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Common Technical Indicators and Interpretations

Moving Averages of Closing Prices

The most widely reported technical indicators are simple moving averages of prior prices, with the most popular being the 50-day and the 200-day moving averages of closing prices. There is no reason to attribute those moving average lengths or any other with special significance except to say that they are widely used. If market participants do in fact react to these particular moving averages, then it is at least a possibility that they are "special" if only because they could lead to self-fulfilling prophesies.

The moving averages are often used in the context of support and resistance. If the current price is above a moving average level, then that particular level of the moving average is considered to be "support". Conversely, if the current price is below its moving average, that moving average level is considered to be "resistance". Thus one might go one step further and consider the 50-day moving average level as an indicator of intermediate term support/resistance, and the 200 day moving average to be an indicator of longer term support/resistance. The precise meaning of support and resistance is rarely well-defined, but presumably, if a stock's price falls towards its level of support, it is more likely to bounce back off the support level than to fall below it. Thus price being above its 50 -and/or 200- day moving average is considered bullish, while below would be a bearish signal.

For a stock in a solid uptrend, not only will the current price be above the two moving averages, but the 50-day moving average will be above the 200-day moving average (MA). (That is because the 50 day MA responds quicker than the 200 day one. In fact, some use the 10-day MA an even shorter term indicator, and for that same stock in an uptrend, the 10 day MA will be above the 50 day MA). That is also considered bullish. If the 50 day is below the 200 day, it is bearish. We look at some of these potential trading rules in action and consider the performance of moving average trading systems below.

Wilder's Relative Strength Index (RSI)

RSI is a widely used member of a class of indicators called oscillators. In general, oscillators are intended to indicate when an asset is "overbought" or "oversold". A stock being oversold presumably means that it is more likely to increase than to decrease in the future. RSI has the nice property that it is bounded between 0 and 100. Most commonly, it is based on the prior 14 days of price data. According to descriptions in many technical analysis books (e.g., Achiles 1995), a level of RSI below 30 is interpreted as the stock being oversold and a buying opportunity, and RSI being above 70 is interpreted as being overbought and contributes to a sell signal Each week, we report which stocks are overbought or oversold according to the RSI indicator. We discuss the performance trading systems using the RSI indicator below.

Moving Average Convergence/Divergence (MACD)

MACD is another oscillator. It has a variety of uses and interpretations, but broadly indicates price trend and momentum. In general, MACD is the difference between a "short" moving average and a "long" moving average of price. When a stock is trending upward and the trend steepens, the short moving average (for example, the 10 day simple MA) tends to pull away from the long term moving average (for example the 50 day simple MA), and MACD increases. If a stock has been falling, but then begins to flatten out, also MACD tends to increase (in this case it goes from being negative to being less negative ). A MACD greater than 0 indicates the stock is in an uptrend and is a bullish signal, and below 0 indicates a downtrend and is a bearish signal. Most commonly, the short moving average is a 12 day exponential moving average and the long moving average is a 26 day exponential moving average.

One of the more common uses of MACD is to compare its current level to a moving average of past levels. That moving average of the MACD is called its signal line, and in the typical case is a 9 day moving average of the MACD(26, 12). Comparing MACD to its signal line is the way to capture momentum (i.e. the change in the trend). If the MACD is greater than (less than) the current value of its signal line, it has positive (negative) momentum. Positive momentum is considered bullish, while negative momentum is bearish (e.g., Achiles 1995, Etzkorn 1997). Below, we examine the performance of MACD trading systems.

Continue to part 3 - "Two Technical Scoring Techniques"

Contents: A View on Technical Indicators and Trading Systems