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THE NEW TRADING OF A LIVING- GENERAL MARKET INDICATORS

THE NEW TRADING OF A LIVING



GENERAL MARKET INDICATORS

You can use technical indicators to analyze any trading vehicle: a stock, a future, an index, etc. Such tools as moving averages, MACD, Force index, and others, can provide signals for any ticker in any timeframe. Now we turn to a different group of tools: general market indicators, which analyze the entire market rather than any specific stock. They are worth following because general market trends are responsible for as much as half the movement in individual stocks.

While there are dozens of general market indicators, this is not an encyclopedic review—I’ll simply share the tools that help me trade. You may use the same or different tools—select those that appeal to you and test them on your market data. We can trust only those indicators that we have tested.

The New High–New Low Index

Stocks that reach their highest level in a year on any given day are the leaders in strength. Stocks that fall to their lowest point for that year on the same day are the leaders in weakness. The New High–New Low Index (NH-NL) tracks the behavior of market leaders by subtracting the number of New Lows from the New Highs. In my experience, NH-NL is the best leading indicator of the stock market.

How to Construct NH-NL

The New High–New Low Index is easy to calculate, using information that appears in many online sources and in major newspapers.

                                      NH-NL = New Highs − New Lows

Most data services in the United States report the daily numbers of New Highs and New Lows, but it is shocking how loosely they define their data. Some are too narrow and track only the NYSE stocks, ignoring other exchanges. Others are too broad and track everything, including interest rate ETFs. I take their data, subtract New Lows from New Highs, and plot the result underneath the daily chart of the S&P 500.

The task of constructing NH-NL is harder for traders outside the United States, in countries where such data isn’t reported. There you’ll need to do a bit of programming. First, run a daily scan of the database of all stocks in your country to find those that have reached the highest high and the lowest low for the year during the day. Once you have those two lists, take the above formula and apply it to the numbers you found.

On the days when there are more new highs than new lows, NH-NL is positive and plotted above the centerline. On the days when there are more new lows than new highs, NH-NL is negative and plotted below the centerline. If the numbers of new highs and new lows are equal, NH-NL is zero. We normally plot the New High– New Low Index as a line, with a horizontal reference line at a zero level.

While I plot NH-NL underneath the S&P 500, keep in mind that it has a much broader reach than the S&P—NH-NL includes data from the NYSE, AMEX, and NASDAQ, excluding only ETFs, unit investment trusts, closed-end funds, warrant stocks, and preferred securities. The chart of the S&P 500 is there simply for a comparison.

Crowd Psychology

A stock appears on the list of new highs when it’s the strongest it’s been in a year. It means that a herd of eager bulls is chasing its shares. A stock appears on the list of new lows when it’s the weakest it’s been in a year, showing that a crowd of aggressive bears is selling its shares.

The New High–New Low Index compares the numbers of the strongest and the weakest stocks on the exchange. It reveals the balance of power between the leaders in strength and the leaders in weakness.

You can visualize all stocks on the New York Stock Exchange, the NASDAQ, or any other exchange as soldiers in a regiment. The new highs and new lows are their officers. The new highs are the officers who lead an attack uphill. The new lows are the officers who are deserting and running downhill.

The quality of leadership is a key factor in any conflict. When I was in officer training, they kept telling us that there are no bad soldiers, only bad officers. The New High–New Low Index shows whether more officers are leading an attack uphill or deserting downhill. Where the officers lead, soldiers follow. The broad indexes, such as the S&P 500, tend to follow the trend of NH-NL.

When NH-NL rises above its centerline, it shows that the bullish leadership is dominant. When NH-NL falls below its centerline, it shows that bearish leadership is in charge. If the market rallies to a new high and NH-NL climbs to a new peak, it shows that bullish leadership is growing and the uptrend is likely to continue. If the market rallies but NH-NL shrinks, it shows that the leadership is becoming weak and the uptrend is in danger. A regiment whose officers are starting to desert is likely to retreat.

