doji, where the market opens, closes, and in-between conducts all buying and selling at the exact same price throughout the time period, is the epitome of indecision, a market that shows no strong inclination to go anywhere in particular. There are dozens of different candlestick formations, along with their respective variations. Probably the most complete resource for identifying and utilizing candlestick patterns is Thomas Bulkowski’s pattern site, which thoroughly explains each corporatefinanceinstitute.com 74 The Corporate Finance Institute The Complete Guide to Trading candlestick pattern and provides statistics on how often each pattern has historically given a reliable trading signal. It’s certainly helpful to know what a candlestick pattern indicates – but it’s even more helpful to know if that indication has proven to be accurate 90% of the time. Technical Indicators – Moving Averages In addition to studying candlestick formations, technical traders can draw from a virtually endless supply of technical indicators to assist them in making trading decisions. Moving averages are probably the single most widely-used technical indicator. Many trading strategies utilize one or more moving averages. A simple moving average trading strategy might be something like, “Buy as long as price remains above the 50period exponential moving average (EMA); Sell as long as price remains below the 50 EMA”. Moving average crossovers are another frequently employed technical indicator. A crossover trading strategy might be to buy when the 10-period moving average crosses above the 50-period moving average. The higher a moving average number is, the more significant price movement in relation to it is considered. For example, price crossing above or below a 100- or 200-period moving average is usually considered much more significant than price moving above or below a 5-period moving average. Technical Indicators – Pivots and Fibonacci Numbers Daily pivot point indicators, which usually also identify several support and resistance levels in addition to the pivot point, are used by many traders to identify price levels for entering or closing out trades. Pivot point levels often mark where trading is contained within a range. If trading soars (or plummets) through the daily pivot and all the associated support or resistance levels, this is interpreted by many traders as ‘breakout” trading that will shift market prices substantially higher or lower, in the direction of the breakout. Daily pivot points and their corresponding support and resistance levels are calculated using the previous trading day’s high, low, opening and closing prices. I’d show you the calculation, but there’s really no need, as pivot point levels are widely published each trading day and there are pivot point indicators freely available that corporatefinanceinstitute.com 75 The Corporate Finance Institute The Complete Guide to Trading you can just load on a chart that do the calculations for you and reveal pivot levels. Fibonacci Retracements Fibonacci levels are another popular technical analysis tool. Fibonacci was a 12th-century mathematician who developed a series of ratios that is very popular with technical traders. Fibonacci ratios, or levels, are commonly used to pinpoint trading opportunities and profit targets that arise during sustained trends. The primary Fibonacci ratios are 0.24, 0.38, 0.62, and 0.76. These are often expressed as percentages – 23%, 38%, etc. Note that Fibonacci ratios complement other Fibonacci ratios: 24% is the opposite, or remainder, of 76%, and 38% is the opposite, or remainder, of 62%. As with pivot point levels, there are numerous freely available technical indicators that will automatically calculate and load Fibonacci levels onto a chart. Fibonacci retracements are the most often used Fibonacci indicator. After a security has been in a sustained uptrend or downtrend for some time, there is frequently a corrective retracement in the opposite direction before price resumes the overall long-term trend. Fibonacci retracements are used to identify good, low-risk trade entry points during such a retracement. For example, assume that the price of stock “A” has climbed steadily from $10 to $40. Then the stock price begins to fall back a bit. Many investors will look for a good entry level to buy shares during such a price retracement. Fibonacci numbers suggest that price retracements will likely extend a distance equal to 24%, 38%, 62%, or 76% of the uptrend move from $10 to $40. Investors watch these levels for indications that the market is finding support from where price will begin rising again. For example, if you were hoping for a chance to buy the stock after approximately a 38% retracement in price, you might enter an order to buy around $30-$31. (The move from $10 to $40 = $30; 38% of $30 is $9; $40 – $9 = $31) Fibonacci Extensions Continuing with the above example – So now you’ve bought the stock at $31 and you’re trying to determine a profit target to sell at. For that, you can look to Fibonacci extensions, which indicate how much higher price may extend when the overall uptrend resumes. The Fibonacci extension levels are pegged at prices that represent corporatefinanceinstitute.com 76 The Corporate Finance Institute The Complete Guide to Trading 126%, 138%, 162%, and 176% of the original uptrend move, calculated from the low of the retracement. So, if a 38% retracement of the original move from $10 to $40 turns out to be the retracement low, then from that price ($31), you find the first Fibonacci extension level and potential “take profit” target by adding 126% of the original $30 move upward. The calculation goes as follows: Fibonacci extension level of 126% = $31 + ($30 x 1.26) = $68 – giving you a target price of $68. Once again, you never actually have to do any of these calculations. You just plug a Fibonacci indicator into your charting software and it displays all the various Fibonacci levels. Pivot and Fibonacci levels are worth tracking even if you don’t personally use them as indicators in your own trading strategy. Because many traders do base buying and selling moves on pivot and Fibonacci levels, then if nothing else there is likely to be significant trading activity around those price points, activity that may help you better determine probable future price moves. Technical Indicators – Momentum Indicators Moving averages and most other technical indicators are primarily focused on determining