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It was seen in the previous lesson that Moving averages have a tendency to 'lag' behind the high and low of the trend. That is, they capture the trend very well but they are late in finding the start or the end of the trend. For this reason, the moving average is often termed a 'trend following' indicator.
Technical analysts have come up with a number of indicators which are not trend following but attempt to find the highs and lows as they occur. These types of indicators are known as 'oscillators'.
In this lesson we will examine 5 of the most common oscillators.
MACD is an acronym for Moving Average Convergence Divergence. Users of moving averages will often find that the moving average, as good an indicator as it is, can sometimes be too late in giving the signal. The MACD attempts to counter this and pick up the signals of the moving averages earlier.
Consider two exponential moving averages. One is a 12 period moving average, the other, a 26 day moving average. If the stock is in a steady downtrend, the moving averages should be moving down and be roughly parallel with each other (red fill). As the stock begins to flatten out (the end of the downtrend?), the two moving averages will begin to converge (blue fill). However, from the trading rules of multiple moving averages, this is still not a buy signal but with the MACD, if the convergence is significant enough, a buy signal may be presented.
From the above description, the MACD is defined as the difference between the 12 period exponential moving average and the 26 period moving average. The signal is given by taking a 9 period exponential moving average of this line.
Note from Marketech: 12 and 26 period exponential moving averages with a 9 period exponential moving average signal line represents the standard parameters among technical analysts for the MACD. After much research, I still cannot find an explanation or origin for this. Marketech sets these parameters as default. However, it allows the user to change the parameters should they so desire.
Mathematically:
The result is an indicator which looks rather like two moving averages. The MACD line is the solid black line and the signal line is the red line. The MACD is often drawn with the 'MACD histogram'. These are the vertical black bars that can be seen projected up and down from the central horizontal line. The MACD histogram is calculated by subtracting the value of the signal line from the MACD line.
The rules for trading the MACD are similar to the trading rules for two moving averages:
Using the histogram, the MACD buy/sell signals could be re-written as:
It can be seen at A, the black MACD line crossed from above to below the red signal line. This also corresponded with the histogram becoming negative. The stock was therefore a SELL at this point. The same pattern was found at C.
At B, the black MACD line crossed from below to above the red signal line and corresponded with the histogram becoming positive. The stock was a BUY at this point.
Note that the signal line used a simple moving average rather than an exponential one. This is because the simple moving average produces more prominent signals that when using the exponential moving average.
Momentum is used to give the analyst an indication as to the RATE at which the stock is moving from one period to the next. A quick glance at a chart can tell us whether a stock is moving or not, but technical analysts are also concerned with how fast the stock is moving. The momentum indicator does this by comparing the closing price of the stock today with the closing price of the stock a certain time ago.
Mathematically:
This is a 'simple' momentum and will produce a chart similar to the NAB chart shown. This chart is using a 9 day momentum.
Similar to the MACD, the momentum indicator is superimposed at the top of the chart.
Remember, mathematically:
| Date | Closing Price | 9 day momentum |
| 18/6/01 | $28.38 | - |
| 19/6/01 | $29.07 | - |
| 20/4/01 | $29.30 | - |
| 23/4/01 | $29.48 | - |
| 24/4/01 | $29.93 | - |
| 26/4/01 | $29.95 | - |
| 27/4/01 | $29.70 | - |
| 30/4/01 | $30.10 | - |
| 1/5/01 | $30.10 | - |
| 2/5/01 | $29.89 | $1.51 |
| 3/5/01 | $30.00 | $0.93 |
| 4/5/01 | $29.89 | $0.59 |
| 7/5/01 | $30.07 | $0.59 |
| 8/5/01 | $29.84 | -$0.09 |
| 9/5/01 | $30.03 | $0.33 |
The table explains how the value of the momentum was obtained. The first entry of the momentum column shows momentum of $1.51. This was obtained by taking the $29.89 price and subtracting the $28.38 which was the closing price 9 periods before. The next entry of $0.93 was calculated by subtracting $29.07 from $30.00 ($29.07 was the price that traded 9 days before the $30.00 price.
