What is an
Indicator?An
indicator is a series of data points that are derived by
applying a formula to the price data of a security. Price
data includes any combination of the open, high, low or
close over a period of time. Some indicators may use only
the closing prices, while others incorporate volume and open
interest into their formulas. The price data is entered into
the formula and a data point is produced.
For example, the average of 3
closing prices is one data point ((41+43+43)/3=42.33).
However, one data point does not offer much information and
does not an indicator make. A series of data points over a
period of time is required to create valid reference points
to enable analysis. By creating a time series of data
points, a comparison can be made between present and past
levels. For analysis purposes, indicators are usually shown
in a graphical form above or below a security’s price chart.
Once shown in graphical form, an indicator can then be
compared with the corresponding price chart of the security.
Sometimes indicators are plotted on top of the price plot
for a more direct comparison.
What does an
Indicator Offer?An
indicator offers a different perspective from which to
analyze the price action. Some, such as moving averages, are
derived from simple formulas and the mechanics are
relatively easy to understand. Others, such as Stochastics,
have complex formulas and require more study to fully
understand and appreciate. Regardless of the complexity of
the formula, indicators can provide unique perspective on
the strength and direction of the underlying price action.
A simple moving average is an indicator that
calculates the average price of a security over a specified
number of periods. If a security is exceptionally volatile,
then a moving average will help to smooth the data. A moving
average filters out random noise and offers a smoother
perspective of the price action. Veritas (VRTS) displays a
lot of volatility and an analyst may have difficulty
discerning a trend. By applying a 10-day simple moving
average to the price action, random fluctuations are
smoothed to make it easier to identify a trend.
Page 2
xxxxxxxxxxxxxxxxxx
Indicators serve three broad functions:
1. Alert. An indicator can act as an alert
to study price action a little more closely. If momentum is
waning, it may be a signal to watch for a break of support.
Or, if there is a large positive divergence building, it may
serve as an alert to watch for a resistance breakout. 2. Confirm Indicators can be used to confirm other technical
analysis tools. If there is a breakout on the price chart, a
corresponding moving average crossover could serve to
confirm the breakout. Or, if a stock breaks support, a
corresponding low in the On-Balance-Volume (OBV) could serve
to confirm the weakness. 3. Predict Some investors and traders use indicators to predict the
direction of future prices. (Here at AegeanCapital we
believe that the above generally holds true for indicators
that are proprietary. We have yet to see an indicator that
is freely available, and yet it has great predicting value.
However, some notable exceptions do exist)
Page 3
xxxxxxxxxx
Keep in mind, ALL indicators are derivatives and not
direct reflections of the price action. This should be taken into consideration
when applying analysis. Any analysis of an indicator should be taken with the
price action in mind. What is the indicator saying about the price action of a
security? Is the price action getting stronger? Weaker?
Even though it may be obvious when indicators generate buy and sell signals,
the signals should be taken in context with other technical analysis tools. An
indicator may flash a buy signal, but if the chart pattern shows a descending
triangle with a series of declining peaks, it may be a false signal.
On the Inktomi (INKT) chart, MACD MACD improved from April to August and
formed a positive divergence in August. All the earmarks of a MACD buying
opportunity were present, but the stock failed to break above the resistance and
exceed its previous reaction high. This non-confirmation from the stock should
have served as a warning sign against a long position. For the record, a sell
signal occurred when the stock broke support from the descending triangle in
early Oct-00 .
Page 4
xxxxxxxxxx
POINTS TO REMEMBER:
As always in technical analysis, learning how to read indicators is more of
an art than a science. The same indicator may exhibit different behavioral
patterns when applied to different stocks. Indicators that work well for IBM
might not work the same for Delta Airlines. Through careful study and analysis,
expertise with the various indicators will develop over time. As this expertise
develops, certain nuances as well as favorite setups will become clear.
There are hundreds of indicators in use today, with new indicators being
created every week. Technical analysis software programs come with dozens of
indicators built in, and even allow users to create their own. Given the amount
of hype that is associated with indicators, choosing an indicator to follow can
be a daunting task. Even with the introduction of hundreds of new indicators,
only a select few really offer a different perspective and are worthy of
attention. Strangely enough, the indicators that usually merit the most
attention are those that have been around the longest time and have stood the
test of time.
When choosing an indicator to use for analysis, choose carefully and
moderately. Attempts to cover more than five indicators are usually futile. It
is best to focus on two or three indicators and learn their intricacies inside
and out. Try to choose indicators that complement each other, instead of those
that move in unison and generate the same signals. For example, it would be
redundant to use two indicators that are good for showing overbought and
oversold levels, such as Stochastics and RSI. Both of these indicators measure
momentum and both have overbought/oversold levels.
Page 5
xxxxxxxxxx
TWO DIFFERENT TYPES OF INDICATORS:
1. LEADING
As their name implies, leading indicators are designed to lead price
movements. Most represent a form of price momentum over
a fixed look-back period, which is the number of periods used to calculate the
indicator. For example, a 20-day Stochastic Oscillator would use the past 20
days of price action (about a month) in its calculation. All prior price action
would be ignored. Some of the more popular leading indicators include Commodity
Channel Index (CCI) , Momentum Relative
Strength Index (RSI) , Stochastic Oscillator and
Williams %R.
2. LAGGING INDICATORS
As their name implies, lagging indicators follow the price action and are
commonly referred to as trend-following indicators. Rarely, if ever, will these
indicators lead the price of a security. Trend-following indicators work best
when markets or securities develop strong trends. They are designed to get
traders in and keep them in as long as the trend is intact. As such, these
indicators are not effective in trading or sideways markets. If used in trading
markets, trend-following indicators will likely lead to many false signals and
whipsaws. Typical trend-following indicators include moving
averages(exponential, simple, weighted, variable) and
MACD
