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Sunday 1 April 2018

10 TECHNICAL TRADING INDICATORS YOU MUST KNOW

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Are you confused by the bright lines on your trader friend’s price charts? What value do those squiggly lines add to your chart analysis?
Let’s find out now.
In technical analysis, these colourful lines are technical indicators used for forecasting the market. There are tonnes of trading indicators with creative traders churning out new variants every day.
There is absolutely no need to master them all. But you should know the ten technical indicators that follow.
For each trading indicator, I will briefly explain its calculation logic. We aim to find out what goes into each indicator while avoiding their intimidating formulae.
(For their exact calculation, refer to ChartSchool.)
I will also describe each indicator’s basic usage together with an example chart and further resources.

TECHNICAL INDICATORS – OVERVIEW

Price Moving Averages
Trading Oscillators
Trend Indicators
Price Channels

PRICE MOVING AVERAGES

moving average is one of the simplest technical indicator derived from price. Although there are many versions out there, there are only two common variants.

1. SIMPLE MOVING AVERAGE (SMA)

The simple moving average was popular in the past as it was easy to calculate manually without the need for computers. Now, despite powerful charting platforms, it continues to attract traders with its sheer simplicity.
Technical Indicator - Simple Moving Average

CALCULATING THE SMA

The SMA is calculated by taking the average closing price of the past N bars. The trader provides the input N.
Simple, right?

INTERPRETING THE SMA

The basic approach is to compare the price with the SMA to assess the market sentiment.
  • Price is above the SMA –> Bullish
  • Price is below the SMA –> Bearish
You can also look at the slope of the SMA.
  • SMA is sloping up –> Bullish
  • SMA is sloping down –> Bearish
As we overlay moving averages on price charts, it is also possible to use them as support/resistance levels.

LEARN MORE ABOUT THE SMA


2. EXPONENTIAL MOVING AVERAGE (EMA)

In the past, the SMA was just MA. But traders grew dissatisfied with the SMA as they always do with simple methods. So, they started to tinker with it. They then had to call it “simple” to distinguish it from its complex counterparts that resulted from the tinkering.
One of the SMA’s sophisticated cousin is the EMA.
Technical Indicator - Exponential Moving Average

CALCULATING THE EMA

Like the SMA, the EMA is also an average closing price of the past N bars. However, it is not a simple average. It is a weighted average.
(A small caveat here. The EMA contains information from more than N bars ago. Read this article to learn more.)
In obtaining the EMA value, we give a higher weight to the more recent values. The result is a moving average that is more responsive to current prices.

INTERPRETING THE EMA

The interpretation of the EMA in trading is the same as that of the SMA as stated above.
The key here is to recognise the trade-offs between the SMA and EMA. As the EMA is more responsive to recent market prices, it produces more signals from bullish to bearish and vice versa. However, the more signals a moving average provides, the less reliable each signal becomes.
This trade-off is inevitable among technical indicators.

LEARN MORE ABOUT THE EMA

TRADING OSCILLATORS

Trading oscillators measure the momentum/speed of price movement. Mostly, they find over-extended market movements that might be reversing.
Let’s take a look at three common oscillators in technical analysis.

3. STOCHASTIC OSCILLATOR

George Lane’s Stochastic Oscillator had been the classic oscillator since its invention decades ago. For a fascinating history of the Stochastic, take a look at this article in MTA’s knowledge base.
Technical Indicator - Stochastic

CALCULATING THE STOCHASTIC

Common Default Value: Stochastic(14,3)
The Stochastic plots with two values: %K and %D.
As an example, consider the price range of the past two weeks. If the price is near the top of this range, the two-week Stochastic produces a high %K value. If price hovers near the bottom of the range, it gives a low %K value.
The %D line, which is usually a 3-period moving average of %K, acts as the trigger line.
A few tweaks in its formula ensure that the Stochastic values always fluctuate between 0 and 100.

INTERPRETING THE STOCHASTIC

If the market is at the extreme (high or low) of the recent trading price range, there is clearly strong momentum in one direction. But the momentum might be unsustainable. Hence, there are overbought and oversold zones.
  • Stochastic values above 80 –> Overbought (look to sell)
  • Stochastic values below 20 –> Oversold (look to buy)
Combining both the %K and %D lines offers exact signals.
  • %K crossing below %D –> Sell signal
  • %K crossing above %D –> Buy signal

LEARN MORE ABOUT THE STOCHASTIC


4. RELATIVE STRENGTH INDEX (RSI)

There is one person we can never avoid when we talk about technical indicators. He is J. Welles Wilder. The RSI is one tool in his diverse and valuable toolbox.
Technical Indicator - RSI

CALCULATING THE RSI

Common Default Value: RSI(14)
The RSI measures the speed of price movement using concepts of average gain and average loss.
The RSI combines the average gain and average loss into a single ratio (RS) that represents price momentum. Then, we apply a smoothing process similar to that of the EMA.
Like the Stochastic, the RSI values are always between 0 and 100.

