6.1. Counter-trend indicators

These indicators are numerous but only a few of them are commonly referred to. They correspond to the graphical representation of mathematical calculations. The latter represents the prices evolution. not their absolute level. They are called oscillators, as they correspond to an estimate of market tensions and behave like a derivative function.

This aspect is crucial in order to understand the representation principle of oscillators. For example, a technical indicator reversing up, getting in an up move after having been heading downward, expresses the beginning of an upward trend on the stock to which it is related. Symmetrically, this is the same on the downside. The crossing of a mid-level by indicators thus expresses a move power at its climax letting expect a lower trend pace ahead of a reversal.

6.2. Oversold / overbought levels

The first interest of oscillators, linked to their tension indicator status, is to mark sensitive levels, forecasting possible reversals. It is for this reason that the “overbought ” and “oversold ” concepts have been set up. These levels correspond to market excesses. For example, in the case of an overbought situation, the stock rose steadily without consolidating or correcting significantly, thus letting expect a forthcoming reversal. This is expressed by the oscillator at a high level, in a zone, which has been defined as oversold area and which shows the existing tension on the market. This is also the case, symmetrically, on the downside while, between both extremities, the market is considered as neutral.

Still, reading these overbought and oversold zones can be more complex. Indeed, oscillators can take two different forms, with or without boundaries. Indicators with boundaries evolve between two fixed limits (often 0 and 100). It is then easy to determine these zones (for example above 75 for overbought and below 25 for oversold). In comparison, indicators without boundaries, by definition, have no theoretical limits on the upside and on the downside, which makes it more difficult to set up such zones. However, though it is careless to buy in an already overbought market, the sole analysis of the indicator level does not necessarily give all information (see graph).

6.3. Divergences

The main analysis element of indicators, though often underestimated, lies in the divergences principle. This corresponds to a disconnection between the prices evolution and that of the indicator (cf. graph). One will thus consider a downward (upward) divergence when the oscillator is following a downward (upward) trend while prices are still rising (falling).

This phenomenon is directly linked to the derived function status of indicators. Indeed, a decrease of the indicator while prices are rising indicates that this rise is pursuing at a lower pace. This breathlessness of the market then lets expect a reversal on the downside. Still, this approach is valid only when linked to the preceding aspect, i.e. the presence of the oscillator in an oversold or overbought area. Indeed, these zones are the predilection place for trend reversals, as they mark an uninterrupted trend. In comparison, a neutrality (cf. graph) of markets makes breathlessness quite unlikely and thus little relevance to the analysis of divergences. Moreover, as divergences are premonitory signs, it is often careless to act in consequence just after the apparition of divergences. It is then much safer to check whether they are validated or not, i.e. if the indicator can rebound on the overbought or on the oversold line (cf. graph).

6.4. Graphical figures

Beyond calculations on indicators, this latter can also provide information by themselves, just as stock prices. Trends and figures can thus be identified. Indicators can also bump under resistances or land on supports. This aspect is also interesting as trend ruptures on oscillators often precede that on stock prices. Within this framework, the neutrality zone (corresponding to the middle of the boundaries for indicators with boundaries) is especially overseen, as it often constitutes a major support or resistance.

Moreover, it is possible to use filters. For example, it is often wise to compare oscillators with their moving average on a certain number of days to eliminate punctual and non-significant variations. It then becomes possible to set up a systematic method, based on the fundamental principle of indicators: not going against the trend. This rule consists in buying as the oscillator breaks up the zero level, while it stands above its moving average, and to sell as this level is crossed down, with the indicators turning around and crossing down the zero level.

This set of counter-trend indicators is based on a simple observation: when stock prices stand in a bullish trend, closes stand at higher and higher levels from day to day while, when stock prices stand in a bearish trend, closes stand at lower and lower levels. Combining both conclusions, it becomes possible to forecast reversals as soon as new tops appear but with closes on the downside.

6.5. The RSI

This indicator (aka Relative Strength Index) aims at establishing a reference scale independently from the stock prices levels themselves. As the RSI has boundaries (0 and 100), it then becomes very easy to determine overbought and oversold areas. Thus, the RSI is one of the most commonly used counter-trend indicators.

It is based on the average of rises and drops of a stock, with the formula.

RSI = 100 – [100 / (1 + RS)]

where RS represents the average of up closes divided by the average of down closes on the considered period.

Consequently, the shorter the studied period, the more volatile the RSI. Depending on trading habits, longer or shorter lengths can thus be used but the most common length is 14 days.

On a graph, lines can be drawn at 30 and 70. A crossing down of 30 indicates that the market is oversold while a crossing up of 70 indicates that the market is overbought.

Just as for the MACD, it is possible to smooth signs given by the RSI by forming two RSI on two different periods. Then, a crossing up of the long-term RSI by the short-term RSI constitutes a buying signal while a crossing down of the long-term RSI by the short-term RSI constitutes a selling signal.

