Stock moving averages can be calculated across a wide range of intervals, making them applicable to both long and short-term investment strategies.

When navigating the financial markets, traders can choose from a number of tried-and-true strategies. One of the most common technical indicators in trading is the moving average. It’s a helpful resource for figuring out when it’s the right time to buy and sell stocks. Smoothing out price fluctuations, it shows the general direction that a stock has been moving recently.

In this article, we’ll take a look at the 200 day moving average, which is among the most widely used indicators.

What Is the 200-day Moving Average?

The 200 day moving average is a stock’s average closing price over the last 40 weeks. It’s a standard tool for gauging the broader direction of the stock market. When the 200 day moving average for a stock’s time frame is higher than its most recent closing price, it is in an uptrend. This figure is commonly employed with other shorter-term market indicators. In addition to revealing the market’s general direction, the space between the moving averages can be used to gauge the trend’s intensity. For example, contrasting the 50 day and 200 day moving averages is rather common.

Pros of the 200 Day Moving Average

As an investor or trader, you can reap several benefits from using the 200 day moving average indicator.

Fundamentally Sound Securities

This indicator helps traders avoid stocks that are trading below their 200 day moving average. This separates stocks that are technically sound from those that aren’t. Stocks that have outperformed the moving average throughout this time span often have solid fundamentals that have sustained high prices. Furthermore, the percentage of businesses performing beyond their 200 day moving average shows the market’s financial condition and trading confidence.

Level of Support and Resistance

Traders can use the 200 day moving average trend line as a tool to identify significant price thresholds that have not been broken. Without a significant event, prices are more likely to reverse course before breaching the moving average. Therefore, the moving average can be used as a solid floor or ceiling for support or resistance. If the 200 day moving average is rising, for instance, and prices are about to bounce off the support level, traders will buy. The trader’s expectation at this point is that the market has bottomed out and prices will begin to rise again. However, when the overall trend climbs too steeply, investors may anticipate a near-term loss of momentum.

Strength of the Current Trend

With the help of the 200 day moving average, investors and traders can gauge the stability of the present trend. For instance, a sharp decrease in the 200 day moving average indicates a severe downward trend.

Price Crossover

When stock prices rise above their 200 day moving average, it may be taken as a positive indicator. These crossovers can be studied by traders and used with other metrics to help pinpoint the best entry points.

Cons of the 200 Day Moving Average

Avoid making the common mistake of relying solely on 200 day moving averages when making investment decisions. Here are some of its disadvantages:

Lag

Despite these benefits, there is one important drawback to using a 200 day moving average that must be taken into account: lag. Stock moving averages are notoriously slow to change, despite the seemingly infinite innovation of market professionals over the years. This works in their favor during periods of irregular price appreciation, but it becomes a severe drawback when the trend reverses.

The longer the period covered by your moving average, the larger the lag — that is, how sensitive your moving average is to market fluctuations. For instance, a 10-day moving average will respond rapidly to price shifts, whereas a 200-day moving average will be much slower to do so.

Not Predictive

The idea that past success does not guarantee future results is one of the most substantial reasons why using the 200 day moving average is unreliable. Day-to-day fluctuations in stock prices are common, and traders should be prepared for the possibility of sudden shifts in the market. The only information that this technical indicator gives is historical. Therefore, it cannot accurately predict the future movement of stocks.

Summing Up

If you want to see how a stock has performed over the last 40 weeks, the 200 day moving average is an excellent indicator. It illustrates the stock’s price strength and describes its long-term trajectory. However, the lagging and non-predictive nature of this indicator presents a disadvantage.

By combining it with other metrics, the 200 day moving average can help traders pinpoint precisely when to enter and exit. Good investing opportunities may include stocks with prices currently higher than the 200-day moving average.

What are market internals?

Market internals give us a peek “under the hood” of the market, if you will. From them we gleam insights into the market’s breadth. The S&P may be up on the day, but the market internals may tell a different story. It may be one sector driving the rally, while the majority of stocks are weak on the day.