It is appropriate at this point to introduce the concept of 'overbought' and 'oversold' when using indicators. Many of the oscillator indicators (including momentum) swing around a zero point. At the extremes from the zero point (the highs and lows of the indicator if you like) the indicator enters into oversold and overbought zones. When the indicator is at an extreme low (with reference to points in the near vicinity) it is said to be in the oversold region and at the extreme highs, in the overbought region. There is no steadfast rule as to where these overbought and oversold zones begin. The standard convention for momentum is to look at the indicator and draw lines across where there is an insignificant amount of the indicator above and below the line. These are the extreme lines (which are going to be different for each stock) and represent the levels of overbought and oversold.
Momentum oscillator indicators do not give a profit target. This is because the indicator seeks out stocks that have entered into areas of overbought and oversold. If the indicator shows a stock is in the region of oversold and then crosses back above the line (signaling a buy), the stock may well slowly drift downwards without the indicator ever returning in to the oversold levels. Momentum indicators are designed to find the extreme lows and highs very quickly after they occur, if not, as they occur. They do not pick up trends, only extreme deviations from the trend. They pick up a change in trend, not the trend themselves. Therefore, profit levels should be calculated using alternate means. Certainly, if the oscillator gives a buy signal and then swings up into the overbought zone, this would represent a sell and in a range trading stock this would be ideal. However, once a low or high has been established, trend following indicators such as the moving average should be used.
Momentum is an excellent indicator for 'glancing' at a chart and quickly assimilating the state of the stock. An obvious disadvantage with the momentum indicator is the arbitrary lines that must be drawn. An experienced analyst will be able to quickly identify the extreme levels without the need for drawing lines, and perform a rough analysis. Momentum is also very good for creating buy and sell signals by comparing convergences and divergences between the indicator and the stock. This analysis is a little more complex and is explained here because it is the method that the Marketech software uses to select the Momentum buy/sell signals.
If the momentum of the stock is moving upwards, this suggests that the difference in price of today's price to the price X periods ago is increasing. Remember that the DIFFERENCE is increasing. So not only is the price moving up, but also the amount by which it is 'moving up' is increasing.
Imagine then if the stock price was not increasing, in fact it was decreasing whilst the Momentum was increasing. Is this possible? It is possible because the period of momentum may differ from the period over which there is a trend against the momentum. Such instances are called DIVERGENCES, that is, where the stock price and the momentum move in opposite directions.
The example of AEN shows a bullish divergence with the momentum (12 day) increasing and the stock price trending lower. A linear regression (line of best fit) has been placed over the stock to show how the stock is trending down.
The reasoning behind this being a bullish signal is that the stock's momentum has increased, yet its stock price has not reacted. It is expected that the price should react upwards imminently.
It is appropriate to introduce Rate of Change (ROC) at this point as this indicator is very similar to momentum, and is identical in its trading method. The difference is that the ROC momentum is measured as a ratio between the last closing price and closing price X periods ago rather than as a direct arithmetical difference.
Mathematically:
The trading rules for the ROC are identical to that of the momentum indicator:
Once the high or low has been established and acted (traded) on, the close of trade signal can be given when the indicator moves into the opposite zone but alternative techniques (such as moving averages) should be consulted.
ROC can also be used in a similar fashion to Momentum in trading divergences. That is:
ROC has the same disadvantages as momentum in that it can be difficult to identify where the oversold and overbought lines should be located. (The next indicator to be introduced (RSI) is a form of momentum indicator but attempts to overcome the problem of 'arbitrary' oversold and overbought lines by limiting the range of the indicator).