A new low in NH-NL shows that the downtrend is well led and likely to persist. If officers are running faster than the men, the regiment is likely to be routed. If stocks fall but NH-NL turns up, it shows that officers are no longer running. When officers regain their morale, the whole regiment is likely to rally.

Trading Rules for NH-NL

Traders need to pay attention to three aspects of NH-NL: the level of NH-NL above or below its centerline, the trend of NH-NL, and divergences between the patterns of NH-NL and prices.

FIGURE  S&P 500 daily, 26- and 13-day EMAs, Autoenvelope, NH-NL daily.

NH-NL Zero Line

The position of NH-NL in relation to its centerline shows whether bulls or bears are in control. When NH-NL is above its centerline, it shows that more market leaders are bullish than bearish and it is better to trade from the long side. When NH-NL is below its centerline, it shows that bearish leadership is stronger, and it’s better to trade from the short side. NH-NL can stay above its centerline for months at a time in bull markets and below its centerline for months in bear markets.

If NH-NL stays negative for several months but then rallies above its centerline, it signals that a bull move is likely to begin. It is time to look for buying opportunities, using oscillators for precise timing. If NH-NL stays positive for several months but then falls below its centerline, it shows that a bear move is likely to begin. It is time to look for shorting opportunities using oscillators for precise timing.

NH-NL Trends

When the market rallies and NH-NL rises, it confirms uptrends. When NH-NL declines together with the market, it confirms downtrends.

1. A rise in NH-NL shows that it’s safe to hold long positions and add to them. If NH-NL declines while the broad market stays flat or rallies, it is time to take profits on long trades. When NH-NL falls below zero, it shows that bearish leadership is strong and it’s safe to hold short positions and even add to them. If the market continues to fall but NH-NL rises, it shows that the downtrend is not well led—it’s time to cover shorts.

2. If NH-NL rises on a flat day, it flashes a bullish message and gives a buy signal. It shows that officers are going over the top while the soldiers are still crouching in their foxholes. When NH-NL falls on a flat day, it gives a signal to sell short. It shows that officers are deserting while the troops are still holding their positions. Soldiers aren’t stupid—if their officers start running away, they will not stay and fight.

NH-NL Divergences

If the latest market peak is confirmed by a new high of NH-NL, that rally is likely to continue, even if punctuated by a decline. When a new market low is accompanied by a new low in NH-NL, it shows that bears are well led and the downtrend is likely to persist. On the other hand, divergences between the patterns of NH-NL and broad market indexes show that leaders are deserting and the trends are likely to reverse.

1. If NH-NL traces a lower peak while the market rallies to a new high, it creates a bearish divergence. It shows that bullish leadership is weakening even though the broad market is higher. Bearish divergences often mark the ends of uptrends, but pay attention to the height of the second peak. If it is only slightly above zero, in the low hundreds, then a big reversal is probably at hand and it’s time to go short. If, on other hand, the latest peak is in the high hundreds, it shows that the upside leadership is strong enough to prevent the market from collapsing.

2. If the market declines to a new low, but NH-NL traces a shallower bottom than its previous decline, it creates a bullish divergence. It shows that bearish leadership is shrinking. If the latest low of NH-NL is shallow, in the low hundreds, it shows that the bearish leadership is exhausted and a major upside reversal is near. If the latest low sinks deep, then bears still have some strength, and the downtrend may pause but not reverse. Keep in mind that bullish divergences at stock market bottoms tend to develop faster than bearish divergences at market tops: buy fast and sell slowly.

NH-NL in Multiple Timeframes and Look-Back Periods

Markets move simultaneously in different timeframes. My original work on the NH-NL focused on the daily charts with a one-year look-back period—counting stocks that have reached a new high or a new low for their latest 52-week range. I have since added several dimensions for a deeper understanding of this key indicator.

Weekly NH-NL

The weekly NH-NL helps confirm major stock market trends and identify major reversals. I build it from the daily data, mentioned above, by running a five-day moving total. I plot the result underneath a weekly chart of the S&P 500.