Market internals are indexes using data derived from stock exchanges like the NYSE or NASDAQ, like the amount of NYSE stocks upticking vs. downticking on a minute to minute basis, or the amount of the stocks advancing in volume, vs. declining in volume, on a minute to minute basis. These internals can often serve as leading indicators, as you can see what the internals of the market’s engine are doing in real-time.

Volume Spread Difference – $VOLSPD or $UVOL-$DVOL

The Volume Spread Index shows the difference between volume on stocks advancing for the day, and volume on stocks declining for the day. This index is essentially made up of two tickers, $UVOL and $DVOL. On some charting platforms, like Thinkorswim, you can simply type “$UVOL-$DVOL” in the ticker box and get this index, while other platforms have their own ticker for it, like $VOLSPD.

This index is most useful on two time frames: a daily chart to see the trend of the last few days, and a short term intraday chart to see where the volume is moving in the next hour.

On the daily chart it is useful to plot a shorter term moving average, like a 10-day, and a zero line. If the moving average is above the zero line, more volume has generally been going into the advancing stocks over the last few days, signalling strength from the bulls.

On the intraday chart, a longer term moving average, like a 50-period, has more application as it gives you a perspective on the broad trend for the day.

NYSE TICK – $TICK

The NYSE $TICK Index only has application on a very short time frame. It is the ultimate pulse of the market on a second-to-second basis. Concisely, the $TICK measures on many stocks on the NYSE in that moment are upticking vs. downticking.

The $TICK’s reading are quoted in negative or positive numbers. For example, a reading of +400 means that in the last 6 seconds, 400 more stocks upticked than downticked on the NYSE.

Generally, the use of the $TICK index is to identify extremes in markets and fade them. Be careful though, in a strong trending market, trying to fade extremes is like trying to catch a falling knife. However, in a choppy market climate, fading extremes can be a very profitable strategy.

Another strategy used by some day traders is to use $TICK in strong trending markets. When they’ve identified a trending day, they will use high $TICK readings as a confirmation indicator, rather than trade divergences.

As more issues get added to the NYSE, the extreme readings change. At the time of writing, here are some extreme levels to take note of:

• 800

• 1000

• 1400

In the choppiest markets, 800 is an extreme reading, while in more volatile and trending markets, you’re better off using 1400 as a reference point. It helps to plot lines at the extreme levels to filter out a lot of noise.

Advance-Decline Difference – $ADD

The Advance Decline Ratio is the difference between advancing and declining stocks. Like the other internals mentioned earlier, this index also gives negative and positive readings. A reading of -400 means that 400 more stocks went down on the day than advanced on the day.

The main use of this is to gauge general stock market strength. For example, Apple and Microsoft make up roughly 7% of the S&P 500, if those two stocks rally while the rest of the stocks trade in a narrow range, the S&P will likely be up on the day. A few disproportionately weighted stocks on extended rallies can make the market look stronger than it really is if the rest of the stocks are not following suit. This is where the Advance Decline Ratio comes in. It measures either confirms the positive (or negative) action in the market, or there is a divergence between the two.

In the example below, you can see that $ADD confirms most price action from the S&P, that a few stocks aren’t driving the rallies or pullbacks.

The S&P 500 Volatility Index – The VIX

By far the most well known indicator in this article, the VIX is widely known as the “fear index” by most traders and investors. The VIX essentially projects out the expected volatility for the next 30 days, on an annualized basis. For example, if the VIX is at 20 right now, the market (based on it’s own activity) is projecting the next 30 days to have the volatility of 20%, on an annualized basis. Basically, when people are getting scared and buying insurance against their portfolio, the VIX goes up.

The VIX has a historically negative correlation with the S&P 500.

There are many ways to use the VIX as an indicator. The first one involves the VIX serving as a leading indicator the market. Essentially using it for convergence or divergence. As noted above, the VIX has a negative correlation with the market, so when the VIX spikes, the S&P is likely to follow with a sharp down move. Combining this with your other trading analysis is sure to improve your results.