INTERPRETING THE RSI

If the average gain outpaces the average loss consistently, the market might be poised to fall. The reverse is true when the average loss is leading.
  • RSI values above 70 –> Overbought (look to sell)
  • RSI values below 30 –> Oversold (look to buy)

LEARN MORE ABOUT THE RSI


5. COMMODITY CHANNEL INDEX (CCI)

Donald Lambert’s CCI is another trader’s favourite. Although originally meant for trading commodities, it is also used for other financial instruments.
Technical Indicator - CCI

CALCULATING THE CCI

Common Default Value: CCI(14)
The CCI uses the deviation between price and its moving average to measure price momentum. It does so by comparing the deviation of the current period with the average deviation in the past N periods.
Unlike the Stochastic and RSI, CCI values are unbounded. But, practically, due to a factor chosen by Donald Lambert, its value is usually between -100 to +100.
Notably, the CCI uses typical price (H+L+C/3) instead of closing price.

INTERPRETING THE CCI

Its name is telling. The CCI works on the assumption that price is typically contained by an invisible channel around a moving average.
If you think that the hidden channel will hold, you should follow these trading rules.
  • CCI values above +100 –> Overbought (look to sell)
  • CCI values below -100 –> Oversold (look to buy)
If you think that the market will break out of the invisible channel, then look at Donald Lambert’s original rules.

LEARN MORE ABOUT THE CCI

TREND INDICATORS

The oscillators above work hard to find reversals. On the other hand, the technical indicators in this section try to pinpoint trends.

6. AVERAGE DIRECTIONAL INDEX (ADX)

Let’s welcome J. Welles Wilder again. He believed that to trade effectively, you must figure out if the market is trending or ranging. And the ADX is his tool for doing so.
Technical Indicator - ADX

CALCULATING THE ADX

Common Default Value: ADX(14)
The ADX is built on the unique concept of directional movement. Positive directional movement (+DM) refers to the difference between the high of a price bar and that of its preceding bar. Negative directional movement (-DM) is the difference between the low of a price bar and that of the bar before it.
Clearly, when the market is bullish, +DM is high. When the market is bearish, -DM is high.
By combining +DM and -DM in a Wilder-ish formula, we get the ADX which is a measure of trend strength.

INTERPRETING THE ADX

The ADX is a trend strength indicator. High values represent a trending market, and low values represent a dull one.
  • ADX values above 25 –> Market is trending
  • ADX values below 25 –> Market is meandering
Something is missing. Doesn’t the ADX show us market trend’s direction?
Alone, it does not. But the ADX is often used with the +DM and -DM plots. For instance, when +DM is above -DM and ADX is above 25 like in the chart above, the market is in a bull trend.

LEARN MORE ABOUT THE ADX


7. MOVING AVERAGE CONVERGENCE DIVERGENCE (MACD)

Gerald Appel’s MACD is one of the most intuitive technical indicators around. It amplifies the value of moving averages in an elegant way to track both trend and momentum.
Technical Indicator - MACD

CALCULATING THE MACD

Common Default Value: MACD(12,26,9)
The MACD plots the difference between two moving averages, usually the 26-period and 12-period.
A 9-period moving average of the MACD is then plotted as the signal line.
If you see a histogram on a MACD plot, it is the difference between the MACD line and its signal line.

INTERPRETING THE MACD

The MACD works because, in a trending market, the space between two different moving averages expands. As the MACD always deduct the shorter moving average from the longer one, its value rises in a bull trend and falls in a bear trend.
  • MACD above signal line –> Bullish
  • MACD below signal line –> Bearish
Also, the histogram highlights the momentum of the market.
  • High positive histogram values –> Strong bullish momentum
  • High negative histogram values –> Strong bearish momentum
However, as the MACD is unbounded with no normal limits, it is not practical to define oversold and overbought regions. Hence, looking for MACD divergence is the preferred method.

LEARN MORE ABOUT THE MACD

PRICE CHANNELS

Price does not move in a straight line. It swings up and down. And the market often looks like it is moving within a price envelope.
This is why many traders favour technical indicators that highlight the market’s channel-like movement.

8. BOLLINGER BAND

John Bollinger has given his name to one of the most popular technical indicators. The Bollinger Band is now a standard overlay for many technical traders.
Technical Indicator - Bollinger Band

CALCULATING THE BOLLINGER BAND

Common Default Value: Bollinger(20,2)
The Bollinger Band might look erratic with its sudden expansions and constrictions. But it is, in fact, a straightforward and logical technical indicator.
First, plot a moving average of the past N periods. Then, calculate the standard deviation of the past N periods.
To get the upper band, displace the moving average upwards by a multiple of the standard deviation. For the lower band, displace the moving average lower by the same distance.