The weekly NH-NL gives its most important signals when it reaches extreme levels and also by divergences. To understand its logic, keep in mind how the weekly NH-NL is constructed. For example, if the weekly NH-NL rises to a +1,500 level, it means that in each of the past five trading days there were on average 300 more New Highs than New Lows. It takes a period of sustainable bullishness or bearishness to push the weekly NH-NL to an extreme.

These are the most important signals of weekly NH-NL:
  • When it drops below minus 4,000 and then rallies above that level, it delivers major buy signals.
  • When the weekly NH-NL rises above plus 2,500, it confirms bull markets.
  • When the tops or bottoms of weekly NH-NL diverge from price patterns, they signal important reversals.

A drop below −4,000 reflects an unsustainable market panic. To fall that low, the market has to deliver an average of 800 more daily New Lows than New Highs for five days in a row. Such massive panic is not going to last. When the weekly NH-NL rises above −4,000, it flashes a buy signal I call a Spike. It’s so powerful and effective in both bull and bear markets that I named our SpikeTrade group after it.

FIGURE  S&P 500 weekly, 26-week EMA, NH-NL weekly. Green line at +2,500, purple line at −4,000. 

When the weekly NH-NL rises to the +2,500 level, it confirms bull markets. This indicator never rises this high during bear market rallies. When you see it above that level, you know you’re in a bull market, with higher prices likely ahead.

The 65-day and 20-day NH-NL

One of the great innovations in the New High–New Low analysis in recent years was the addition of two new look-back windows: a 20-day and a 65-day. While the regular daily NH-NL compares each day’s high and low to the high-low range for the preceding year, a 20-day NH-NL compares it only to the preceding month and a 65-day NH-NL to the preceding quarter. These shorter-term views of the NH-NL are useful for short-term timing.

These two new time windows deliver more sensitive signals than the standard year-long NH-NL. The logic is simple: before a stock reaches a new high for the year, it must first make a new high for the month and then for the quarter. If a stock has been in a downtrend, it may take a long time to recover and reach a new yearly high, but it can reach monthly and quarterly highs much sooner.

In addition to the usual signals, such as trends and divergences, a very sharp short-term buy signal occurs when the 20-day NH-NL drops below minus 500 and then rallies above that level. It shows that the market has touched and rejected a short-term bearish extreme, and afterwards it usually launches a short-term rally. We call this a “Spike bounce” signal.

Tracking market leaders with the help of NH-NL helps improve timing. There are two ways to utilize the New High–New Low signals. First, since individual stocks largely depend on broad market trends, we can use NH-NL signals to decide when to buy or sell our stocks. Furthermore, we can use NH-NL signals to trade vehicles that track the broad market, such as the S&P e-mini futures.

Stocks above 50-Day MA

This broad stock market indicator is based on the key concepts regarding prices and moving averages. Each price represents a momentary consensus of value among market participants, while a moving average represents an average consensus of value during its time window. This means that when a stock trades above its MA, the current consensus of value is above average—bullish. When a stock trades below its MA, the current consensus of value is below average—bearish.

When the market is trending higher, the percentage of stocks above their moving averages keeps growing. In a broad downtrend, the number of stocks above their MAs keeps shrinking.

FIGURE  S&P 500 weekly and 26-week MA; Stocks above 50 MA with reference lines at 75% and 25%.

This indicator tracks all stocks traded on the New York Stock Exchange, American Exchange, and NASDAQ and calculates how many of them trade above their moving averages. It plots that percentage as a line that fluctuates between 0% and 100%. We can use the pattern of this line to confirm market trends and anticipate reversals.

The indicator for tracking the number of stocks above their 50-day MAs is included in many software packages. I like to view it on a weekly chart, where it helps catch intermediate reversals—market turns that augur in trends that last anywhere from several weeks to several months. You don’t need to look at this indicator daily, but it can be an important part of weekend homework.

In theory, the highest possible reading of this indicator would be 100%, if all stocks rallied above their MAs. Its lowest possible reading of 0% would occur if all stocks were to fall below their MAs. In practice, only exceptional market moves swing it near the 90% or 10% extremes. Normally, this indicator tends to top out near 75% and bottom out near 25%. I draw two reference lines on its chart at 75% and 25% and start looking for the market turn as this indicator approaches those levels.

