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eSignal’s Basic Studies (Part 1)
In this issue, we’ll begin a new series discussing the basic studies included in eSignal. This may be a review for some clients, but for those who aren’t familiar with all of the different studies in the product, this should prove useful. In Part 1, we’ll take a look at the price studies that are included with your eSignal subscription.
A price study is one that appears in the same space as price data. Plenty of other studies are available in eSignal under the Formulas folder, but, for this article series, we’ll stick with the basic ones.
Moving Average
The first study we'll take a look at is one of the most fundamental indicators used in technical analysis. Moving Averages are so widely used, it is hard to find a market technician who doesn’t use them at some level. The lines applied to the chart are often used all by themselves, but the underlying calculation method is also used in many other popular indicators.
The basic calculation, or Simple Moving Average, uses a mean of prices over time. For example, a 10-period simple moving average uses the last 10 closes of each price bar, adds them together and then divides by 10 to determine the average price over that time range. That average is then plotted across the chart using the last 10 periods from each point in time.
Many variations on the basic moving average study, such as exponential, weighted and volume weighted, use somewhat complex mathematical models to place emphasis on certain price bars within the calculation.
Moving averages can be used for a variety of purposes, such as determining trend direction and support and resistance. They can even be used in conjunction with crossovers to determine potential entry and exit points.
Envelope
The next indicator we’ll look at comprises three lines, all of which are derived from a moving average. The envelope takes the same principles of the moving average and offsets them above and below the moving average line, based on a specific percentage set by the user. This creates a channel within the price data should remain in normal trading conditions.
Envelopes are used in much the same way as Moving Averages, namely determining trend and for support and resistance. It has the added benefit of also providing a means for determining abnormal trading behavior as seen in the chart shown previously. The large breakout on January 23is a clear demonstration of this principle.
Bollinger Bands
One of the more widely used price studies is the Bollinger Bands indicator. This study, like the envelope, creates a channel based on a moving average as the basis of the two outer lines. The main difference in calculation is that, instead of a straight percentage, the outer bands use a specified number of standard deviations to determine how wide the bands are.
The purpose of this article is not to go into a detailed explanation of statistics. So, suffice it to say, the main thing a trader needs to know is that the wider the bands are, the more the price data is deviating from the moving average and the more volatile the market has become. When the bands narrow, the price data is consolidating.
A variety of strategies use Bollinger Bands, and it’s a fairly intricate study. One of the main methods involves looking for periods of tightening bands and, then, looking for price breakouts once the price breaks through the bands’ channel. This took place on January 23 on the preceding chart.
Donchian Channel
This price study resembles the other channels we’ve looked at, but it is calculated very differently. In the indicators previously discussed, the middle line was the starting point for the outside channel lines. In the case of the Donchian Channel, this is reversed. The outside lines are determined by the highest high and the lowest low during the bar period; by default, this is 20 bars. This means that the top channel line is always drawn based on the highest price during the last 20 periods, and the bottom channel is drawn based on the lowest price in the same amount of time. The middle line is exactly that -- the mid-point between the top and bottom channel.
Donchian channels are used in various ways just like other channels. Support and resistance and trend breakouts are common uses. But, another popular method involves using the channels to first determine trend direction, and, then, using the midline as a trigger to re-enter the trend. If the price crosses the midline, a change in trend is possible, and a counter-trend trade can be taken in the reverse direction.
Linear Regression
All the price studies we’ve looked at thus far have been made up of lines that rise, fall and curve around the price data; however, the Linear Regression study comprises three straight lines. Just like many of the other channels and envelopes we’ve looked at, a Linear Regression channel has a middle line as the starting point for determining the outer lines. This basis line is calculated based on a complex statistical model called least squares.
The main thing a trader needs to know is that this line finds the line of best fit along the data series -- a line drawn along the “middle” of all the data. The outside lines are determined by another statistics calculation that we’ve already seen -- standard deviation.
The Linear Regression study is used in a variety of ways, just like all the channels we’ve used; however, the popular methods include general support and resistance lines and for confirming changes in trend. A tighter channel with less standard deviations can also be used to trigger into or out of a trade.
Parabolic SAR
The Parabolic Stop and Reverse (SAR) was originally designed to be a standalone trading system that we’ll discuss shortly. But, first, we’ll look at how the study takes shape. The term parabolic refers to the shape that the lines can take and also has to do with the internal calculations of the study. The methods used to calculate this study are complex and beyond the scope of this article; however, a trader should know the basics.
The Parabolic SAR dots, or hashes, are below the price data in an up trend, and they are above the price data in a down trend. As the bars continue to rise with an up trend, the slope of the dots increases, and the slope continues to increase with each new high that is made. The same is true for a down trend: As bars make new lows, the SAR dots head down faster. Eventually, the price will cross the dots, and, when that occurs, the dots will flip to the opposite side, and the slope calculation will restart.
In its simplest form, the Parabolic is used by taking a long position at the time the SAR switches from being above the price data to being below. Then, a trailing stop is placed at the price level of the SAR dots and adjusted as each new dot increases. When the price crosses the dots, the position is stopped out and a short position is taken. Stop levels are repeated, and the short trade continues until the prices crosses again, and so it continues ad infinitum.
This trade system has great potential, and it can pull down large profits in trending markets; however, the big downside of the SAR system is that, in choppy or sideways markets, a trader can lose as much -- or more -- during this period. As we’ll see in later articles, there are ways to determine whether a market is trending or not, and, thus, ride out the difficult times using the Parabolic SAR trading system.
In the next article, we’ll take a look at some of the pane studies in eSignal.