INTERPRETING THE BOLLINGER BAND

For a range trade,
  • Price tags upper band –> Look to sell
  • Price tags lower band –> Look to buy
The Gimmee Bar is an example of using the Bollinger Band in a sideways market.
For a break-out trade,
  • Price closes above upper band –> Look to buy
  • Price closes below lower band –> Look to sell

LEARN MORE ABOUT THE BOLLINGER BAND


9. DONCHIAN CHANNEL

This indicator got its name from Richard Donchian, a pioneer of managed futures and the well-known Turtle trend-following method. There is no way we are giving this indicator a miss.
Technical Indicator - Donchian Channel

CALCULATING THE DONCHIAN CHANNEL

Common Default Value: DonchianChannel(20)
The normal default period of 20 aims to contain four weeks of trading activity on the daily chart.
The Donchian Channel plots the highest high in the last N periods as its top channel line. The lowest low in the last N periods is plotted as its bottom channel line.

INTERPRETING THE DONCHIAN CHANNEL

The Donchian Channel is designed to follow a trend. Each break-out of the channel is a possible start of a new trend.
  • Price breaks out above the channel –> Potential bull trend
  • Price breaks out below the channel –> Potential bear trend

LEARN MORE ABOUT THE DONCHIAN CHANNEL


10. KELTNER CHANNEL

The Keltner Channel as most traders know it now combines the ideas of Chester Keltner and Linda Bradford Raschke.
Technical Indicator - Keltner Channel

CALCULATING THE KELTNER CHANNEL

The construction of the Keltner Channel is like that of the Bollinger Bands.
However, instead of using standard deviation to draw the bands, it uses Wilder’s Average True Range. This difference causes the Keltner Channel to look smoother than the Bollinger Band.

INTERPRETING THE KELTNER CHANNEL

For a range trade,
  • Price tags the upper channel line –> Look to sell
  • Price tags the lower channel line –> Look to buy
For a break-out trade,
  • Price closes above the upper channel line –> Look to buy
  • Price closes below the lower channel line –> Look to sell

LEARN MORE ABOUT THE KELTNER CHANNEL

WHAT’S NEXT?

We have covered the basics of 10 essential technical indicators. But there is much more to learn before you can extract value from them.

UNDERSTAND THAT RULES ARE GUIDELINES

The interpretation rules above look straightforward and mechanical. But they are merely guidelines. In fact, if you apply them mechanically, you will not make money.
Master technical indicators with these tips:
  • Grasp the market context in which they work.
  • Learn to read price action together with technical indicators to complete your learning.
  • Learn from the masters by following the links in the “Learn More” sections above.
  • Combine indicators to form a rounded perspective.
For a solid education on technical indicators, get this book – Technical Analysis: The Complete Resource for Financial Market Technicians (2nd Edition).

EXPERIMENT WITH LOOK-BACK PERIODS

The behaviour of each technical indicator varies with its look-back period. The default settings might not always make sense. Experiment!
(This 2-period ADX strategy is a product of my experiments.)

ADD VOLUME INDICATORS INTO THE MIX

The ten technical indicators we covered are derived from price. Volume is another important piece of market data.
When you feel up to it, add in volume indicators for another dimension of analysis. Start with the OBV indicator.

10 STEPS TO CREATING YOUR FIRST TRADING STRATEGY

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Most new traders start by learning the trading strategies of other traders. I began my trading career this way as well. But, many traders ask, how do I get started with my trading strategy?
The good news: Creating your first trading strategy is easy.
The bad news: Creating a profitable trading strategy is hard.
Start with the right expectations. Forming a trading strategy is easy. Learn a few trading tools and indicators, and you can do it.
However, it’s not realistic to think that your first trading strategy will make you rich.
Finding an objective trading edge is tough. On top of that, you’ll realise that trading profitably goes beyond your trading strategy.
Then why should you still form your trading strategy? Why not just use the trading strategy of a successful trader?
Traders might share their tools and approaches. But no trader can or will guarantee your profits. Every trader is different. Hence, you can only benefit from a unique and personal blend of trading tools.
The best and most sustainable approach is to develop your trading strategy.
Follow these 10 steps to forming your first trading strategy:

STEP 1: FORM YOUR MARKET IDEOLOGY

Before you jump into creating your own trading strategy, you must develop an idea of how the market works. Most importantly, you need to answer this question.
Why do you think you can make money from the markets?
Form your market ideology by reading widely. Read about both technical and fundamental analysis.
Avoid get-rich-quick claims.
Think about demand and supply.
Doubt theories that claim that people are perfectly rational.
Your ideology will define every step that follows. Give it the attention it deserves.
Regardless, I urge you to follow one principle in your first trading strategy.
Keep it as simple as possible.
You don’t want to be overwhelmed by a complex strategy right from the start. Moreover, a trading strategy with more moving parts is harder to manage and improve.