The next effective use of the VIX is to take advantage of it’s mean reverting nature. If you’re familiar with options trading, one of the core tenants of premium sellers is that implied volatility is overstated. This fact is evidenced by models created by options trading/education firm Tastytrade in the below graph:

To sum up these findings, when implied volatility is high, it’s time to sell, as their is premium built into that high price, in other words, it’s a positive expectancy bet. Because the VIX is simply a measure of SPX’s implied volatility, one can use these volatility tendencies on the VIX.

Simply looking at a moving average (20-day) of the VIX over time, we can see volatility’s mean reverting nature in action.

The cup and handle pattern was first introduced in 1988 by analyst William O’Neill and has since become a favored chart pattern among traders because it is relatively straightforward to recognize and trade on. The pattern forms during as a result of consolidation a bullish movement and indicates a continuation of that bullish trend after its completion.

Cup and Handle Pattern

The cup and handle pattern is a bullish continuation pattern that consists of two parts, the cup and the handle. The cup typically takes shape as a pull back and subsequent rise, with the candlesticks in the center of the cup giving it the form of a rounded bottom. The handle is made up of downward-sloping price action that soon breaks out above the upper resistance line to indicate the continuation of the original bullish trend.

Inverted cup and handle patterns are also possible during downtrends and signal bearish continuations. In this case, the cup shape is inverted such that it represents a resurgence in price after a downtrend followed by a downward movement. The handle slopes upwards before breaking out sharply downward to continue the original bearish trend.

Timeframes

Cup and handle patterns typically are seen to occur on a daily chart after a strong trend has progressed for one or more months. As a trend matures, the chances that the cup and handle forms decrease, while any cup and handle that does form is likely to produce a smaller continuation movement with less upside potential.

Cup and handle patterns can also occur on shorter timeframes, although trading these requires quick recognition and confirmation of the breakout at the end of the handle in order to profit. Again, beware cup and handle patterns that form at the end of a trend rather than partway through it, as they are less likely to signal a strong continuation.

Cup and Handle Patterns Simplified

Cup and handle patterns form as the result of consolidation after an uptrending stock tests its previous highs. At that level, traders who bought the stock near the previous highs are likely to sell, causing a gentle pullback. This pullback is then met with bullish activity, which causes the rounded bottom and rise of the right side of the cup. As the stock once again tests its highs, another pullback – the handle – is observed, but this time bullish investors are able to push the stock higher as they snap up discounted shares.

How to Trade Cup and Handle Patterns

Recognizing Cup and Handle Patterns

When evaluating whether a cup and handle pattern is real, it is important to look at the shapes of both the cup and the handle.

The cup should be more U-shaped than V-shaped, as a gentle pullback from the high is more indicative of consolidation than a sharp reversal. The U-shape also demonstrates that there is strong support at the base of the cup and the cup depth should retrace less than 1/3 of the advance prior to the consolidation pullback. However, cup depths between 1/3 to ½ the level of the prior advance are possible in volatile markets, and even cup depths retracing 2/3 of the prior advance are possible in extreme setups. The cup can develop over a period of one to six months on daily charts, or even longer on weekly charts. Ideally, the highs on the left and right side of the cup are at roughly the same price level, corresponding to a single resistance level.

The handle can be either a small, unorganized pullback, or a bear flag or pennant. In any case, the handle should retrace less than 1/3 to 1/2 the depth of the cup – the shallower the retracement, the more bullish the movement following a breakout should be. The handle can develop over one week to several months on a daily chart, although ideally completes in less than one month.

Breakout

A bullish breakout, signaling a continuation of the prior bullish trend, occurs when the handle breaks above the upper trendline of the handle, which is typically below the resistance line set by the right side of the cup. The breakout should occur on high trading volume and continue above the trendline drawn from the left to the right side of the cup to provide confirmation. However, if the right side of the cup is well below the left side, it is prudent to wait until the handle breaks above the level of the left side of the cup before committing to the breakout and anticipated continuation.