likely market direction, up or down. But there is another class of technical indicators, however, whose main purpose is not so much to determine market direction as to determine market strength. These indicators include such popular tools as the Stochastic Oscillator, the Relative Strength Index (RSI), the Moving Average Convergence-Divergence (MACD) indicator, and the Average Directional Movement Index (ADX). By measuring the strength of price movement, momentum indicators help investors determine whether current price movement more likely represents relatively insignificant, rangebound trading or an actual, significant trend. Because momentum indicators measure trend strength, they can also serve as early warning signals that a trend is coming to an end. For example, if a security has been trading in a strong, sustained uptrend for several months, but then one or more momentum indicators signals the trend steadily losing strength, it may be time to think about taking profits. The 4-hour chart of USD/SGD below illustrates the value of a momentum indicator. The MACD indicator appears in a separate window below the main chart window. The sharp upturn in the corporatefinanceinstitute.com 77 The Corporate Finance Institute The Complete Guide to Trading MACD beginning around June 14th indicates that the corresponding upsurge in price is a strong, trending move rather than just a temporary correction. When price begins to retrace downward somewhat on the 16th, the MACD shows weaker price action, indicating that the downward movement in price does not have much strength behind it. Soon after that, a strong uptrend resumes. In this instance, the MACD would have helped provide reassurance to a buyer of the market that (A) the turn to the upside was a significant price move and (B) that the uptrend was likely to resume after price dipped slightly on the 16th. Because momentum indicators generally only signal strong or weak price movement but not trend direction, they are often combined with other technical indicators as part of an overall trading strategy. Technical Analysis – Conclusion Keep in mind the fact that no technical indicator is perfect. None of them give signals that are 100% accurate all the time. The smartest traders are always watching for warning signs that signals from their chosen indicators may be misleading. Technical analysis, done well, can certainly improve your profitability as a trader. However, what may do more to improve your fortunes in corporatefinanceinstitute.com 78 The Corporate Finance Institute The Complete Guide to Trading trading is spending more time and effort thinking about how best to handle things if the market turns against you, rather than just fantasizing about how you’re going to spend your millions. corporatefinanceinstitute.com 79 The Corporate Finance Institute The Complete Guide to Trading The ADX Indicator The average directional movement index (ADX) was developed by the famed technical analyst, Welles Wilder, as an indicator of trend strength. As a commodity trader, Wilder developed the indicator for trading commodity futures. However, it has since been widely applied by technical analysts to virtually every other tradeable investment, from stocks to forex to ETFs. What is the ADX? The ADX is calculated to reflect the expansion, or contraction, of the price range of a security over a period of time. The traditional setting for the ADX indicator is 14 time periods, but analysts have commonly used the ADX with settings as low as 7 or as high as 30. Lower settings will make the average directional movement index respond more quickly to price changes but tend to generate more false signals. Higher settings will minimize false signals but make the ADX a more lagging indicator. Wilder calculated the ADX by first calculating both a positive directional movement index (+DMI) and a negative directional movement index (-DMI) that compare current high and low prices to the previous time period’s high and low prices. The ADX itself is then calculated as the sum of the differences between +DMI and – DMI over a given time period. All the necessary calculations are a bit complex. Fortunately there’s no need to do them yourself. All you have to do is apply the average directional movement index indicator to a chart, with all the necessary calculations done for you, according to whatever time period setting you choose. Again, the default number of time periods is 14. The ADX on a Chart The ADX, like momentum indicators such as the MACD or RSI, is typically shown in a separate window above or below the main chart window that shows price movement. The ADX is shown as a line representing values that range from zero to 100. It’s important to keep in mind that the ADX is not a trend direction indicator, but an indicator of trend strength. A strong uptrend or a strong downtrend will both result in high ADX values. Some versions of the average directional index will also show the +DMI and –DMI lines. In Wilder’s original conception of the ADX, he envisioned using the +DMI and –DMI lines to determine trend corporatefinanceinstitute.com 80 The Corporate Finance Institute The Complete Guide to Trading direction and the ADX line to determine trend strength, thus, in effect, making the ADX a combination trend indicator and momentum indicator. However, since then many technical analysts have preferred just seeing the ADX line itself, for two reasons: (1) the three lines intermingled can sometimes be visually confusing and (2) crossovers of the +DMI and –DMI lines have been found to frequently generate false signals. In short, the average directional movement index trading system that Wilder designed has generally been found to be more reliable as a trend strength indicator and less reliable as a trend direction indicator. Using the ADX Indicator The ADX is used first of all to determine whether a market is trending at all, as opposed to merely trading back and forth within a range, and secondly to determine the strength of a trend in a trending market. Finally, the ADX is also often used, as other momentum indicators are, to indicate a potential market reversal or trend change. When the value of the ADX line is below 25 a market is considered to be ranging rather than trending. Some analysts peg only ADX readings below 20 as indicative of the absence of a trend, and readings between 20 and 25 as possibly, but not conclusively, indicating the presence of a trend. Any ADX reading above 25 is