The percentage of stocks above their 50-day MA gives its trading signals not by reaching any certain levels but rather by reversing near those levels. It signals the completion of a top by rising to or above the upper reference line and then sinking below that line. It signals that a bottom has been formed when it falls below or even near the lower reference line and then turns up.

Notice that the tops of this indicator tend to be broad, while its bottoms are sharper. Tops are formed by greed, which is a happier, longer-lasting emotion. Bottoms are formed by fear—a more intense and shorter-lived emotion.

While some of this indicator’s signals are right on time in catching reversals, others mark only temporary pauses in major trends. Let this serve as a reminder never to rely on a single indicator for trading decisions. Use multiple tools: when they confirm each other’s signals, they reinforce one another.

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THE NEW TRADING OF A LIVING- THE DIRECTIONAL SYSTEM

THE NEW TRADING OF A LIVING



THE DIRECTIONAL SYSTEM

The Directional system is a trend-following method developed by J. Welles Wilder, Jr., in the mid-1970s and modified by several analysts. It identifies trends and shows when a trend is moving fast enough to make it worth following. It helps traders to profit by taking chunks out of the middle of important trends.

How to Construct the Directional System

Directional Movement is defined as the portion of today’s range that is outside of the previous day’s range. The Directional system checks whether today’s range extends above or below the previous day’s range and averages that data over a period of time. These complex calculations are best performed on a computer. The Directional system is included in most programs for technical analysis.

FIGURE  Directional Movement.

1. Identify “Directional Movement” (DM) by comparing today’s high-low range with yesterday’s high-low range. Directional Movement is the largest part of today’s range outside of yesterday’s range. There are four types of DM. DM is always a positive number (+DM and −DM refer simply to movement above or below yesterday’s range).

2. Identify the “True Range” (TR) of the market you analyze. TR is always a positive number, the largest of the following three:
a. The distance from today’s high to today’s low
b. The distance from today’s high to yesterday’s close
c. The distance from today’s low to yesterday’s close

3. Calculate daily Directional Indicators (+DI and −DI). They allow you to compare different markets by expressing their directional movement as a percentage of each market’s true range. Each DI is a positive number: +DI equals zero on a day with no directional movement up; −DI equals zero on a day with no directional movement down.


4. Calculate smoothed Directional Lines (+DI13 and −DI13). Smooth +DI and −DI are created with moving averages. Most software packages allow you to pick any period for smoothing, such as a 13-day moving average. You get two indicator lines: smoothed Positive and Negative Directional lines, +DI13 and −DI13. Both numbers are positive. They are usually plotted in different colors.

The relationship between Positive and Negative lines identifies trends. When +DI13 is on top, it shows that the trend is up, and when −DI13 is on top, it shows that the trend is down. The crossovers of +DI13 and −DI13 give buy and sell signals.

5. Calculate the Average Directional Indicator (ADX). This unique component of the Directional system shows when a trend is worth following. ADX measures the spread between Directional Lines +DI13 and −DI13. It is calculated in two steps:
a. Calculate the daily Directional Indicator DX:


For example, if +DI13 = 34 and −DI13 = 18, then,



b. Calculate the Average Directional Indicator ADX by smoothing DX with a moving average, such as a 13-day EMA.

During a persistent trend, the spread between two smoothed Directional lines increases, and ADX rises. ADX declines when a trend reverses or when a market enters a trading range. It pays to use trend-following methods only when ADX is rising.

Crowd Behavior

The Directional system tracks changes in mass bullishness and bearishness by measuring the capacity of bulls and bears to move prices outside of the previous day’s range. If today’s high is above yesterday’s high, it shows that the market crowd is more bullish. If today’s low is below yesterday’s low, it shows that the market crowd is more bearish.