Trading Strategies

Stop buy orders can be used to automatically trade a breakout above the handle’s upper trendline or above the level of the right side of the cup. Once an entry is made, it is possible to set a price target on the extent of the bullish movement by adding the price difference between the bottom of the cup and the level of the breakout above the handle’s upper trendline to the price at the breakout point.

Examples

The first example shows a shallow cup and handle pattern developing over the course of approximately two to three months. The cup features a gentle pullback after a strong bullish movement and the right side of the cup reaches the same price level as the left side of the cup. The false breakout in the handle on August 13 occurs on low trading volume, demonstrating the importance of using trading volume as a method of confirming the breakout. Estimating the extent of the continuation movement by measuring the distance between the base of the cup and the breakout slightly underestimated the movement.

The second example is another classic cup and handle pattern that develops over three to four months, with the handle forming over approximately two weeks. The cup retraces slightly more than half the preceding movement, which is relatively mature prior to the cup and handle pattern’s formation. The right side of the handle rises higher than the left and the pattern slightly overestimates the extent of the bullish continuation after the breakout.

Conclusion

The cup and handle pattern is a bullish continuation pattern triggered by consolidation after a strong upward trend. The pattern takes some time to develop, but is relatively straightforward to recognize and trade on once it forms. As with all chart patterns, trading volume and additional indicators should be used to confirm a breakout and continuation of the original bullish price movement.

Wedge patterns are chart patterns similar to symmetrical triangle patterns in that they feature trading that initially takes place over a wide price range and then narrows in range as trading continues. However, unlike symmetrical triangles, wedge patterns are reversal signals and have a strong bias towards being either bullish – for falling wedges – or bearish – for rising wedges. Wedge patterns can be difficult to recognize and trade effectively since they often look much like background trading activity on charts.

Wedge Patterns

Rising Wedges

Rising wedges are bearish signals that develop when a trading range narrows over time but features a definitive slope upward. This means that in contrast to ascending triangles, both subsequent lows and subsequent highs within the wedge pattern will be rising as the trading range narrows towards the apex of the wedge.

As bearish signals, rising wedges typically form at the end of a strong bullish trend and indicate a coming reversal. However, rising wedges can occasionally form in the middle of a strong bearish trend, in which case they are running counter to the main price movement. In this case, the bearish movement at the end of the rising wedge is a continuation of the main downward trend.

Falling Wedges

Falling wedges are the inverse of rising wedges and are always considered bullish signals. They develop when a narrowing trading range has a downward slope, such that subsequent lows and subsequent highs within the wedge are falling as trading progresses.

Falling wedges are typically reversal signals that occur at the end of a strong downtrend. However, they can occur in the middle of a strong upward movement, in which case the bullish movement at the end of the wedge is a continuation of the overall bullish trend.

Timeframes

Both rising and falling wedges can occur over both intraday and months-long timeframes, although intraday wedges can be difficult to identify with much certainty. The strongest wedge patterns develop over a three- to six-month period and are preceded by a strong trend that is at least several months long. However, it is also possible that the trend is contained partially or entirely within the wedge pattern itself. The reversal signaled by the wedge may be either an intermediate reversal within the larger trend or a long-term reversal.

Wedge Patterns Simplified

Wedge patterns are typically a result of consolidation following a strong trend, but in contrast to triangle patterns they indicate a weakening of the prior trend rather than a strengthening. Rising wedge patterns form when the support line is rising faster than the resistance line, while falling wedge patterns form when the support line is falling faster than the resistance line. When a wedge breaks out, it is typically in the opposite direction of the wedge – marking a reversal of the prior trend.

How to Trade Wedges

Wedges can be tricky to identify since the trend preceding the formation of the wedge can be encompassed partially or entirely within the wedge itself. As the trading price range narrows as the wedge progresses, trading volume should decrease.