In this example of ALL, the trader would have shorted the stock at A as the ROC has moved from above the overbought region, down below the overbought line (a signal to short-sell). They would have then closed the short position at B as the stock has moved into the oversold region. From C to D, the ROC gave a couple of signals which may have 'whipsawed' the trader in and out of the stock but in this case, probably profitably. At E, there was a strong buy signal as the ROC moved out of the oversold zone and profit was taken at F where the ROC entered into the overbought region. (The example even shows that the trader should have reversed the position and short-sold the stock as the ROC has moved downwards out of the overbought region).
As mentioned in the previous section, the Relative Strength Index is a form of momentum indicator. It is a more complex indicator to calculate but it has the distinct advantage over the simple momentum and ROC indicators in that the indicator is standardized for all stocks. The RSI does this by calculating the absolute values of momentum and limiting the range of the indicator between 0 and 100. This then makes it relatively simple to define overbought and oversold zones. For example, if the indicator falls below 30 the stock is in the oversold zone and if it rises above 70, it is in the overbought zone.
Mathematically:
where:
In the example, it can be seen that the RSI does look a little different to the Momentum and Rate of Change indicators. In particular, there is a noticeable 'regularity' in the indicator itself. It appears more symmetrical and less erratic. This is because the indicator has been 'standardised' by bringing the value of the indicator back to values between 0 and 100. The two horizontal lines have been projected onto the indicator with the lines drawn at 30% and at 70%, which represents the oversold and overbought lines respectively.
There is no common convention among technical analysts as to what period RSI to use. As with nearly every tool in technical analysis, each analyst will develop their own favourite parameters.
The lines of 30% and 70% used in the example are fairly standard levels used among technical analysts. For particularly volatile stocks that regularly see a penetration of these lines, some analysts may stretch them out to 20% and 80% to capture the truly oversold and overbought stocks.
The trading rules for the RSI are identical to that of the momentum and ROC indicator:
Again, once the high or low has been established and acted (traded) on, the close of trade signal can be given when the indicator moves into the opposite zone but alternative techniques (such as moving averages) should be consulted.
Using the ALL example again on a 9 period RSI, it can be seen that quite a number of buy and sell signals are generated. As a general rule for all the momentum type oscillators, the longer the period, the less the number of buy/sell signals that are generated.
In the example, a sell signal was generated at A as the RSI crossed from above the 70% line to below it. The position was closed at B and a new long position opened at C, as the RSI crossed out the oversold region and crossed back above it (open long position). The long position was closed at D as the RSI crossed into the overbought position.
As an exercise, see if you can read the remaining buy/sell signals, then click here to reveal the answers.
Stochastics look, and are in fact traded in a similar manner to the RSI. The difference is that the RSI formula uses the average of high or low days in the previous n days whereas the stochastic uses the actual highs and lows.
Mathematically:
This basic stochastic is referred to as %K and it is usually given a 3 day smoothing. The smoothed stochastic is referred to as %D.
The trading rules for the stochastic are identical to that of the RSI indicator:
Again, once the high or low has been established and acted (traded) on, the close of trade signal can be given when the indicator moves into the opposite zone but alternative techniques (such as moving averages) should be consulted.
The stochastic is designed so that, unlike the momentum indicator, the indicator oscillates between two fixed points. This allows for easy recognition of when the indicator crosses the extreme lines. For stochastics, the indicator oscillates between zero and 100 and the extreme lines are by convention, drawn at 30 and 70.
Stochastics are often used in varying period, usually depending upon the volatility of the stock. Depending on the period chosen, a stochastic may be a fast stochastic or a slow stochastic. The default parameters shown in the example above (5,3,3) are the generally accepted parameters for a fast stochastic.
This lesson has covered a number of oscillator indicators - indicators which try to capture peaks and troughs as they occur. Oscillators are not the best indicators when wanting to capture the big trends but will certainly improve the timing of trading in a stock that is trading in a range.
A number of other types of indicators exist which are neither oscillators nor trend-following. They are discussed in the next lesson.