The relative positions of Directional lines identify trends. When the Positive Directional line is above the Negative Directional line, it shows that bullish tradersdominate the market. When the Negative Directional line rises above the Positive Directional line, it shows that bearish traders are stronger. It pays to trade with the upper Directional line.

The Average Directional Indicator (ADX) rises when the spread between Directional lines increases. This shows that market leaders, for example bulls in a rising market, are becoming stronger, the losers weaker, and the trend is likely to continue.

ADX declines when the spread between Directional lines narrows down. This shows that the dominant market group is losing its strength, while the underdogs are gaining. It suggests that the market is in turmoil, and it’s better not to use trend-following methods.


FIGURE  ANV daily, 22-day EMA, Directional System (13).

Trading Rules

  1. Trade only from the long side when the positive Directional line is above the negative one. Trade only from the short side when the negative Directional line is above the positive one. The best time to trade is when the ADX is rising, showing that the dominant group is getting stronger.
  2. When ADX declines, it shows that the market is becoming less directional. There are likely to be many whipsaws. When ADX points down, it is better not to use a trend-following method.
  3. When ADX falls below both Directional lines, it identifies a flat, sleepy market. Do not use a trend-following system but get ready to trade, because major trends emerge from such lulls.
  4. The single best signal of the Directional system comes after ADX falls below both Directional lines. The longer it stays there, the stronger the base for the next move. When ADX rallies from below both Directional lines, it shows that the market is waking up from a lull. When ADX rises by four steps (i.e., from 9 to 13) from its lowest point below both Directional lines, it “rings a bell” on a new trend. It shows that a new bull market or bear market is being born, depending on what Directional line is on top.
  5. When ADX rallies above both Directional lines, it identifies an overheated market. When ADX turns down from above both Directional lines, it shows that the major trend has stumbled. It is a good time to take profits on a directional trade. If you trade large positions, you definitely want to take partial profits.

Market indicators give hard signals and soft signals. For example, when a moving average changes direction, it is a hard signal. A downturn of ADX is a soft signal. Once you see ADX turn down, you ought to be very, very careful about adding to positions. You should start taking profits, reducing positions, and looking to get out.

Average True Range—Help from Volatility

Average True Range (ATR) is an indicator that averages True Ranges (described in "How to Construct the Directional System" above) over a selected period of time, such as 13 days. Since volatility is a key factor in trading, you can track it by plotting a set of ATR lines above and below a moving average. They will help you visualize current volatility and you can use that for decision making.

Kerry Lovvorn likes to plot three sets of lines around a moving average: at one, two, and three ATRs above and below an EMA. These can be used for setting up entry points and stops, as well as profit targets.

Entries  On moving averages, we saw that it was a good idea to buy below value—below the EMA. But how far below? Normal pullbacks tend to bottom out near the minus one ATR.

Stops  You want your stop to be at least one ATR away from your entry. Anything less than that would place your stop within the zone of normal market noise, making it likely to be hit by a random short-term move. Placing your stop further away makes it more likely that only a real reversal can hit your stop.


FIGURE  LULU daily, 21 EMA, volume with 8 EMA, ATR channels.

Targets  After you buy a stock, depending on how bullish it appears to you, you can place an order to take profits at +1, +2, or even +3 ATRs. Kerry likes to get out of his winning positions in several steps, placing orders for taking profits for one third at 1 ATR, another third at 2 ATR, and the rest at 3 ATR.

It is highly unusual for any market to trade outside of three ATRs—three times average true range—for a long time. Those tend to be the extreme moves. Wheneveryou see a market trade outside of its three ATRs, either up or down, it is reasonable to expect a pullback.

ATR channels work not only with prices. We can also use them to bracket technical indicators to help identify the extreme levels where trends are likely to reverse. I use ATR channels on the weekly charts of Force Index.

Oscillators

While trend-following indicators, such as MACD Lines or Directional system, help identify trends, oscillators help catch turning points. Whenever masses of traders become gripped by greed or fear, they surge but after a while their intensity fizzles out. Oscillators measure the speed of any surge and show when its momentum is starting to break.