Importantly, in contrast to triangle patterns, both the high and low points that form the wedge should be moving in the same direction – either up or down – as the trading range narrows. For a rising wedge, this means that both the lows and highs are increasing as the wedge progresses, while for a falling wedge both the highs and lows are decreasing as the wedge progresses. In rising wedges where the highs rise only a little, or in falling wedges where the lows fall only a little, it can be very difficult to tell a wedge apart from an ascending or descending triangle that signals an opposite price movement upon breakout.

The breakout – bullish in a falling wedge and bearish in a rising wedge – should be convincing and come on strong trading volume before trading on it. It is often prudent to wait until the breakout surpasses a prior support or resistance line before trading.

Unlike for triangle patterns, there is no reliable method for estimating a price target on the extent of the movement following the breakout based on the shape of the wedge. Therefore, trailing stop losses are extremely important and other charting indicators should be used to estimate the extent of the movement.

Examples

The first example shows a rising wedge that follows a strong uptrend and develops over an approximately three-month period. Note that there are numerous tests of the lower support line, some of which could be interpreted as false breakouts if there is no effort made to confirm the breakout with trading volume or other indicators. The true breakout is a bearish reversal, as expected for rising wedges, and comes on high trading volume.

The second example also shows a rising wedge, although in this case the wedge runs counter to the main trend and the bearish breakout represents a continuation of the main downward trend. The area of the wedge breakout then serves as a resistance line on a subsequent rally. Note that the volume on the bearish breakout is relatively low in this continuation move, although it is still higher than the trading volume in the days prior to the breakout.

Conclusion

Wedge patterns are typically reversal patterns that can be either bearish – a rising wedge – or bullish – a falling wedge. These patterns can be extremely difficult to recognize and interpret on a chart since they bear much resemblance to triangle patterns and do not always form cleanly. Therefore, it is important to be careful when trading wedge patterns and to use trading volume as a means of confirming a suspected breakout.

Triangle patterns are a chart pattern commonly identified by traders when a stock price’s trading range narrows following an uptrend or downtrend. Unlike other chart patterns, which signal a clear directionality to the forthcoming price movement, triangle patterns can anticipate either a continuation of the previous trend or a reversal. Although triangles more frequently predict a continuation of the previous trend, it is essential for traders to watch for a breakout of the triangle before acting on this chart pattern.

Triangle Patterns

A triangle pattern forms when a stock’s trading range narrows following an uptrend or downtrend, usually indicating a consolidation, accumulation, or distribution before a continuation or reversal.

Triangle patterns come in three varieties – ascending, descending, and symmetrical – although all three types of triangles are interpreted similarly.

Ascending and Descending Triangles

Ascending and descending triangle patterns are right-angle triangles in that the line extending along two or more lows or two or more highs, respectively, is horizontal. Ascending triangles have a rising lower trendline as a result of accumulation and are always considered bullish signals regardless of whether they form after an uptrend or downtrend. Descending triangles have a falling upper trendline as a result of distribution and are always considered bearish signals.

Symmetrical Triangles

Symmetrical triangles have descending highs and ascending lows such that both the upper and lower trendlines are angled towards the triangle’s apex. Symmetrical triangles are a sign of consolidation and usually result in a continuation of the prior trend, although they can also indicate reversals.

Triangle Pattern Timescales

Triangle patterns are most commonly applied on daily charts and interpreted over a period of several months. For example, strong triangle patterns on daily chart require a prior trend that is at least a few months old and typically develop for several months before a breakout occurs. However, triangle patterns can also be observed and used for trading on shorter timescales, although doing so leaves the drawing of the triangle patterns up to a greater degree of interpretation.

Triangle Patterns Simplified

Triangle patterns work because they represent underlying patterns of consolidation (symmetrical triangles), accumulation (ascending triangles), or distribution (descending triangles). In symmetrical triangles, both bullish and bearish traders are evening out and testing the price of a stock following a significant price trend until eventually either bulls or bears win out – with the result usually following the lead of the previous trend. In an ascending triangle, buyers continue to get more aggressive over time – resulting in a rising lower trendline as subsequent lows increase – until they eventually win out over bearish traders and the stock price breaks out. The opposite action occurs in a descending triangle, where sellers are becoming more aggressive and driving consecutive highs lower until the stock breaks out bearishly.

