Making trading decisions and developing a sound and effective trading strategy is an important foundation of trading. Before developing a trading strategy, a trader should have a working knowledge of technical analysis as well as knowledge of some of the more popular technical studies.
In making decisions about where and when to take a position, investors, traders and analysts use two different approaches: fundamental analysis and technical analysis. Fundamental analysis is the appreciation of the economics underlying a particular trade. If you want to know where to invest and why, you use the techniques of fundamental analysis. Technical analysis is concerned with the when and the how of placing money. It determines the optimal timing for a position and its conclusions about how long to stay in a particular trade have significant importance for the kind of derivatives structure one may use to take a position.
Technical analysis is an art in which quasi-statistical techniques and formal statistics are used to determine the existence and strength of trends in financial time series and to identify turning points in these trends. If you can do this with a reasonable degree of accuracy, then you can improve your chances of making a profitable trade. Technical analysis is important in the structuring of derivative products because of the leverage involved and because of the inclusion of such features as barriers and compound strikes. Timing is everything.
Strategy 1 - Simple Moving Average.
Successful trading is often described as optimizing your risk with respect to your reward, or upside. Trading strategy should have a disciplined method of limiting risk while making the most out of favorable market moves. For this strategy I will illustrate one decision making model which uses a Simple Moving Average ("SMA") technical study, based on a 12-period SMA, where each period is 15 minutes.
I will use a simple algorithm: when the price of the currency crosses above the 12-period SMA, it will be taken as a signal to buy at the market. When the currency price crosses below the 12-period SMA, it will be a signal to "Stop and Reverse" ("SAR"). In other words, a long position will be liquidated and a short position will be established, both with market orders. Thus this system will keep you in the market - you will always have either a long or short position after the first signal. In the chart below, the white line represents the price of USDJPY, the purple line represents the 12-period SMA of USDJPY, and the red line indicates where USDJPY crosses above the SMA, generating a buy signal at approximately 129.90:
The moving average method has an element of risk control built in: a long position will be stopped out fairly quickly in a falling market because the price will drop below the SMA, generating a stop-and-reverse signal. The same holds true for a sell signal in a rising market.
Strategy 2 - Support and Resistance Levels
Think of security prices as the result of a head-to-head battle between a bull (the buyer) and a bear (the seller). The bulls push prices higher and the bears push prices lower. The direction prices actually move reveals who is winning the battle
One use of technical analysis, apart from technical studies, is in deriving "support" and "resistance" levels. The concept here is that the market will tend to trade above its support levels and trade below its resistance levels. If a support or resistance level is broken, the market is then expected to follow through in that direction. These levels are determined by analyzing the chart and assessing where the market has encountered unbroken support or resistance in the past.
For example, in the chart below EURUSD has established a resistance level at approximately .9015. In other words, EURUSD has risen up to .9015 repeatedly, but has been unable to move beyond that point:
The trading strategy would then be to sell EURUSD the next time it gets close to .9015, with a stop placed just above .9015, say at .9025. This would have indeed been a good trade as EURUSD proceeded to fall sharply, without breaking the .9015 resistance. Hence a substantial upside can be achieved while only risking 10 or 15 pips (.0010 or .0015 in EURUSD).
I am thoroughly convinced that most investors could significantly improve their performance if they would pay more attention to the underlying causes affecting security prices: investor expectations and supply/demand.[1]\
Support/Resistance concepts
The following is a very brief summary of the support/resistance concepts
1. A security's price represents the fair market value as agreed between buyers (bulls) and
sellers (bears).
2. Changes in price are the result of changes in investor expectations of the security's future
price.
3. Support levels occur when the consensus is that the price will not move lower. It is the point
where buyers outnumber sellers.
4. Resistance levels occur when the consensus is that the price will not move higher. It is the
point where sellers outnumber buyers.
5. The penetration of a support or resistance level indicates a change in investor expectations
and a shift in the supply/demand lines.