Oscillators identify emotional extremes of market crowds. They allow you to find unsustainable levels of optimism and pessimism. Professionals tend to fade those extremes. They bet against deviations and for a return to normalcy. When the market rises and the crowd gets up on its hind legs and roars from greed, professionals get ready to sell short. They get ready to buy when the market falls and the crowd howls in fear. Oscillators help us time those trades.

Overbought and Oversold

Overbought means a market is too high and ready to turn down. An oscillator becomes overbought when it reaches a high level associated with tops in the past. Oversold means a market is too low and ready to turn up. An oscillator becomes oversold when it reaches a low level associated with bottoms in the past.

Be sure to remember that those aren’t absolute levels. An oscillator can stay overbought for weeks when a new strong uptrend begins, giving premature sell signals. It can stay oversold for weeks in a steep downtrend, giving premature buy signals. Knowing when to use oscillators and when to rely on trend-following indicators is a hallmark of a mature analyst.

We can mark overbought and oversold oscillator levels by horizontal reference lines. Place those lines so that they cut across only the highest peaks and the lowest valleys of that oscillator for the past six months. The proper way to draw those lines is to place them so that an oscillator spends only about 5 percent of its time beyond each line. Readjust these lines once every three months.

When an oscillator rises or falls beyond its reference line, it helps identify an unsustainable extreme, likely to precede a top or a bottom. Oscillators work spectacularly well in trading ranges, but they give premature and dangerous signals when a new trend erupts from a range.

We’ve already reviewed one important oscillator—MACD-Histogram. We looked at it “ahead of schedule” because it’s derived from a trend-following indicator, MACD Lines. We’ll now explore very popular oscillators: Stochastic and Relative Strength Index (RSI).

Stochastic

Stochastic is an oscillator popularized by the late George Lane. It’s now included in many software programs and widely used by computerized traders. Stochastic tracks the relationship of each closing price to the recent high-low range. It consists of two lines: a fast line called %K and a slow line called %D.

1. The first step in calculating Stochastic is to obtain “raw Stochastic” or %K:


   where    Ctod = today’s close.
                      Ln = the lowest point for the selected number of days.
                     Hn = the highest point for the selected number of days.
                         n = the number of days for Stochastic, selected by the trader.

 The standard width of Stochastic’s time window is 5 days, although some traders use higher values. A narrow window helps catch more turning points, but a wider window helps identify more important turning points.

2. The second step is to obtain %D. It is done by smoothing %K—usually over a three-day period. It can be done in several ways, such as:


 There are two ways to plot Stochastic—Fast and Slow. Fast Stochastic consists of two lines—%K and %D—plotted on the same chart. It’s very sensitive but leads to many whipsaws. Many traders prefer to use Slow Stochastic, adding an extra layer of smoothing. The %D of Fast Stochastic becomes the %K of Slow Stochastic and is smoothed by repeating step 2 to obtain %D of Slow Stochastic. Slow Stochastic does a better job of filtering out market noise and leads to fewer whipsaws.

Stochastic is designed to fluctuate between 0 and 100. Reference lines are usually drawn at 20 percent and 80 percent levels to mark overbought and oversold areas.

Crowd Psychology

Each price is the consensus of value of all market participants at the moment of transaction. Daily closing prices are important because the settlement of trading accounts depends on them. The high of any period marks the maximum power of bulls during that time. The low of that period shows the maximum power of bears during that time.

Stochastic measures the capacity of bulls or bears to close the market near the upper or lower edge of the recent range. When prices rally, markets tend to close near the high. If bulls can lift prices during the day but can’t close them near the top, Stochastic turns down. It shows that bulls are weaker than they appear and gives a sell signal.

Daily closes tend to occur near the lows in downtrends. When a bar closes near its high, it shows that bears can only push prices down during the day but cannot hold them down. An upturn of Stochastic shows that bears are weaker than they appear and flashes a buy signal.



FIGURE  CVX daily, 26-day EMA. 5-day Slow Stochastic.

Trading Rules

Stochastic shows when bulls or bears become stronger or weaker. This information helps decide whether bulls or bears are likely to win the current fight. It pays to trade with winners and against losers.