interpreted as indicating the existence of a genuine trend. Readings between 25 and 50 indicate a beginning or moderate strength trend. Readings between 50 and 100 represent increasingly strong trends. The chart shown below shows the ADX indicating an increasingly strong uptrend as average directional index readings rise from below 10 to nearly 50. corporatefinanceinstitute.com 81 The Corporate Finance Institute The Complete Guide to Trading The direction of trend strength – increasingly or decreasingly strong – can easily be determined simply by looking at the slope of the ADX line. An upsloping ADX line shows a strengthening trend, while a downsloping ADX line indicates a weakening trend. A steeper angle of slope indicates a stronger trend, while a shallower angle indicates a trend with less strength. NOTE: A change in the direction of the ADX slope can serve as an early indicator of a developing trend even before ADX readings go above 25. Referring to the chart shown above, you can see that the ADX slope turned upward well before the ADX reading rose to 25 and indicated the existence of a trend. But before you go buying a security every time the ADX slope turns from downward to upward, keep in mind that the ADX line might just as easily have turned back to the downside before a genuine uptrend became established – in other words, you might get caught jumping the gun a bit. Price and the ADX Analysts and investors rarely use the ADX indicator alone. Since it does not indicate trend direction, it is commonly used in conjunction with trend indicators such as moving averages or support and resistance areas which are used to analyze price movement. For example, an ideal application of using trend indicators in combination with the ADX would be an instance where the price of a security has traded within a range, with clearly defined support and resistance price levels, but then breaks out of that trading range by trading through a support or resistance level. If the price breakout is accompanied by rising ADX readings that indicate the corporatefinanceinstitute.com 82 The Corporate Finance Institute The Complete Guide to Trading presence of a trend, then that would constitute a confirming indication of the validity of the breakout, and an analyst would project a trend continuing in the direction of the breakout. The ADX as a Divergence Indicator The ADX is also sometimes used, as other momentum indicators are, as a divergence indicator that can signal an impending trend change or market reversal. ADX values will rise to increasingly high levels along with price in a market that is trending strongly higher. But if ADX levels begin to decline even as price rises higher, this divergence between price movement and the ADX may signal that the market is losing momentum and therefore may be due for a turn to the downside. In such a situation, analysts will carefully monitor price movement for any further indications of a possible trend change, the ADX decline having served as a sort of early warning signal. Conclusion – the Value of the ADX The ADX has been found by technical analysts to be a very helpful indicator and has become one of the most frequently used technical tools around. It is one of the most reliable trend strength indicators and has helped many analysts to correctly identify ranging markets and thus avoid being lured into buying false breakouts or buying into markets that are basically just flat and going nowhere. Wilder developed a number of technical indicators, but always maintained that the ADX was his best creation. You may well wish to consider adding the ADX indicator to your technical analysis arsenal. corporatefinanceinstitute.com 83 The Corporate Finance Institute The Complete Guide to Trading Triangle Patterns It’s important for every technical trader to recognize patterns as they form in the market. Patterns are vital in a trader’s quest to spot trends and predict future outcomes so that they can trade more successfully and therefore more profitably. Triangle patterns are important because they help indicate the continuation of a bullish or bearish market. They can also assist a trader in spotting market reversals. There are three types of triangle patterns: ascending, descending, and symmetrical. The picture below depicts all three. As you read the breakdown for each pattern, you can use this picture as a point of reference, a helpful visualization tool you can use to get a mental picture of what each pattern looks like. And here is the short version on triangle patterns: • Ascending triangles are a bullish formation that anticipates an upside breakout. • Descending triangles are a bearish formation that anticipates a downside breakout. • Symmetrical triangles, where price action grows increasingly narrow, may be followed by a breakout to either side, up or down. corporatefinanceinstitute.com 84 The Corporate Finance Institute The Complete Guide to Trading Ascending Triangle Patterns Ascending triangle patterns are bullish, meaning that they indicate that a security’s price is likely to climb higher as the pattern completes itself. This pattern is created with two trendlines. The first trendline is flat, along the top of the triangle, and acts as a resistance point which – after price successfully breaks above it – signals the beginning or resumption of an uptrend. The second trendline – the bottom line of the triangle that shows price support – is a line of ascension formed by a series of higher lows. It is this configuration formed by higher lows that forms the triangle and gives it a bullish characterization. The basic interpretation is that the pattern reveals that each time sellers attempt to push price lower, they are increasingly less successful. The ascending triangle pattern forms as a security’s price bounces back and forth between the two lines. Prices move to a high at a resistance level that leads to a drop in price as securities are sold. Although price may fail to overcome the resistance several times, this does not lead to increased power for sellers, as evidenced by the fact that each sell-off after meeting resistance stops at a higher level than the previous sell-off attempt. Eventually price breaks through the upside resistance and continues in an uptrend. In many cases, price is already in an overall uptrend and the ascending triangle pattern is viewed as a consolidation and continuation pattern. In the event that an ascending triangle pattern forms during an overall