6. Volume is useful in determining how strong the change of expectations really is.
7. Traders' remorse often follows the penetration of a support or resistance level as prices
retreat to the penetrated level.
Strategy 2 - ASOLUTE BREADTH INDEX
1 Overview
The Absolute Breadth Index ("ABI") is a market momentum indicator that was developed by Norman G. Fosback.[1]
The ABI shows how much activity, volatility, and change is taking place on the New York Stock Exchange while ignoring the direction prices are headed.
2 Interpretation
You can think of the ABI as an "activity index." High readings indicate market activity and change, while low readings indicate lack of change.
In Fosback's book, Stock Market Logic, he indicates that historically, high values typically lead to higher prices three to twelve months later. Fosback found that a highly reliable variation of the ABI is to divide the weekly ABI by the total issues traded. A ten-week moving average of this value is then calculated. Readings above 40% are very bullish and readings below 15% are bearish.
3 Example
The following chart shows the S&P 500 and a 5-week moving average of the ABI.
Strong rallies occurred every time the ABI's moving average rose above 310.
4 Calculation
The Absolute Breadth Index is calculated by taking the absolute value of the difference between NYSE Advancing Issues and NYSE Declining Issues.
Absolute value (i.e., ABS) means "regardless of sign." Thus, the absolute value of -100 is 100 and the absolute value of +100 is also 100.
Strategy 4 - ACCUMULATION/DISTRIBUTION
1 Overview
The Accumulation/Distribution is a momentum indicator that associates changes in price and volume. The indicator is based on the premise that the more volume that accompanies a price move, the more significant the price move.
2 Interpretation
The Accumulation/Distribution is really a variation of the more popular On Balance Volume indicator. Both of these indicators attempt to confirm changes in prices by comparing the volume associated with prices.
When the Accumulation/Distribution moves up, it shows that the security is being accumulated, as most of the volume is associated with upward price movement. When the indicator moves down, it shows that the security is being distributed, as most of the volume is associated with downward price movement.
Divergences between the Accumulation/Distribution and the security's price imply a change is imminent. When a divergence does occur, prices usually change to confirm the Accumulation/Distribution. For example, if the indicator is moving up and the security's price is going down, prices will probably reverse.
3 Example
The following chart shows Battle Mountain Gold and its Accumulation/Distribution.
Battle Mountain's price diverged as it reached new highs in late July while the indicator was falling. Prices then corrected to confirm the indicator's trend.
4 Calculation
A portion of each day's volume is added or subtracted from a cumulative total. The nearer the closing price is to the high for the day, the more volume added to the cumulative total. The nearer the closing price is to the low for the day, the more volume subtracted from the cumulative total. If the close is exactly between the high and low prices, nothing is added to the cumulative total.
Strategy 5 - ACCUMULATION SWING INDEX
1 Overview
The Accumulation Swing Index is a cumulative total of the Swing Index. The Accumulation Swing Index was developed by Welles Wilder.
2 Interpretation
Mr. Wilder said, "Somewhere amidst the maze of Open, High, Low and Close prices is a phantom line that is the real market." The Accumulation Swing Index attempts to show this phantom line. Since the Accumulation Swing Index attempts to show the "real market," it closely resembles prices themselves. This allows you to use classic support/resistance analysis on the Index itself. Typical analysis involves looking for breakouts, new highs and lows, and divergences.[2]
Wilder notes the following characteristics of the Accumulation Swing Index:
• It provides a numerical value that quantifies price swings.
• It defines short-term swing points.
• It cuts through the maze of high, low, and close prices and indicates the real strength and
direction of the market.
3 Example
The following chart shows Corn and its Accumulation Swing Index.
You can see that the breakouts of the price trendlines labeled "A" and "B" were confirmed by breakouts of the Accumulation Swing Index trendlines labeled "A'" and "B'."
