Advanced technical indicators include dozens of tests that demonstrate momentum levels and anticipate changes. Among these is the moving average (MA) of price.
MA is nothing more than the average price over a fixed number of sessions. For example, if you use a 20-day moving average, it consists of the last 20 days added together and then divided by 20. Tomorrow, the oldest day is removed and the newest day added in and the average is recalculated.
Moving averages help spot true trends, whereas short-term price patterns may be chaotic and less reliable.
The calculation becomes cumbersome for longer-span MA like the popular 200-day moving average. Fortunately, with online free charting, MA is easily added into charts instantly and without the need to perform any math.
MA’s purpose is to remove the short-term volatility from the price trend and to show how the average price trend is evolving over time. This is most valuable when the MA is below or above current price and remains there as the current trend moves forward, and the trigger for action takes place when price and MA cross over.
To make MA even more valuable, it helps to weight the latest days on the theory that more recent portions of the period are more relevant than the older days. The most popular weighting formula is called exponential moving average (EMA). This is a formula built into online charts to adjust MA to weight the most recent entries.
The most popular MA-based formula is called MACD, which is an abbreviation of ‘Moving average convergence/divergence.’ This daunting title simply refers to the analysis of two separate moving average lines, how they relate to price levels, and how the two move closer together or farther apart.
These relationships—breadth between averages and price or between the two averages—help to anticipate a coming price reversal. And as the two lines converge and then cross, or diverge and move farther apart, technicians interpret the changes in terms of how they affect momentum.
The trends you spot in changing moving averages are extremely valuable. By the time the lines cross, most traders already know a reversal has taken place, so the smart move is to spot a coming reversal before everyone else acts.
MA analysis is valuable because it serves as a reliable method of confirming chart patterns or candlestick indicators. Beyond MA, you may use dozens of more advanced indicators. These are broadly called oscillators. These are indicators that track trends in order to identify when a stock is either overbought or oversold. When oscillators reach extreme levels on either side, they act as signals. Traders rely on oscillators to find entry and exit points.
Following are two of the most widely used. First is the Chaikin Money Flow (CMF). This is an indicator that calculates when buying or selling pressure reaches a point of extreme, when traders should sell (overbought) or buy (oversold).
The CMF summarizes the accumulation/distribution line, which is based on the theory that volume tends to increase before a stock’s price moves. So it tracks this trend and identifies positive or negative money flow (volume flow).
A second valuable oscillator is the Relative Strength Index (RSI). This is an analysis of momentum that compares recent upward and downward movements in the stock and uses averages of up days and down days to calculate a single value showing traders the strength or weakness of price at current levels.
These more technical indicators may involve complex mathematical calculations. Fortunately, you need only understand the concept behind the calculation in order to use it. Online free charting services calculate numerous oscillators for you and add them to charts as additional charting segments or color-coded overlays along with the latest price information.
Online free charting has opened up a broad range of complex technical indicators to everyone. However, it is important to understand what is being calculated before making trading decisions based on how those indicators change.
Trading is made more efficient with the Internet, but also more complicated. The wealth of information is valuable, but the volume of information may be counterproductive. For this reason, it makes sense to pick a short list of indicators you believe provide the most reliable initial and confirming information, and track those indicators. If trading direction is uncertain, you can also add in additional indicators if that helps; but start out with fewer rather than with more.
Technical Analysis, Dow Theory, and Practice provide background on some of the technical theories that form the trading philosophy used by so many people and institutions. It is always valuable to know the basic theories and how they are applied. However, at the same time, it is important to remember the distinction between theory and practice.
Copyright 2011 by Michael C. Thomsett. All rights reserved. John Wiley & Sons, Inc."
Content provided here under exclusive license
Related "Essential Technical Indicators" articles
- Essential Technical Indicators
- Support and Resistance: The Trading Range as a Defining Attribute of Price
- Popular Price Patterns and Their Meaning
- Trend Lines for Spotting Reversals
- Breakouts and Gaps
→ Moving Averages, Oscillators, and Volume Tests