downtrend in the market, it is typically seen as a possible indication of an impending market reversal to the upside. Indications and Using the Ascending Triangle Pattern Because the ascending triangle is a bullish pattern, it’s important to pay close attention to the supporting ascension line because it indicates that bears are gradually exiting the market. Bulls (buyers) are then eventually capable of pushing the security price past the resistance level indicated by the flat top line of the triangle. As a trader, it’s wise to be cautious about making trade entries before prices break above the resistance line because the pattern may fail to fully form or be violated by a move to the downside. There is less risk involved by waiting for the confirming breakout. Buyers can then reasonably place stop-loss orders below the low of the triangle pattern. corporatefinanceinstitute.com 85 The Corporate Finance Institute The Complete Guide to Trading Using Descending Triangle Patterns Based on its name, it should come as no surprise that a descending triangle pattern is the exact opposite of the pattern we’ve just discussed. This triangle pattern offers traders a bearish signal, indicating that price will continue lower as the pattern completes itself. Again, two trendlines form the pattern, but in this case the supporting bottom line is flat, while the top resistance line slopes downward. Just as an ascending triangle is often a continuation pattern that forms in overall uptrend, a descending triangle is a common continuation pattern that forms in a downtrend. If it appears during a long-term uptrend, it is usually taken as a signal of a possible market reversal and trend change. This pattern develops when a security’s price falls but then bounces off the supporting line and rises. However, each attempt to push prices higher is less successful than the one before, and eventually sellers take control of the market and push price below the supporting bottom line of the triangle. This action confirms the descending triangle pattern’s indication that prices are headed lower. Traders can sell short at the time of the downside breakout, with a stop-loss order placed a bit above the highest price reached during the formation of the triangle. Using Symmetrical Triangle Patterns Traders and market analysts commonly view symmetrical triangles as consolidation patterns which may forecast either the continuation of the existing trend or a trend reversal. This triangle pattern is formed as gradually ascending support lines and descending resistance lines meet up as a security’s trading range becomes increasingly narrow. Typically, a security’s price will bounce back and forth between the two trendlines, moving toward the apex of the triangle, eventually breaking out in one direction or the other and forming a sustained trend. Regardless of whether a symmetrical triangle breakout goes in the direction of continuing the existing trend or in the direction of a trend reversal, the momentum that is generated when price breaks out of the triangle is usually sufficient to propel the market a significant distance. You can imagine the increasingly narrow trading range as a phenomenon that gradually builds up more and more pressure until finally price “explodes” out in one direction or the other. Thus, the breakout from a symmetrical triangle is usually considered a strong signal of trend direction which traders can follow with some confidence. Again, the triangle formation offers corporatefinanceinstitute.com 86 The Corporate Finance Institute The Complete Guide to Trading easy identification of reasonable stop-loss order levels: below the low of the triangle when buying, or above the triangle high if selling short. The Bottom Line In the end, as with any technical indicator, successfully using triangle patterns really comes down to patience and due diligence. While these three triangle patterns tend toward certain signals and indications, it’s important to stay vigilant and remember that the market is not known for being predictable and can change directions quickly. This is why judicious traders eyeing what looks like a triangle pattern shaping up will wait for the breakout confirmation by price action before adopting a new position in the market. Also keep in mind that triangle patterns don’t usually form as clearly as shown in the example illustrations above. The lines that form a triangle pattern may be a bit more ragged, not quite so straight. corporatefinanceinstitute.com 87 The Corporate Finance Institute The Complete Guide to Trading The TRIN Indicator The TRIN indicator, also known as the ARMS index because it was developed by Richard Arms, is functionally an oscillator type indicator that is primarily used to identify short-term overbought or oversold conditions in the overall stock market. It does this by comparing advancing versus declining stocks, along with advancing versus declining volume. TRIN is short for “TRading INdex”. The TRIN indicator is referred to as breadth indicator because it gives an indication of how widely spread, in terms of advances versus declines, stock market price movement is as reflected in a major stock market index such as the S&P 500 Index or the NASDAQ 100 Index. Because the TRIN indicator factors in both price advances or declines and volume figures, it is seen as indicating both the velocity (advances/declines) and mass (volume figures) of the stock market’s overall price movement. Calculating the TRIN Indicator Looking at the calculation for the TRIN indicator makes it very easy for a trader to understand what the TRIN reflects. The calculation for the TRIN is as follows: (advances/declines) / (advancing volume/declining volume) The TRIN first divides the number of advancing stocks for the day by the number of declining stocks for the day. It then divides the volume of advancing stocks by the volume of declining stocks. Finally, it divides the result of the first calculation by the result of the second calculation. So, for example, if on a given day the number of advancing stocks was 2,275 and the number of declining stocks was 764, then the advance decline ratio would be 2.98. If the total volume of advancing stocks was 1,176 and the total volume of declining stocks was 164, then the advance decline volume ratio would be 7.17. The TRIN would then be calculated as 2.98/7.17 = 0.42 Interpreting TRIN Values Successfully using TRIN levels to indicate temporary overbought or oversold levels