Strategy 6 - ADVANCE/DECLINE LINE
1 Overview
The Advance/Decline Line ("A/D Line") is undoubtedly the most widely used measure of market breadth. It is a cumulative total of the Advancing-Declining Issues indicator. When compared to the movement of a market index (e.g., Dow Jones Industrials, S&P 500, etc) the A/D Line has proven to be an effective gauge of the stock market's strength.
2 Interpretation
The A/D Line is helpful when measuring overall market strength. When more stocks are advancing than declining, the A/D Line moves up (and vice versa).
Many investors feel that the A/D Line shows market strength better than more commonly used indices such as the Dow Jones Industrial Average ("DJIA") or the S&P 500 Index. By studying the trend of the A/D Line you can see if the market is in a rising or falling trend, if the trend is still intact, and how long the current trend has prevailed.
Another way to use the A/D Line is to look for a divergence between the DJIA (or a similar index) and the A/D Line. Often, an end to a bull market can be forecast when the A/D Line begins to round over while the DJIA is still trying to make new highs. Historically, when a divergence develops between the DJIA and the A/D Line, the DJIA has corrected and gone in the direction of the A/D Line.
A military analogy is often used when discussing the relationship between the A/D Line and the DJIA. The analogy is that trouble looms when the generals lead (e.g., the DJIA is making new highs) and the troops refuse to follow (e.g., the A/D Line fails to make new highs).
3 Example
The following chart shows the DJIA and the A/D Line.
The DJIA was making new highs during the 12 months leading up to the 1987 crash. During this same period, the A/D Line was failing to reach new highs. This type of divergence, where the generals lead and the troops refuse to follow, usually results in the generals retreating in defeat as happened in 1987.[1]
4 Calculation
| Table 2 | ||||
| Date | Advancing | Declining | A-D | A/D Line |
| 02/15/94 | 1198 | 882 | 316 | 316 |
| 02/16/94 | 1183 | 965 | 218 | 534 |
| 02/17/94 | 882 | 1251 | -369 | 165 |
| 02/18/94 | 706 | 1411 | -705 | -540 |
| 02/22/94 | 1139 | 1003 | 136 | -404 |
Because the A/D Line always starts at zero, the numeric value of the A/D Line is of little importance. What is important is the slope and pattern of the A/D Line.
Strategy 7 ADVANCE/DECLINE RATIO
1 Overview
The Advance/Decline Ratio ("A/D Ratio") shows the ratio of advancing issues to declining issues. It is calculated by dividing the number of advancing issues by the number of declining issues.
2 Interpretation
The A/D Ratio is similar to the Advancing-Declining Issues in that it displays market breadth. But, where the Advancing-Declining Issues subtracts the advancing/declining values, the A/D Ratio divides the values. The advantage of the Ratio is that it remains constant regardless of the number of issues that are traded on the New York Stock Exchange (which has steadily increased).
A moving average of the A/D Ratio is often used as an overbought/oversold indicator. The higher the value, the more "excessive" the rally and the more likely a correction. Likewise, low readings imply an oversold market and suggest a technical rally.
Keep in mind, however, that markets that appear to be extremely overbought or oversold may stay that way for some time. When investing using overbought and oversold indicators, it is wise to wait for the prices to confirm your belief that a change is due before placing your trades.
Day-to-day fluctuations of the Advance/Decline Ratio are often eliminated by smoothing the ratio with a moving average.
3 Example
The following chart shows the S&P 500 and a 15-day moving average of the A/D Ratio.
You can see that prices usually declined after entering the overbought level above 1.25 ("sell" arrows) and that they usually rallied after entering the oversold level below 0.90 ("buy" arrows).[1]
4 Calculation
The A/D Ratio is calculated by dividing the number of stocks that advanced in price for the day by the number of stocks that declined.