Stochastic gives three types of trading signals, listed here in the order of importance: divergences, the level of Stochastic lines, and their direction.

Divergences

The most powerful buy and sell signals of Stochastic are given by divergences between this indicator and prices.

  1. A bullish divergence occurs when prices fall to a new low, but Stochastic traces a higher bottom than during its previous decline. It shows that bears are losing strength and prices are falling out of inertia. As soon as Stochastic turns up from its second bottom, it gives a strong buy signal: go long and place a protective stop below the latest low in the market. The best buy signals occur when the first bottom is below the lower reference line and the second above it.
  2. A bearish divergence occurs when prices rally to a new high, but Stochastic traces a lower top than during its previous rally. It shows that bulls are becoming weaker and prices are rising out of inertia. As soon as Stochastic turns down from the second top, it gives a sell signal: go short and place a protective stop above the latest price peak. The best sell signals occur when the first top is above the upper reference line and the second below.

Overbought and Oversold

When Stochastic rallies above its upper reference line, it shows that the market is overbought. It means that a stock or even the entire market is unusually high and ready to turn down. When Stochastic falls below its lower reference line, it shows that a stock or even the entire market is oversold: too low and ready to turn up.

These signals work fine during trading ranges but not when a market develops a trend. In uptrends, Stochastic quickly becomes overbought and keeps giving sell signals while the market rallies. In downtrends, it quickly becomes oversold and keeps giving premature buy signals. It pays to combine Stochastic with a long-term trend-following indicator. The Triple Screen trading system allows traders to take buy signals from daily Stochastic only when the weekly trend is up. When the weekly trend is down, it allows traders to take only sell signals from daily Stochastic.

1. When you identify an uptrend on a weekly chart, wait for daily Stochastic lines to decline below their lower reference line. Then, without waiting for their crossover or an upturn, place a buy order above the high of the latest price bar. Once you are long, place a protective stop below the low of the trade day or the previous day, whichever is lower.

The shape of Stochastic’s bottom often indicates whether a rally is likely to be strong or weak. If the bottom is narrow and shallow, it shows that bears are weak and the rally is likely to be strong. If it is deep and wide, it shows that bears are strong and the rally is likely to be weak. It is better to take only strong buy signals.

2. When you identify a downtrend on a weekly chart, wait for daily Stochastic lines to rally above their upper reference line. Then, without waiting for their crossover or a downturn, place an order to sell short below the low of the latest price bar. By the time Stochastic lines cross over, the market is often in a free fall. Once you are short, place a protective stop above the high of the trade day or the previous day, whichever is higher.

The shape of Stochastic’s top often indicates whether a decline is likely to be steep or sluggish. A narrow top of Stochastic shows that bulls are weak and a severe decline is likely. A Stochastic top that is high and wide shows that bulls are strong—it is safer to pass up that sell signal.

3. Do not buy when Stochastic is overbought, and don’t sell short when it is oversold. This rule filters out most bad trades.

Line Direction

When both Stochastic lines are headed in the same direction, they confirm the shortterm trend. When prices rise and both Stochastic lines rise, the uptrend is likely to continue. When prices slide and both Stochastic lines fall, the short-term downtrend is likely to continue.

More on Stochastic

You can use Stochastic in any timeframe, including weekly, daily, or intraday. Weekly Stochastic usually changes its direction one week prior to weekly MACD-Histogram. If weekly Stochastic turns, it warns you that MACD-Histogram is likely to turn the next week—time to tighten stops on existing positions or start taking profits.

Choosing the width of the Stochastic window is important. Shorter-term oscillators are more sensitive. Longer-term oscillators turn only at important tops and bottoms. If you use Stochastic as a stand-alone oscillator, a longer Stochastic is preferable. If you use Stochastic as part of a trading system, combined with trend-following indicators, then a shorter Stochastic is preferable.

Relative Strength Index

Relative Strength Index (RSI) is an oscillator developed by J. Welles Wilder, Jr. It measures any trading vehicle’s strength by monitoring changes in its closing prices. It’s a leading or a coincident indicator—never a laggard.


