The most commonly used indicator by far is the moving average. Its value is easy to understand intuitively and one of the least controversial indicators. Almost any trader will agree to the value of moving averages.

Moving Average Basics

A moving average represents the average value of an issue over a trailing window.  All moving averages are designated in terms of a time span for how many days of trailing data should be included in the average.  For example, 10 day, 50 day and 200 day moving averages are commonly used.  There are however several ways to calculate this average.  The two most common are the simple moving average and the exponential moving average.

Simple Moving Average

The simple moving average is the most obvious type of moving average.  For an X day moving average you simply total the values of the previous X days and divide by X.  However, in addition to being simple, this method of calculation is somewhat volatile.  The fact that all days are given an equal impact on the average leads to a high sensitivity to the value that has just dropped out of the window.

Exponential Moving Average

In an exponential moving average, or EMA the weight of each piece of data decays as it gets farther from the present.  While much harder to calculate, these tend to give results that are less subject noise.  The impact of each day decays exponentially as it gets farther from the present and thus the most recent data is the most influential.

Trading with Moving Averages

Using these moving averages is fairly straightforward.  In general you want to be trading in the direction of the moving average, however there are some caveats:

When price has deviated particularly far from its moving average, there is a good chance it will return and “touch” the MA again.  This deviation can be a good opportunity to take profits and re-enter the position when it returns to the moving average.

When a price crosses a moving average, this can indicate a change in trend direction.  Many traders will use this as an indicator for a trend change.

Moving averages are integral to trading and are also pivotal in calculating other indicators.  They are the basis of most numeric analysis of stocks and understanding them is very important.

Everyone liked the candlestick video so much I thought I’d point out another cool video that makes a good point about how to look at things simply. Those who’ve been reading my technical analysis basics series can tell that I’m a fan of simple chart analysis. This video gives a great example of looking at trends with an eye for a solid trendline, and using other tools for confirming data.

Given several other indicators of broader economic welfare, most potently the money supply, I’ve got a bit of a bearish feel already. The NASDAQ in particular has been a bit overzealous in it’s climb and seems a possibility for an appealing short. Looking at the trendlines in this video you can see some compelling indications that it may be time to start closing out longs at a bare minimum. Of course the evidence has mounted since this video was made and it was a good opportunity to make some money, or at least save some.

It’s also pretty striking to look at the kind of climb we’ve had without any significant retracement. Even if it’s only a short-term dip, there could very well be some money making opportunities here. I never rush in when fighting the trend long-term, but if you’ve been long you’ve made quite a bit of money and you should at least take a look and see if there’s evidence that the tide might be turning.

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No one factor is likely to drive broad trading decisions than inflation. As with so many other factors right now, there are fundamental indicators swinging in both directions when trying to make a call on inflation. The conventional wisdom has been that a recovery will mean inflation due to a policy of quantitative easing, and that if the green shoots aren’t really green, that we’ll have deflation. There are problems with both of these suggestions however.

The Problem with the Deflation Hypothesis

If you look at the CPI numbers you will be impressed with the year over year (yoy) deflation.  The recession has been biting us hard and we’ve been tightening our belts driving prices down.  That all sounds good except the data don’t seem to support that at all.  If you look at the 12 month CPI numbers for June 2009, you’ll see that other

than Transportation and Energy there has been no other sector that has experienced deflation.  Let’s be clear about what that means.  Despite all the panic going on, overall prices haven’t come in at all except for the collapse of oil prices and the disinterest in cars.  This would seem to suggest that once the economy gets moving again we’re going to have rampant inflation once all the money the government has printed gets moving.

The Problem with the Inflation Hypothesis

But of course things can’t be that simple.  On the flip side of all this is an important fact:  A tremendous amount of wealth was destroyed in the financial crisis.  While the numbers vary, there are suggestions that somewhere around 40% of the world’s wealth was destroyed by the financial crisis.   Imagine the impact of that destruction of wealth on the buying power of the world.  If people are not exercising the same purchasing power they did before, then all that money that the government is printing may never gain enough velocity to cause any real inflation.  Unless governments printed a lot of money, they’re going to have a hard time counteracting all that destruction of wealth.

Another Case for Technical Analysis

This leads me to the same old drum I’ve been beating all along.  In cases like this you have to resort to the technicals (e.g. this free video from INO.com, simply join their mailing list and you’ll get a fantastic resource for free).  Buy (or sell) and hold can be disasterous when applied at times of chaos like this.  You can be right in the long term and still go broke in the short term.  Thus I strongly suggest arming yourself with the tools to make decisions based on market psychology as well as other factors.  In addition, in times like this you can hedge your bets with what I call the the “Triple Call Technique.”

Photo Credit: Erik Charlton

Price and volume are the two essential pieces of information from which most technical analysis is derived. Volume reflects the activity of participants in a given issue. Each unit of volume reflects two people’s actions — One participant buys a share, contract or other issue and the other sells one. The total number of issues that changed hands is the volume.

Typically on charts volume is represented as vertical bars at the bottom of the chart.  The height of these bars represents the amount of volume for a given period of time.  Typically this histogram appears on a chart below the price data.  Volume can reflect many elements of the market psychology at a given time.