How to Trade Triangle Patterns

A symmetrical triangle requires at least four points – two highs, where the second high is lower than the first, and two lows, where the second low is higher than the first. In ascending triangles the highs are the same across the triangle rather than descending, while in descending triangles the lows are the same across the triangle rather than ascending.

For a triangle to exist, there must be a well-established prior trend: for example, one that is at least a few months old when looking at a daily chart.

For all three types of triangle patterns, drawing a line from the first high to the second and continuing it while drawing a line from the first low to the second and continuing should form a triangle as the two lines intersect. The triangle pattern identification is more supported as more high and low points are added to the lines. As the stock proceeds further into the triangle pattern over time, volume should also diminish.

Triangle patterns typically last for anywhere from one months to three months or more on a daily chart before a breakout occurs, when the stock price moves outside the lines of the triangle. The best price action occurs when the breakout forms about halfway to three-quarters of the way to the apex of the triangle, where the triangle’s length is measured from the apex to the base of the lower trendline. A break before or after this point may be insignificant as the stock has not fully consolidated or the breakout becomes inevitable as the apex approaches.

The direction and strength of the breakout is extremely important. Although the direction of the initial break should indicate whether the previous trend will continue or reverse in a symmetrical triangle, it is important for traders to confirm the breakout before trading since triangles resulting in reversals often feature false breakouts. Strong breakouts will come with a spike in trading volume, especially for uptrends, and will move at least several percent of the price as well as last for several days.

After the breakout, the apex and breakout price levels typically act as support or resistance levels. To estimate a price target on the breakout, measure the base of the triangle – the distance between the widest high and low points on the triangle – and add that to the price at the breakout point. Alternatively, draw a trendline parallel to the lower triangle line that extends from the highest high in the triangle.

Examples

The first example shows a symmetrical triangle following an extended uptrend. The lower trendline has two support points, while the upper trendline has three. The breakout occurs in the direction of the prior trend and is strong enough to provide confidence in the continuation. A secondary breakout can be seen as the stock price breaks above the price target predicted by the triangle pattern.

The second example shows a ascending triangle pattern, with three consecutive highs at a constant level and three consecutive lows increasing each time. The breakout occurs bullishly and the extent of the following uptrend is predicted almost exactly by the height of the base of the ascending triangle.

Conclusion

Triangle patterns are frequently observed following a strong, extended price trend as buyers and sellers test the new price of a stock and become more or less aggressive over time. Ascending triangles are always considered bullish signals and descending triangles are always considered bearish signals, while symmetrical triangles typically result in a continuation of the prior trend but may also signal a reversal. Triangles are highly favorable trading patterns because they are straightforward to interpret and confirm and establish support and resistance levels and a price target following a breakout.

Stochastics Oscillator

The stochastics oscillator, developed by analyst George Lane in the 1950’s, is a momentum indicator used widely by traders to predict reversals in trending stocks. While the stochastics oscillator can be used similarly to MACD, the stochastics oscillator is calculated fundamentally differently – it compares current price data to the high-low range of a stock’s price over a set timeframe. In addition, the stochastics oscillator is frequently used by traders as a complement to RSI since it can be used to identify overbought and oversold levels.

Type of Indicator

The stochastics oscillator is an oscillating momentum indicator, meaning that it is range-bound between 0 and 100 and tracks changes in the momentum of a stock’s price rather than the price itself. As a momentum indicator, it can be used to predict upcoming reversals in a stock’s price.