in a market can be a bit tricky. First of all, TRIN values appear to be inverse, in that higher values indicate increased selling while lower values indicate increased buying. corporatefinanceinstitute.com 88 The Corporate Finance Institute The Complete Guide to Trading Generally speaking, TRIN values below 0.50 are considered to indicate overbought conditions in which analysts may anticipate an impending corrective retracement downward. TRIN values above 3.00 are typically interpreted as indicative of oversold conditions that may give rise to an upside rally. A TRIN value of 1.00 indicates a balanced stock market that is neither overbought nor oversold. One can quickly see that there’s a wide middle range of possible TRIN values between overbought values below 0.50 and oversold values above 3.00. In order to make the TRIN indicator more useful, analysts look not just at the basic TRIN values but also at how the TRIN value changes throughout a trading day or over a longer period of time such as during a trading week. By doing so, analysts can more precisely pinpoint what constitute extreme levels, to one side or the other, in the TRIN under whatever the current market conditions are. For example, the market might go through a period where TRIN values go no lower than 0.75 and no higher than 2.25. In such market conditions, analysts may determine that those two extreme values accurately reflect overbought and oversold conditions for the market during that specific time period, even though they fall short of what are typically the TRIN value levels that are considered to indicate overbought/oversold conditions. Some traders and analysts who watch the TRIN indicator focus on the TRIN’s equilibrium value of 1.00 and consider any readings significantly below 1.00 as potential indications of overbought conditions and any readings significantly above 1.00 as potential indications of oversold conditions. Volatility Shortcoming of TRIN One of the shortcomings of the TRIN indicator is that its value can fluctuate significantly either intraday or from one trading day to the next even under overall market conditions that would not usually be described as volatile. In order to smooth out some of the inherent volatility in the TRIN indicator, some traders and analysts prefer to look at a 10-day moving average of the TRIN value. Using the TRIN Analysts commonly use the TRIN indicator to identify market conditions under which the short-term market trend may soon shift from bullish to bearish (when the market is temporarily overbought) or from bearish to bullish (when the market is corporatefinanceinstitute.com 89 The Corporate Finance Institute The Complete Guide to Trading temporarily oversold). Traders may use the TRIN to identify potentially profitable buying or selling price levels. The chart below shows that traders who bought into the market when the TRIN showed values above 3.00, indicating oversold conditions at the market levels indicated by the green up arrows, would have fared very well. However, traders who sold the market based on TRIN values below 0.50 indicating overbought conditions would not have been so profitable over the same time period. The TRIN is typically a leading indicator – one that projects a market turn before it happens. Looking at the above chart, one can easily see that the TRIN often anticipated an actual turn in stock market direction by a day or two. While this may afford a trader an opportunity to “sell the top” or “buy the bottom”, most traders will look for confirming price action in stock market index values before trading based on an anticipated market reversal. corporatefinanceinstitute.com 90 The Corporate Finance Institute The Complete Guide to Trading When TRIN values are relatively steady and around the 1.00 equilibrium level, many traders will stand aside and wait for further market action before making or adjusting any investments. Market activity that occurs without moving the TRIN indicator very much one way or the other is more likely to prove insignificant for the trading day. Conclusion The TRIN indicator can be very useful to traders of stock indexes who aim to catch and profit from overall stock market reversals; however, because of its capacity for extreme volatility it is one of the technical indicators that are known for being prone to generating false signals. corporatefinanceinstitute.com 91 The Corporate Finance Institute The Complete Guide to Trading The MACD Indicator The Moving Average Convergence Divergence (MACD) oscillator is one of the most popular and widely used technical indicators that traders and analysts use to gauge momentum in markets. Understanding the MACD The popularity of the MACD indicator can be directly linked to its ability to accurately indicate rapid short-term momentum increases. Gerald Appel developed the Moving Average Convergence Divergence in the latter part of the 1970s. While the name seems long and complicated, the MACD is one of the least complicated indicators to actually calculate and put into practical application. The MACD utilizes two different trend tracking indicators – moving averages – and creates a momentum oscillator from them by subtracting the moving average of the longer time period from the moving average of the shorter time period. In a sense, this makes the MACD a double-edged technical indicator in that it offers traders and analysts the ability to identify and follow trends in the market, as well as to gauge the momentum of price movements and trends. The calculated moving averages used in the MACD will inevitably converge, cross over one another, and then proceed to diverge, or move away from each other, making the MACD jump over or under the zero line as this happens. Traders are then able to watch for these signaling crossovers and divergences in order to help them spot changing market trends, either bullish or bearish. corporatefinanceinstitute.com 92 The Corporate Finance Institute The Complete Guide to Trading How is the MACD calculated? The picture above illustrates how shorter term and longer term moving averages come closer together (converge), move further apart (diverge), and cross over one another. The MACD reflects the changing relationship of short-term exponential moving averages to long-term exponential moving averages. The equation used to calculate the MACD is as follows: (12 day EMA – 26 day EMA) = MACD Traders and analysts typically use closing prices for 12-day and 26day time periods to