Table 3 shows the calculation of the A/D Ratio.
| Table 3 | |||
| Date | Advancing | Declining | A/D Ratio |
| 02/15/94 | 1198 | 882 | 1.3583 |
| 02/16/94 | 1183 | 965 | 1.2259 |
| 02/17/94 | 882 | 1251 | 0.7050 |
| 02/18/94 | 706 | 1411 | 0.5004 |
| 02/22/94 | 1139 | 1003 | 1.1356 |
Strategy 8 ADVANCING-DECLINING ISSUES
1 Overview
The Advancing-Declining Issues is a market momentum indicator which shows the difference between stocks listed on the New York Stock Exchange that advanced in price minus those that declined. As of this writing, about 2,500 issues trade each day on the NYSE.
The difference between the number of advancing and declining issues is the foundation of many market breadth indicators. These indicators include the Advance/Decline Line, Advance/Decline Ratio, Absolute Breadth Index, Breadth Thrust, McClellan Oscillator and Summation Index. Indicators that use advancing and declining issues in their calculations are called market breadth indicators.
2 Interpretation
The Advancing-Declining Issues indicator shows the difference between the number of advancing issues and the number of declining issues. Plotted by itself, this indicator is helpful to determine daily market strength. Strong up days generally show readings of more than +1,000. Very weak days have readings of less than -1,000.
I prefer to plot a 5-to-40 day exponential moving average of the Advancing-Declining Issues rather than the daily values themselves. The moving average creates an excellent short-term overbought/oversold indicator. Both the Over-bought/-Oversold indicator and the McClellan Oscillator are created using moving averages of advancing minus declining issues.
3 Example
The following chart shows the DJIA and a 40-day moving average of the Advancing-Declining Issues indicator.
I drew "buy" arrows when the moving average rose above -50 and "sell" arrows when it fell below 125. Normally, I would use 100, but the strong up-trend during this period caused the indicator to have an upward bias.
4 Calculation
The Advancing-Declining Issues is calculated simply by subtracting the number of declining issues from the number of advancing issues.
The following table shows the calculation of the Advancing-Declining Issues.
| Table 4 | |||
| Date | Advancing | Declining | A/D |
| 02/15/94 | 1198 | 882 | 316 |
| 02/16/94 | 1183 | 965 | 218 |
| 02/17/94 | 882 | 1251 | -369 |
| 02/18/94 | 706 | 1411 | -705 |
| 02/22/94 | 1139 | 1003 | 136 |
Strategy 9 - ADVANCING, DECLINING, UNCHANGED VOLUME
1 Overview
Advancing, declining, and unchanged volume are all market momentum indicators. They reflect movement on the New York Stock exchange in millions of shares.
Advancing volume is the total volume for all securities that advanced in price. Declining volume is the total volume for all securities that declined in price. And similarly, unchanged volume is the total volume for all securities that were unchanged in price.
2 Interpretation
Numerous indicators have been developed using up and down volume indicators. These indicators include the Cumulative Volume Index, Negative Volume Index, Positive Volume Index, and the Upside-Downside Ratio. Charts of the advancing or declining volume can be used to look for volume divergences (where advancing volume increases but the market falls) to see if selling pressure is waning, to view daily trends, etc.
Due to the erratic fluctuations in advancing and declining volume, I suggest you smooth the indicators with a 3- to 10-day moving average.
3 Example
The following chart shows the S&P 500 and a 10-day moving average of advancing volume.
A bearish divergence developed as prices tried to rally (trendline "A") while the advancing volume was declining (trendline "B"). If you only looked at the S&P 500 you might think the market was gaining strength. The Advancing Volume showed the true picture and prices were forced to correct.[1]
Strategy 9 - ANDREWS' PITCHFORK
1 Overview
Andrews' Pitchfork is a line study consisting of three parallel trendlines based on three points you select. This tool was developed by Dr. Alan Andrews.
2 Interpretation
The interpretation of a pitchfork is based on normal trendline support and resistance principles.
3 Example
The following chart of Xerox shows an Andrews' Pitchfork.
The pitchfork was displayed by selecting the three points shown. You can see how prices tended to "walk along" the trendlines.