Calculating Stochastics

The calculation of the stochastics oscillator depends on the current closing price of a stock as well as its highest high and lowest low over a set time period. Typically, this time period is set to 14 intervals, which can be minutes, days, weeks, or another time frame depending on the time scale a trader is interested in studying. The primary variable calculated from this information, %K, is calculated as the difference between the 14-period low and the current close, divided by the difference between the 14-period high and 14-period low, all multiplied by 100 to yield a percentage. The second variable, %D, is simply a three-day simple moving average of %K. Thus:

%K = 100 * (Current Close – 14-period Low) / (14-period High – 14-period Low)

%D = 3-day simple moving average of %K

In this way, the 14-period high-low range of a stock’s price is the denominator in the calculation of %K, and %K will be above 50 when the stock closes in the upper half of the high-low range and below 50 when it closes in the lower half of the range. %D will respond more slowly to changes in a stock’s price action than will %K.

Note that it is possible to change the time period in the calculation of the stochastic oscillator, as well as to smooth the oscillator by taking an X-period (often a three-period) simple moving average of %K. In the latter case, %D is calculated as a three-day simple moving average of the smoothed %K.

How to Trade with Stochastics

Divergences

The primary use of stochastics is to predict potential reversals in a stock price, and a divergence between a stock’s price and the stochastic oscillator is the first indication of a potential reversal. A divergence occurs when a stock’s price reaches a new lowest low or highest high, while the stochastic oscillator (that is, %K) forms a higher low or lower high, respectively. This divergence indicates that there is less downside or upside momentum, which may precipitate a reversal.

Divergence alone cannot confirm a reversal, but there are additional signs in the stochastics oscillator that can provide information. The most important is whether the oscillator breaks above 50 in the case of a potential bullish reversal or below 50 in the case of a potential bearish reversal. If this occurs, it is significantly more likely that a reversal will follow since this indicates that the stock is trading above or below the average of its price over the 14-interval period.

The second thing to look for to confirm a potential bullish or bearish reversal is whether the %K line crosses above or below the %D line, respectively. Since the %D line lags the %K line, this indicates a shift in momentum similar to a signal line crossover on an MACD chart. A move back above 20 or below 80, if the stochastic oscillator had indicated oversold or overbought conditions, can also be used as evidence of a likely reversal.

Looking at other indicators as well as checking whether the stock has broken above or below a key resistance line can provide additional evidence to confirm a reversal predicted by stochastics.

Setups

Setups are essentially the inverse of divergences. A bullish stochastics setup occurs when a stock sets a lower high while the stochastics oscillator sets a higher high, while a bearish setup occurs when a stock sets a higher low while the stochastics oscillator sets a lower low. This situation indicates strengthening upside or downside momentum even as the stock price fails to set a new highest high or lowest low. This indicates that buying on the following pullback or rebound, especially as the stochastics oscillator dips below 20 and then rebounds or rises above 80 and then falls, will be lucrative since the stock should break sharply up or down afterwards. Traders can interpret either a move above 20 or below 80, a cross of the %D line, or a move above or below 50 as signals to buy or short.

Overbought and Oversold Levels

Because of the oscillating nature of the stochastics indicator, it is possible to use stochastics to identify overbought and oversold levels in a similar way to how RSI is used. %K is bound between 0 and 100 and most traders consider %K values above 80 to indicate that a stock is overbought while values below 20 indicate that a stock is oversold.

However, as with RSI, the interval used for calculating stochastics may alter the interpretation of overbought and oversold levels. In addition, overbought or oversold conditions do not in themselves signal an imminent reversal, since it is possible for a stock to be consistently overbought or oversold during a strong uptrend or downtrend. A move in %K back above 20 or below 80, combined with a %D crossover and information from additional indicators such as RSI and MACD, is necessary to identify a potential reversal.

Indicator Comparison

The stochastics oscillator has similarities to both MACD and RSI and in many ways combines features of the two. First of all, all three indicators are oscillators. Like MACD, the stochastics oscillator tracks a stock’s momentum and involves a signal line – %D – that lags the primary oscillator to provide a trading signal based on changes in price momentum. Like RSI, the stochastics oscillator can be used to identify overbought and oversold levels in a stock.

However, it is important to remember that the calculation for stochastics is very different than that for MACD and RSI. The result is that stochastics works better in sideways-moving markets trading within a set price range, while MACD and RSI work better in strongly trending markets.

