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eSignal’s Basic Studies (Part 3)
This is the last article of our three-part series on the technical indicators that come with the eSignal application. In case you missed the earlier issues, please visit the Exchange archive. Six pane studies will be covered this month: On Balance Volume, Stochastic, Williams %R, Price Oscillator, Rate of Change and RSI.
On Balance Volume (OBV)
Our first study is a momentum indicator designed to give you an indication of how the money is moving in and out of a company or futures contract. When the OBV is trending up, more and more money is flowing in. And, as the OBV trends down, the reverse is true. When the OBV turns sideways and becomes indecisive, the price will also demonstrate this behavior.
The calculation of OBV is quite simple. If the close of the current bar is greater than that of the previous bar, that bar’s volume is added to the previous bar's OBV value. If the bar closes lower than the previous bar’s close, the volume is subtracted from the OBV. If the closes are equal, no change occurs to the OBV.
The interpretation of the OBV is varied, just as price and volume interpretation is. The most common method is to watch for trend changes in the OBV because these often precede trend changes in price. For instance, in the preceding image, the uptrend on IBM in January 2008 ended abruptly and retraced 75 percent of its earlier trend. The OBV caught this early, by breaking its trend line drawn along the valleys of the indicator.
In February, the OBV changed its tune again and so did the price. For almost the next two months, the OBV rode nearly a straight line until recently breaking its trend line on March 26. We could either be heading into an area of indecision or possibly a retracement, but this is a good sign that you should at least take some money off the table if you’re in a long position on IBM.
Stochastic and Williams %R
These indicators are being discussed together because, for all intents and purposes, they have identical mathematical calculations and usage models. There are only two main differences between them. The first is that the Stochastic indicator is plotted from 0 to 100, and the Williams %R is plotted from 0 to -100. The second difference is that the Stochastic is often plotted with a second line on the chart that is a moving average (called the %D) of the main line (called the %K). If you compare the blue lines in the subsequent screenshot, you’ll recognize them as being equal.
The calculation for these indicators is not equal, but the results, when plotted, are the same. To avoid going too deeply into discussion of the algorithms behind these indicators, I’ll keep to the basic premise. That is, the Stochastic %K line and Williams %R plots the relationship between the current closing value to the High and Low range over the last X number of bars.
If the close is exactly at the highest point in the high / low range, the indicator will be at its maximum value. If the close is at its lowest point in the range, the indicator will be at its minimum value. The red %D line, as mentioned earlier, is simply a moving average of the %K line (default is a 3-period SMA).
General usage of these indicators is to determine overbought (OB) and oversold (OS) conditions. Specifically for the Williams %R, it is OB when above -20 and OS when below -80. The same is true for the Stochastic, but on a different scale: It is OB when greater than 80 and OS when less than 20.
Practically speaking, the usage of these studies is pretty varied. One method involves looking for divergences between price and study (as marked by the red lines on the candlesticks) and the Williams %R study. Please refer to our previous article for a discussion on divergences. The other method involves looking for %K and %D crossings when overbought or oversold on the Stochastic to take quick counter-trend trades marked by dark blue arrows on the image shown previously.
Price Oscillator
The price oscillator is a lagging indicator designed to highlight the overall price trend. Although it is deviously simple in its calculation, that by no means indicates that it is just as simple to use. Much like its underlying "brother", the Moving Average (MA), it is quite a nuanced study that can be analyzed deeply or very simply.
The price oscillator is calculated by finding the difference of two moving averages. The default settings in eSignal use a 10- and 21-period simple moving average to determine its histogram. As seen in the image shown subsequently, I’ve plotted those two moving averages in the price pane to demonstrate that, the farther apart the MAs are, the farther the oscillator is from zero.
As mentioned before, you can use the price oscillator a number of ways. The easiest to understand is simply to go long when the price oscillator rises from being below zero to above zero, and then reverse and go short when the oscillator goes back below zero. While this method can reap very profitable trades in trending markets, it is not recommended because volatile markets can quickly eat up those profits with reversals, head-fakes and whipsaws (for instance, false signals).
A second method involves just generally using the price oscillator to help identify the strength of a particular trend. The farther the study is from zero, the more powerful the trend has become.
The third and, in my opinion, the most powerful way to use the oscillator is for confirming the end of a trend. When in a long or a short position, watch for the study to disagree with the price move. Take a look at the end of 2007 on IBM and notice how the price oscillator was heading down despite the price data continuing to move up.
In essence, this is a warning sign that the trend is weakening, and scaling out of the position is advisable. This is also occurring again during this last month. IBM is making higher highs, but the oscillator is making lower highs.
Rate of Change (ROC)
The Rate of Change is another type of oscillator that attempts to predict reversals via its extreme peaks and valleys. This indicator is very similar to that of the Momentum indicator we discussed last month with the exception that, instead of showing the price difference between the current bar and the bar X periods ago, the ROC shows the percentage difference between those two values.
The use of the ROC is practically identical to that of the Momentum study, so we’ll add onto what we’ve already learned about that study. A second method that can be used for these indicators is to look at the patterns that have already occurred and estimate some overbought and oversold levels for that particular symbol. In the case of IBM, +/- 7.5 percent seems to be appropriate, so in the preceding image, I’ve added these levels to the chart.
As the ROC line crosses into the OB / OS areas, the trends will likely continue for an indeterminate amount of time. What we need from this is to look for the ROC exiting the OB / OS areas -- that is, crossing of the lines back across the 7.5 percent lines toward zero. Much like the CCI, these counter-trend trades are riskier but can often lead to higher profits.
Relative Strength Index (RSI)
The Relative Strength Index is the last indicator we’ll be looking at, and it is certainly not the least valuable by any means. Of all the oscillators we’ve looked at this month, the RSI is actually the most specific on how to use it.
The calculation for the RSI is fairly lengthy, so we won’t get into the specific details. What a trader needs to know is that, at the core of calculation, the RSI is a ratio of the average gain on up days versus the average loss on down days. If the gains are larger on green candles than the losses are on the red candles, the RSI will rise. If the losses are bigger on average, the RSI will drop.
This produces very specific oversold and overbought indicators on a chart. When the RSI is less than 30, the symbol being analyzed is quite oversold, and it is likely that that trend cannot be sustained for much longer. In the same way, when the RSI is greater than 70, the symbol is overbought, and a reversal or end to the trend is imminent.
Throughout most of these examples, we’ve looked at longer-term charts; however, these strategies can often be applied to much shorter-term trading with a few tweaks here and there. This adjusted method of using the RSI is for identifying short-term swings within an established trend. Some small, but reliable, quick scalps can be had when these trading conditions set up.
In the preceding screenshot, you’ll see how the bottoms of the RSI picked up the retracements in the down trend with surprising accuracy. Likewise, the trend continuations were also highlighted by the peaks in the RSI (marked with red arrows).
I hope that this broad look at all the indicators included in eSignal has added new tools to your trading repertoire. This is really only scratching the surface on technical analysis, so I would encourage those who want more education on the subject to head over to eSignal Learning for even more trading education.