generate the EMAs used to calculate the Moving Average Convergence Divergence. Following this, a 9-day moving average of the MACD itself is then plotted alongside the indicator to serve as a signaling line to help illuminate when a market may be turning. corporatefinanceinstitute.com 93 The Corporate Finance Institute The Complete Guide to Trading The picture above clearly indicates the MACD line, the signal line, and the MACD histogram which is a representation of the difference between the 9-day moving average of the MACD and the current MACD reading. When the oscillator line crosses above the 9-day average (signal line), the histogram reads as positive (above the zero line that is indicated on the right hand side of the MACD window). Conversely, the histogram is negative when the MACD line dips below the signal line. As mentioned earlier, 12-period and 26-period values are the default settings used to calculate the MACD. Changes in the time periods used for the MACD calculation can be made to accommodate a trader’s specific trade goals or their particular style of trading. How to interpret the MACD The MACD is built on movement – the movement of moving averages either towards one another (convergence) or away from one another (divergence). The MACD fluctuates, or oscillates, over and under the zero line, otherwise known as the centerline. This fluctuation is a crossover which signals to traders that the shorter moving average price has crossed over the path of the longer moving average price. The MACD is seen as positive when the 12-day moving average crosses above the 26-day average. As the shorter term moving average diverges and moves further and further from the longer term moving average, the positive values of the MACD increases. corporatefinanceinstitute.com 94 The Corporate Finance Institute The Complete Guide to Trading This reflects the fact that upside momentum is increasing. With this in mind, it’s not a stretch to understand that when the opposite happens – the 12-day average dips below the 26-day average – the oscillator turns negative and as the shorter term moving average moves further downward and away from the longer term moving average, an increase in downside momentum is indicated. Crossing the Signal Line Crossovers of the signal line by the MACD line are one of the MACD’s staple signals. The signal line, as we’ve covered already, is the 9-day moving average of the MACD itself. The signal line is an estimated valuation for the movement of the oscillator that makes bullish and bearish MACD turns easier to see. When a trader sees that the MACD turns north, crossing over the signal line and staying above it, a bullish crossover has occurred. This is a signal that a security’s price is on the rise. The exact opposite is true when the MACD line crosses down over the signal line. This is a bearish crossover and if the oscillator continues to drop below the signal line, it’s a good indication that the bears are taking over. Depending on the steepness of the drop and the number of days the drop continues, many traders holding long (buy) positions may prefer to sell before they lose a significant amount of value. This can also be an opportunity for savvy traders to pick up undervalued securities during a temporary downside retracement that occurs in an overall uptrend. Moving Average Divergence The MACD is frequently watched by analysts for signs of divergence from the movement of price. When price continues rising to a new high level but the MACD does not follow suit – instead turning south – this divergence from price action is commonly interpreted as a sign of impending trend change. In fact, many traders use the MACD solely as a possible trend change indicator, always watching for such divergence from price action. The Bottom Line Any time the signal line is crossed over at either extremely high or extremely low points, be cautious before you act. Similarly, if a crossover seems shallow, or seems to move either or up down but then plateau, be vigilant but don’t make a move in haste. The volatility in an underlying security can be deceptive and cause the MACD to move in unusual ways. corporatefinanceinstitute.com 95 The Corporate Finance Institute The Complete Guide to Trading As with anything, putting the MACD into practice and working with it on a regular basis will allow you to get a feel for its common patterns and movements and help you sharpen your eye when it comes to extreme or uncommon fluctuations. The longer you work with this oscillator, the easier it will be to interpret its signals accurately and trade successfully. corporatefinanceinstitute.com 96 The Corporate Finance Institute The Complete Guide to Trading A Pin Bar Scalping Strategy for Day Traders This is a simple scalping strategy for day traders, one that uses the pin bar indicator, one of the most reliable candlestick formations, to identify market reversals. The pin bar, also known as a hammer, is a single candlestick indicator that signals a strong rejection of further price movement in one direction and a reversal in the opposite direction. Pin bar candlesticks are characterized by having long wicks, or tails, that indicate rejection of price in the direction of the tail, and short candlestick bodies that indicate an impending market reversal. A bearish pin bar indicates a reversal to the downside, and a bullish pin bar indicates a reversal to the upside. The critical feature of a pin bar candlestick is the elongated tail which shows that during the formation of the candlestick price moved significantly in one direction but then dramatically back in the opposite direction so that the candlestick closes back near its open. The pin bar candlestick body is very short and the candlestick tail at least two to three times longer than the candlestick body. The wick on the opposite side of the candlestick body from the long tail should either be very short or non-existent, no wick at all. Trading Pin Bars on the Five-Minute Chart The five-minute chart time frame is a favorite of scalpers looking to quickly make small profits. However, sometimes you can catch a reversal on the five-minute time frame that turns out to be the corporatefinanceinstitute.com 97 The Corporate Finance Institute The Complete Guide to Trading beginning of a major trend reversal that enables you to bank major profits. The setup for trading with pin bars on the five-minute chart uses two moving averages, a 10-period exponential moving average and a 