STEP 2: CHOOSE A MARKET FOR YOUR TRADING STRATEGY

Forex? Equities? Options? Futures?
If you choose to trade forex, understand what you are buying and selling with a currency quote. Make sure you learn about the different models of forex brokers. Know how the margin is calculated.
Or if you choose to trade equities, you must know what a share means. You must know the difference between a blue-chip and a penny stock.
The point is there’s a lot to learn about each market. But you cannot start to learn in-depth until you choose your trading market.
Although I recommend futures trading for intraday traders, the choice is yours. The only rule is that you must understand the market you choose to trade.

STEP 3: CHOOSE A TRADING TIME FRAME

Before you gain any trading experience, it’s hard to decide on a trading time frame. You will not know if you are more suited to quick scalping or daily swing trading.
Should you trade the 5-minute time frame or the daily charts?
Hence, you can start by considering your circumstances. If you have time to watch the market for extended periods, try intraday trading.
When you trade fast time frames, you get fast feedback to shorten your learning time. Even if you end up with longer timeframes, what you learn from intraday price action will still be useful.
Of course, if you are not able to watch the market for extended periods, start with end-of-day charts. With sustained effort, you can learn enough to decide if swing trading is for you.
Choose Your Trading Time Frame

STEP 4: CHOOSE A TOOL TO DETERMINE THE TREND (OR LACK OF)

You don’t trade when you see a Pin Bar. You trade when the market is rising, and you use a bullish Pin Bar to trigger your trade.
You don’t trade when you see a Gimmee Bar. You trade when you judge that the market is going sideways, and you use a Gimmee Bar to enter the market.
Decide on a tool to help you judge the market context. (i.e. trending or not, up or down)
You can choose price action tools like swing pivots and trend lines. You can also use technical indicators like moving averages and MACD.

STEP 5: DEFINE YOUR ENTRY TRIGGER

Even with the right market context, you need an objective entry trigger. It will help you enter the market without hesitation.
Both bar and candlestick patterns are useful triggers. If you prefer indicators, oscillators like the RSIand stochastics are good options too.
Stochastic for Swing Trading

STEP 6: PLAN YOUR EXIT TRIGGER

You need to plan how to exit when things go wrong. The market can go against you, causing you losses beyond your imagination. Having a stop-loss is critical.
You also need to plan how to exit when things go your way. The market will not go your way forever. Hence, you need to know when to take profits.

STEP 7: DEFINE YOUR RISK

Once you have your entry and exit rules sorted out, you can work on limiting risk.
The primary way to do so is by position sizing. For a given trading setup, your position size determines how much money you are putting on the line.
Double your position size, and you will double your risk. Watch your position size carefully.

STEP 8: WRITE DOWN YOUR TRADING RULES

At this stage, your trading strategy is simple. You might be able to memorise the trading rules. However, you must still write down your trading rules.
Having a written trading plan is a robust method to ensure discipline and consistency.
It also provides a record of your trading strategy. You will find it useful when you are trying to refine it.

STEP 9: BACKTEST YOUR TRADING STRATEGY

With your written rules, you can now backtest the strategy.
If you have a discretionary trading strategy, backtesting can be an arduous process. You need to replay the market price action and record your trades manually.
If you have a mechanical trading strategy and a coding background, you can speed up this stage.
Nonetheless, looking through the trades one by one is a great way to develop your market instinct. Doing so can also help you think of ways to improve your trading strategy.

STEP 10: PLAN HOW TO IMPROVE YOUR TRADING STRATEGY

Your first trading strategy will not be profitable. But it’s okay. Your trading strategy is a living object. It is not static.
With your growing experience and knowledge, your trading strategy will improve.
But let’s not leave this to chance. Plan how you will obtain feedback and improve your trading strategy.
Forward test your trading strategy. Plan to take good notes of your market observations. Record your trades and keep your chart images in good order.
Avoid drastic changes to your trading strategy.
For this final step (which might take forever), remember that your aim is to achieve positive expectancy with every trade. Not positive profits for each trade.
Let statistics work for you. Don’t force your will on the market.

CONCLUSION

Follow the 10 steps above, and you will find yourself with a basic trading strategy.
This strategy is not the Holy Grail. But it is formed with your experience and according to your trading style. 
Keep working on it, and you will stand a chance to succeed