RSI fluctuates between 0 and 100. When it reaches a peak and turns down, it identifies a top. When it falls and then turns up, it identifies a bottom. The pattern of RSI peaks and valleys doesn’t change in response to the width of its time window. Trading signals become more visible with shorter RSI, such as 7 or 9 days.

Overbought and oversold RSI levels vary from market to market and even from year to year in the same market. There are no magical levels for all tops and bottoms. Oversold and overbought signals are like hot and cold readings on a window thermometer. The same temperature levels mean different things in summer or winter.




FIGURE  CVX daily, 13-day RSI.

Horizontal reference lines must cut across the highest peaks and the lowest valleys of RSI. They are often drawn at 30% and 70%. Some traders use 40% and 80% levels in bull markets or 20% and 60% in bear markets. Use the 5 percent rule: draw each line at a level beyond which RSI has spent less than 5 percent of its time in the past 4 to 6 months. Adjust reference lines once every three months.

Mass Psychology

Each price represents the consensus of value of all market participants at the moment of transaction. The closing price reflects the most important consensus of the day because the settlement of traders’ accounts depends on it. When the market closes higher, bulls make money and bears lose. When the market closes lower, bears make money and bulls lose.

Traders pay more attention to closing prices than to any other prices of the day. In the futures markets, money is transferred from losers’ to winners’ accounts at the end of each trading day. RSI shows whether bulls or bears are stronger at closing time—the crucial money-counting time in the market.

Trading Rules

RSI gives three types of trading signals. They are, in order of importance, divergences, chart patterns, and the level of RSI.

Bullish and Bearish Divergences

Divergences between RSI and prices tend to occur at important tops and bottoms. They show when the trend is weak and ready to reverse.

  1. Bullish divergences give buy signals. They occur when prices fall to a new low but RSI 87979797979makes a higher bottom than during its previous decline. Buy as soon as RSI turns up from its second bottom, and place a protective stop below the latest minor price low. Buy signals are especially strong if the first RSI bottom is below its lower reference line and the second bottom is above that line.
  2. Bearish divergences give sell signals. They occur when prices rally to a new peak but RSI makes a lower top than during its previous rally. Sell short as soon as RSI turns down from its second top, and place a protective stop above the latest minor high. Sell signals are especially strong if the first RSI top is above its upper reference line and the second top is below it.

Charting Patterns

RSI often breaks through support or resistance a few days ahead of prices, providing hints of likely trend changes. RSI trendlines are usually broken one or two days before price trend changes.

  1. When RSI breaks above its downtrend line, place an order to buy above the latest price peak to catch an upside breakout.
  2. When RSI breaks below its uptrend line, place an order to sell short below the latest price low to catch a downside breakout.

RSI Levels

When RSI rises above its upper reference line, it shows that bulls are strong but the market is overbought and entering its sell zone. When RSI declines below its lower reference line, it shows that bears are strong but the market is oversold and entering its buy zone.

It pays to buy using overbought signals of daily RSI only when the weekly trend is up. It pays to sell short using sell signals of daily RSI only when the weekly trend is down.

  1. Buy when RSI declines below its lower reference line and then rallies above it.
  2. Sell short when RSI rises above its upper reference line and then crosses below it.
When we analyze markets, we deal with only a few numbers—the opening, high, low, and closing prices for each bar, plus volume, and also open interest for derivatives, such as futures and options. A typical beginner error is “shopping for indicators.” A trader may feel bullish about the stock market, but then he notices that the moving averages of the Dow and the S&P are still declining. Their bearish message doesn’t sit well with him; he starts scrolling through his software menu and finds several oscillators, such as Stochastic or RSI. Sure enough, they look oversold, which is normal in a downtrend. The eager beginner takes those oversold readings as a signal to buy. The downtrend continues, he loses money—and then complains that technical analysis didn’t work.

It is much better to use only a small number of indicators with a strict hierarchy for their analysis, including multiple timeframes.

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