21-period exponential moving average. The trading strategy is as follows: • Price should be noticeably above or below both moving averages. The position of price away from the moving averages when the pin bar formation occurs lends some confirmation to a possible market reversal by virtue of the fact that it indicates that price may have become a bit overextended. • The possibility of the market becoming temporarily overbought or oversold – and therefore due for a reversal and correction – is strengthened if there have been several candlesticks in a row moving price in one direction immediately preceding the formation of the pin bar. This is illustrated in the chart below where, just to the left of the middle of the chart, five consecutive down candlesticks precede a pin bar formation that accurately signals a market reversal to the upside. • When a pin bar candlestick is formed, traders should enter in the direction of the indicated reversal immediately following the close of the pin bar. Do not enter before then because a candlestick may appear to be forming a pin bar, only to have a sudden price move just before the close of the candlestick negate the pin bar formation. • A stop-loss order should be placed just beyond the extreme tail of the pin bar candlestick (in the example shown in the photo above, a stop-loss order would be placed just below the low of the bullish reversal pin bar). This is one of the best features of this trading strategy – the fact that it is very low risk, allowing traders to reasonably run a very tight, close stop. When this strategy works, price does not usually move corporatefinanceinstitute.com 98 The Corporate Finance Institute The Complete Guide to Trading beyond the extreme low or high represented by the tail end of the pin bar. • A profit target can be price moving back to touch or crossover one of the moving averages. More aggressive traders can aim for larger profits by continuing to stay in the trade, looking for the reversal trend to continue, but moving their stop-loss order to breakeven, their trade entry point, in order to guard against taking a loss. Conclusion The pin bar reversal indication is stronger, more likely to be accurate, when it occurs at a previously identified support or resistance price level, since price is more likely to reverse at such levels. Support or resistance levels may be any price levels where the market has previously reversed direction from, such as pivot points, weekly highs or lows, or Fibonacci retracement levels. This trading strategy is very popular with forex traders, but can also be applied to stock or commodity trading. corporatefinanceinstitute.com 99 The Corporate Finance Institute The Complete Guide to Trading The Three Simplest Trend Following Strategies Here are three of the simplest trend-following trading strategies around. But don’t mistake “simple” for “not-very-good”. While these are indeed simple trading strategies, they are also among the most reliable trading strategies for consistent profits with low risk. These strategies are designed primarily for long-term traders who trade using analysis of the daily time frame charts; however, they can also be applied to shorter time frame charts such as the four hour and one hour charts. Each of these strategies is designed to enable a trader to ride a long-term trend for maximum profitability. They will not work well in range-bound or extremely volatile markets, but in a trending market, either up or down, should allow you to capture most, or at least a substantial part of, any long-term trend move. 1 – The Golden Cross/Death Cross Strategy Let’s start with possibly the simplest strategy, one that utilizes just two simple moving averages, the 50-period moving average and the 200-period moving average. This strategy is a favorite of many stock market traders, applied to both individual stock prices and to market indexes, and it’s as simple as this: • Be a buyer (long) as long as the 50 MA is above the 200 MA • Be a seller (short) as long as the 50 MA is below the 200 MA As noted earlier in this book, the crossover of the 50-period moving average from below to above the 200-period moving average is referred to as the “golden cross”, basically meaning that a security is “gold” once this occurs. Such a crossover is considered a very bullish long-term trend signal. The 50-period moving average crossing from above to below the 200-period moving average is known as the “death cross” because it is considered a strong signal of a bear market downtrend. Here’s an example of the golden cross trading signal in action, applied to First Energy stock: corporatefinanceinstitute.com 100 The Corporate Finance Institute The Complete Guide to Trading 2 – The 5,8,13 Fibonacci Strategy The 5,8,13 Fibonacci strategy (so called because it utilizes the Fibonacci number sequence of 5, 8, and 13) can work well for a trader on a couple of levels. First of all, it will often clue a trader in near the start of a long-term trend. Secondly, it gives clear signals to both a strong trend and to a range-bound or consolidating market. This trading strategy is implemented as follows: Plot a 5-period, 8period, and 13-period exponential moving average on your chart. The buy/sell signal for this strategy occurs when the 5-period moving average crosses above or below the 13-period moving average. When a strong trend is in place, traders will see two indications of this. First, the space between the three moving averages will widen or fan out. Secondly, in an uptrend candlestick closes will usually remain above the highest – the 5-period – moving average. (Conversely, in a downtrend candlestick closes will tend to remain below the 5-period moving average line.) When the three moving averages converge and flatten out, all of them packed tightly together and appearing roughly horizontal rather than as upsloping or downsloping lines, this indicates a market that is either range-bound or in a consolidation period. You can see in the chart below where, on the left hand side of the chart, an uptrend forms coincident with the 5-period moving average crossing above the 13-period moving average. As the bullish trend continues and strengthens, the space between the moving averages widens out and the 5-period moving average (the corporatefinanceinstitute.com 101 The Corporate Finance Institute The Complete Guide to Trading blue line) provides support for price during the trend. In the middle of the chart, the moving averages come together and flatten out, indicating a consolidation period that is then followed by a resumption of the uptrend. 