The principle of divergences is also applicable to the RSI, and is more easily applicable than on the MACD, as overbought and oversold areas can legitimately be drawn.

Finally, just as on stock prices themselves, supports and resistances can appear, especially when nearing the neutrality zone (near 50).

6.6. Stochastic Oscillator (by METASTOCK)

The Stochastic Oscillator compares where a security’s price closed relative to its trading range over the last x-time periods.

The formula for the %K parameter of the Stochastic is.

%K = 100 x [ (C – Lx) / (Hx – Lx) ]

For example, to calculate a 10-day %K: First, find the security’s highest high and lowest low over the last 10 days. For this example, let’s assume that during the last 10 days the highest high was 46 and the lowest low was 38—a range of 8 points. If today’s closing price was 41, %K would be calculated as.

The 0.375 in this example shows that today’s close was at the level of 37.5% relative to the security’s trading range over the last 10 days. If today’s close was 42, the Stochastic Oscillator would be 0.50. The 0.50 would show that the security closed today at 50%, or the mid-point, of its 10-day trading range.

The above example used a %K Slowing Period of 1-day (no slowing). If you enter a value greater than one, MetaStock will average the highest high and the lowest low over the number of %K Slowing Periods before performing the division.

A moving average of %K is then calculated using the number of time periods you specified in the %D Periods. This moving average is called %D.

Finally, MetaStock multiplies all stochastic values by 100 to change decimal values into percentages for better scaling (e.g. 0.375 is displayed as 37.5%).

The Stochastic Oscillator always ranges between 0% and 100%. A reading of 0% shows that the security’s close was the lowest price that the security has traded during the preceding x-time periods. A reading of 100% shows that the security’s close was the highest price that the security has traded during the preceding x

-time periods.

Stochastic Oscillators can be used as both short- and intermediate-term trading oscillators depending on the number of time periods used when calculating the oscillator. When displaying a short term Stochastic Oscillator (e.g. 5-25 days), it is popular to slow the %K value by 3-days.

There are several ways to interpret a Stochastic Oscillator. Three popular methods include.

— Buy when the Oscillator (either %K or %D) falls below a specific level (e.g. 20) and then rises above that level, and sell when the Oscillator rises above a specific level (e.g. 80) and then falls below that level. However, before basing any trade off of strict overbought/oversold levels it is recommended that you first qualify the trend of the market using indicators such as r 2 (see r 2 ) or CMO (see Chande Momentum Oscillator). If these indicators suggest a non-trending market, then trades based on strict overbought/oversold levels should produce the best results. If a trending market is suggested, then you can use the oscillator to enter trades in the direction of the trend.

— Buy when the %K line rises above the %D (dotted) line and sell when the %K line falls below the %D line.

— Look for divergences. For example, where prices are making a series of new highs and the Stochastic Oscillator is failing to surpass its previous highs.

The constitution of these indicators is more complex than that of other oscillators. A first oscillator, called %K, is constituted, with the formula.

%K = 100 x [(C – Lx) / (Hx – Lx)]

where C represents the last close price, Lx the lowest price on the past x days and Hx the highest price in the past x days. The most common length used is five days.

Thus, when the market stands on its highs, the closing price is close to its tops of the last few days. The ratio then tends towards 1 and the %K oscillator towards 100. Oppositely, on the downside, the ratio tends towards 0 and so does %K.

%K thus expresses market tensions (oversold or overbought) in the RSI manner but, as opposed to the latter, is related to extreme prices and not close prices.

A second indicator, %D, is then constituted, so as to smooth %K, with the formula.

%D = 100 x Hy /Ly

where Hy represents the sum of (C – Lx) on the past y days and Ly the sum of (Hx – Lx) on the past y days, with y < x. In other words, %D is an average of %K (x days) expressed on the past y days. This new length is often three days.

In spite of this smoothing, it remains difficult to compare %D and %K as %K can easily come from 0 to 100 from a session to another. Then, %D becomes the new reference indicator. A third indicator, slow %D, is then created so as to smooth %D. This indicator is formed by taking the average of %D on three days. %D and slow %D are then respectively called fast and slow stochastics.

Stochastics can be used in different ways. First, the presence of the fast stochastic on extremes (near 0 or 100) indicates oversold or overbought situations. Despite the smoothing of %K by %D, this indicator remains volatile, which makes it difficult to use in this framework. Reciprocally, this strong volatility makes it possible to consider that, if %D remains on high (resp. low levels) for a long time, stock prices are standing on a strongly rising (resp. falling) trend.

Moreover, buying (resp. selling) signals occur when the slow stochastic stands on low (resp. high) levels and crosses up (resp. down) the slow stochastic.

Finally, as for the other indicators with boundaries, divergences between the oscillator evolution and that of stock prices can occur.