You can actually look at volume in several dimensions:

• The most obvious is the number of shares, contracts or other issues that traded handeds.  This is the most common way to measure volume.
• Another way to look at volume is simply in the number of transactions that took place.  The size is irrelevant, simply the number of times some number of shares traded hands.  This number can give some insight into the number of participants in a market, but should obviously be taken with a grain of salt and is not widely used.
• Another way to measure volume is the number of price changes that occurred during a given period of time.  This measurement can be referred to as tick volume.  In this measurement, the number of shares or transactions are irrelevant until the price changes.

Volume is often seens as the primary measure of liquidity in a market.  A market which makes many trades a day typically is viewed as more liquid than one which trades fewer.  Volume is represented in several indicators, but is sometimes ignored by many traders.  It can be an important element in confirming your beliefs on a trade and can be key in analyzing charts.  Be sure to pay attention to volume during your trade lest you get false signals.

Photo Credit: Drab Makyo

Types of Moving Averages

There are many ways to calculate moving averages.  The first is a simple moving average in which a given number of days’ values are added up and then divided by the number of days.  So for example to calculate a 10 day simple moving average of closing price we would add up the previous 10 days’ close and then divide them by 10.  As we did this daily the plotted points would form a useful indicator.

While the simple moving average is handy because it is easy to calculate, an exponential moving average is more commonly used.  In this type of moving average the weight of each day’s data decreases as you get further from the current period.  Thus as a day gets further in the past its influence on the moving average becomes less, instead of simply disappearing on the day it moves out of the term.  While there are many other ways to calculate moving averages, these two are the most commonly used.

Using the Averages

Moving averages have many ways they can be used in trading.  Prices often have a tendency to “bounce off” of the averages as they trend.  As a stock trends up it tends to stay above its moving average but also tends to touch it periodically in the process.  This can be useful in identifying what kind of trend you are in for different periods.  Traders will often use a 10 day EMA for a short term trend, a 50 day EMA for a medium term trend and a 200 day EMA for a long term trend.

Also with the different time periods associated with these different trends, you can use moving average crossovers as a signal.  This is the basis of the MACD histogram.  Watching the convergence and divergence of different moving average periods can give you insight into how each trend is changing relatively.

Price crossovers can also be used to watch for a change in trend.  If a chart has been trending in one direction, staying above its EMA and then crosses over to the other side, this can be an indicator that the trend has ended.  This can be a good time to either close or open a position.

Moving averages are one of the most fundamental concepts to understand in your technical analysis education.  Many other indicators are based on them in one way or another.   Even if you eschew more complicated indicators they can be useful in simple chart analysis and should be part of any trader’s understanding.

The first indicator we will cover in depth is the MACD, or Moving Average Convergance/Divergence. This is predicated on the knowledge of a moving average, which we’ll actually discuss later, but is a pretty simple concept. A moving average is simply the average of the previous number of days. So a 5 day moving average is the average of the previous 5 days closing prices. The EMA, or exponential moving average is a decaying average of some number of days where the more recent days are weighted more heavily.

The MACD is calculated first by picking a fast and a slow exponential moving average. Typically most of the MACD charts you see use a 12 and 26 day EMA for the fast and slow lines. When MACD is presented it is typically as a histogram, where a signal line is generated as the 9 day EMA of the MACD and then the histogram is MACD – signal. This is the gist of the math for deriving the MACD histogram, if you’d like more detail on it refer to Alexander Elder’s Trading for a Living.

Using MACD

While it’s good to know how to calculate MACD and generate the histogram, knowing how to use it is even better. MACD is generally used as an indicator of a change in trend. When the MACD crosses over the signal line, meaning the histogram crosses over the middle line, that is often seen as a signal to trade in the direction of the crossover. Thus if the histogram goes from below to above, it would suggest to go long and vise versa.

MACD in Context

Like most other indicators MACD is not particularly useful in isolation. Moreover modern market conditions have made it less reliable. It can however give you confirming indication of a trend that is suggested by another indicator. Some other ways to trade MACD are to look for divergences. A divergence is when the underlying chart makes a new high or low, but the MACD does not confirm with the same indication. This can indicate that a trend is losing steam and may be ready to reverse. You will find it in common use as one of the broad indicators in multi-indicators systems.

MACD has fallen somewhat out of favor as compared to its historical usage, but remains a valuable indicator. While one would rarely build a system based solely on this indicator it can be a good source to look for validation of other indicators. It would be foolhardy to ignore it simply because it is not en vogue right now.

Photo Credit: Jenny Downing

One thing that this book does that is rarely seen in these kinds of tomes is the author explains exactly the mathematics behind each indicator he presents.  I have literally used this book to write implementations of the indicators.  While you may not want to do any programming any time soon, having a basic understanding of the math also helps you understand exactly what the tool is telling you.  You may have a vague understanding of the MACD and what it means, but if after reading this book you will understand it so much better.  This can only lead to making better trading decisions.

For those who only trade stocks and their derivatives, like myself, the focus of the book on futures may require an extra step to make sure that you understand how it applies to stocks.  In reality though, almost all of the information is almost immediately applicable to any market.  When the book was written, technical indicators were not so en vogue in the stock market.  Additionally the money management techniques he describes are just as valid for just about any kind of trader.

Ultimately the value of this book is in developing a strong fundamental education in technical trading.  Learning by rote, without understanding the indicators you’re trading on is a dangerous game that sounds more like gambling.  Buy Alexander Elder’s Trading for a Living if you really want to have the kind of background that can help you make quality decisions.