3 – The Simple ADX Trading Strategy This trading strategy is based solely on price action and a single momentum indicator – the Average Directional Movement Index, known simply as the ADX, discussed in an earlier section. (Just a passing note purely for the sake of entertainment: For all his brilliance as a technical analyst, Wilder still managed to lose more than one fortune in the course of his trading. He was less adept at applying his technical indicators than he was at creating them, and suffered from the bad habit of many traders – overtrading.) Are you ready for simple? – This is simple. Apply the ADX indicator, which appears in a separate window below the main chart window, to your chart. corporatefinanceinstitute.com 102 The Corporate Finance Institute • The Complete Guide to Trading When the ADX reading is above 25, which indicates the existence of a trend, and price is generally moving higher, be a buyer or hold a long position. • When the ADX reading is above 25, and price is overall declining, be a seller or hold a short position. • When the ADX reading falls below 25, this indicates a trendless, ranging, or consolidating market. Exit existing positions and remain out of the market until the ADX reading again rises to a reading of 25 or higher. • More aggressive traders can use an ADX reading above 20, rather than above 25, as indicative of a trend. That’s it. (I told you it was simple.) Conclusion You can, of course, aim to refine any of these trading strategies by using supplemental confirming indicators. But the fact is that many of the most successful trading strategies are relatively simple, and that adding indicator after indicator often results more in confusion than clarity. There’s no reason to make generating trading profits any more complicated than necessary, so you may well wish to at least try out one or more of these very easy technical trading strategies. They may be all you need to help you become a highly successful trader. corporatefinanceinstitute.com 103 The Corporate Finance Institute The Complete Guide to Trading The Psychology of Trading: Winning Mindset Being a trader is not just about formulating better strategies and performing more extensive analysis. It’s also about developing a winning mindset. According to many studies of traders, what separates a winning trader from a losing one • Is NOT that winning traders have better trading strategies • Is NOT that winning traders are smarter • Is NOT that winning traders do better market analysis What separates a winning trader from a losing trader is their psychological mindset. Most traders, when they first begin trading mistakenly believe that all they need to do is find a great trading strategy. After that, they’ll be able to just come to the market each day, plug in their great trading strategy, and the market will immediately start pumping money into their account. Unfortunately, as any of us who have ever traded have learned, it’s not that easy. There are plenty of traders who use intelligent, welldesigned trading strategies and systems who still regularly lose money rather than make money. The few traders who do consistently win the game of trading are those who have developed the appropriate psychological mindset that enables them to be consistent winners. There are certain beliefs, attitudes, and psychological characteristics that are essential to conquering the world of trading. Attitudes about the Markets and about Yourself Attitudes and beliefs about the market include things such as believing that the market is rigged against you. Such negative – and erroneous – beliefs can have a significant impact on your ability to trade successfully. If you’re looking at the market as being out to get you, then you’re not looking at it properly, in accord with reality, and therefore you can’t hope to be able to objectively evaluate market opportunities. The market is completely neutral – it doesn’t care whether you make money or lose money. Our beliefs about ourselves are critical elements of trading psychology. One personal characteristic that most all winning traders share is that of self-confidence. Winning traders possess a firm, basic belief in their ability to BE winning corporatefinanceinstitute.com 104 The Corporate Finance Institute The Complete Guide to Trading traders – a belief that is not seriously shaken by a few, or even several, losing trades. In contrast, many losing traders have serious, nagging self-doubt. Unfortunately, if you see yourself as a losing trader, cursed with bad luck or whatever, that belief tends to become a self-fulfilling prophecy. Traders who doubt their ability often hesitate to push the button and initiate trades, and thereby often miss out on good trading opportunities. They also tend to cut profits short, overly fearful that the market will turn against them at any moment. Winning traders have a healthy respect for the fact that even their best market analysis may sometimes not match up with future price movements. Nonetheless, they possess an overall confidence in their ability as traders – a confidence which enables them to easily initiate trades whenever a genuine opportunity arises. Key Characteristics of a Winning Trader Psychologically, the very best of traders share the same key characteristics, including the following: • They are comfortable with taking risks; People with very low risk tolerance, those who cannot accept losing trades, are not cut out to be winning traders, since losing trades are simply part of the game of trading. Winning traders are able to emotionally accept the uncertainty that is inherent in trading. Trading is not like investing your money in a savings account with a guaranteed return. • They are capable of quickly adjusting to changing market conditions (They don’t fall in love with, and “marry”, their analysis of a market – If price action indicates that they need to change their viewpoint on probable future price movements, they do so without hesitating). • They are disciplined in their trading and can view the market objectively, regardless of how current market action is affecting their account balance. • They don’t give in to being excessively excited about winning trades or excessively despairing about losing trades. • They make the necessary effort and take the necessary steps to be self-disciplined traders who operate with stric