4 Calculation
The first trendline begins at the left-most point selected (either a major peak or trough) and is drawn so it passes directly between the two right-most points. This line is the "handle" of the pitchfork. The second and third trendlines are then drawn beginning at the two right-most points (a major peak and a major trough) and are drawn parallel to the first line. These lines are the "tines" of the pitchfork.
Strategy 11 ARMS INDEX
1 Overview
The Arms Index is a market indicator that shows the relationship between the number of stocks that increase or decrease in price (advancing/declining issues) and the volume associated with stocks that increase or decrease in price (advancing/declining volume). It is calculated by dividing the Advance/Decline Ratio by the Upside/Downside Ratio.
The Arms Index was developed by Richard Arms in 1967. Over the years, the index has been referred to by a number of different names. When Barron's published the first article on the indicator in 1967, they called it the Short-term Trading Index. It has also been known as TRIN (an acronym for TRading INdex), MKDS, and STKS.
2 Interpretation
The Arms Index is primarily a short-term trading tool. The Index shows whether volume is flowing into advancing or declining stocks. If more volume is associated with advancing stocks than declining stocks, the Arms Index will be less than 1.0; if more volume is associated with declining stocks, the Index will be greater than 1.0.
The Index is usually smoothed with a moving average. I suggest using a 4-day moving average for short-term analysis, a 21-day moving average for intermediate-term, and a 55-day moving average for longer-term analysis.
Normally, the Arms Index is considered bullish when it is below 1.0 and bearish when it is above 1.0. However, the Index seems to work most effectively as an overbought/oversold indicator. When the indicator drops to extremely overbought levels, it is foretelling a selling opportunity. When it rises to extremely oversold levels, a buying opportunity is approaching.
What constitutes an "extremely" overbought or oversold level depends on the length of the moving average used to smooth the indicator and on market conditions. Table 5 shows typical overbought and oversold levels.
| Table 5 | ||
| Moving Average | Overbought | Oversold |
| 4-day | 0.70 | 1.25 |
| 21-day | 0.85 | 1.10 |
| 55-day | 0.90 | 1.05 |
3 Example
The following chart contains a 21-day moving average of the Arms Index and the New York Stock Exchange Index.
Horizontal lines are drawn at the oversold level of 1.08 and at the overbought level of 0.85. I drew "buy" arrows when the Arms Index peaked above 1.08 and "sell" arrows when the Index bottomed below 0.85. In most of the cases the arrows occur at, or one day before, significant changes in price.
4 Calculation
The Arms Index is calculated by first dividing the number of stocks that advanced in price by the number of stocks that declined in price to determine the Advance/Decline Ratio. Next, the volume of advancing stocks is divided by the volume of declining stocks to determine the Upside/Downside Ratio. Finally, the Advance/Decline Ratio is divided by the Upside/Downside Ratio.
My Approach
There are many technical analysis tools in this paper. The most difficult part of technical analysis may be deciding which tools to use! Here is an approach you might try.
1. Determine the overall market condition.
If you are trading equity-based securities (e.g., stocks), determine the trend in interest rates, the trend of the New York Stock Exchange, and of investor sentiment (e.g., read the newspaper). The object is to determine the overall trend of the market.
2. Pick the securities.
I suggest that you pick the securities using either a company or industry you are familiar with, or the recommendation of a trusted analyst (either fundamental or technical).
3. Determine the overall trend of the security.
Plot a 200-day (or 39-week) moving average of the security's closing price. The best buying opportunities occur when the security has just risen above this long-term moving average.
4. Pick your entry points.
Buy and sell using your favorite indicator. However, only take positions that agree with overall market conditions.
Much of your success in technical analysis will come from experience. The goal isn't to find the holy grail of technical analysis, it is to reduce your risks (e.g., by trading with the overall trend) while capitalizing on opportunities (e.g., using your favorite indicator to time your trades). As you gain experience, you will make better, more informed, and more profitable investments.
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