Examples

The first example shows a bearish divergence in the stochastic oscillator. The price of Facebook (FB) reaches a high on January 11 before falling, rebounding, and posting a higher high on February 1. However, the stochastic oscillator has posted a lower high on February 1 than on January 11, establishing a divergence. This divergence is further supported by the fact that the stochastic oscillator is above 80, indicating overbought conditions. As the divergence predicts, the bullish trend reverses sharply after February 1.

The second example shows the effectiveness – and complexity – of using stochastics to identify and trade on overbought and oversold levels. The chart of Microsoft shows numerous periods during which the stochastics oscillator indicates that the stock is overbought given a %K above 80. At the end of many of these periods, a dip below 80 coincides with a bearish crossover of the %D line and immediately precedes a pullback that could be traded on.

However, it is also worth noting that one of the most profitable strategies in hindsight would be simply holding Microsoft stock to ride the entire uptrend. This demonstrates that overbought and oversold conditions may in many cases simply be the result of a strong trend and are not always indicative of a reversal.

Conclusion

Stochastics is an oscillating momentum indicator widely used by both beginning and advanced traders to predict potential reversals and to identify overbought and oversold levels. While stochastics bears many similarities to MACD and RSI, this indicator often works more effectively in sideways-moving markets and can be used in combination with MACD and RSI to provide additional information about potential changes in price momentum.

PSAR

The Parabolic Stop-and-Reverse (PSAR) indicator places a set of dots on a chart in order to highlight whether a stock is trending up or down and to indicate when a price trend breaks ahead of a potential reversal. PSAR was developed by Welles Wilder in 1978 and has remained popular among traders ever since as a tool for identifying price trends as well as potential entry and exit points. When used in combination with other indicators to confirm potential reversals, PSAR can be a powerful indicator for trading trending stocks.

Type of Indicator

PSAR is a trend following indicator, essentially trailing behind price during a trend to indicate the direction of a price trend. If PSAR is less than the stock price over repeated time intervals it indicates that the stock is trending upward, while if PSAR is greater than the stock price it indicates that the stock is trending downward. The power of PSAR is that it can foretell reversals if its value flips from below the stock price to above it or vice versa.

Calculating PSAR

PSAR is particularly difficult to calculate by hand because it depends on whether the value of PSAR itself is rising or falling and includes an acceleration factor that changes with each time interval in the current trend. The acceleration factor is an important component in calculating PSAR – typically, it is initialized with a value of 0.02 and increases by a value of 0.02 every time the stock price reaches a new highest high or lowest low in the current trend up to a maximum value of 0.20.

If the stock price, and consequently PSAR, is trending upward, PSAR is calculated by subtracting the last time period’s PSAR from the highest high in the uptrend, multiplying that value by the acceleration factor, and then adding the result to the previous period’s PSAR. Thus:

PSAR (uptrend) = Previous PSAR + Acceleration Factor*(Highest High – Previous PSAR)

If the stock price and PSAR are trending downward, the calculation for PSAR is somewhat different. To calculate PSAR, subtract the lowest low of the current downtrend from the previous time period’s PSAR (the opposite of the subtraction for an uptrend), multiply the result by the acceleration factor, and add this to the previous PSAR. Thus:

PSAR (downtrend) = Previous PSAR + Acceleration Factor*(Previous PSAR – Lowest Low)

It is also worth noting that PSAR cannot be above the lows of either of the previous two time periods in an uptrend, or below the highs of the previous two time periods in a downtrend. In these cases, use the lowest of the two lows or the highest of the two highs as the new PSAR value.

Acceleration Factor

The acceleration factor is the primary variable in the calculation of PSAR that can be manipulated to achieve different effects with the indicator, and particularly to tune the sensitivity of PSAR and its propensity to flip from uptrending to downtrending and vice versa. PSAR sensitivity can be decreased by reducing the change in the acceleration factor with each new high or low and increased by increasing the change in the acceleration factor with each new high or low. Thus, a step of 0.01 in the acceleration factor will produce less reversals in PSAR, while a step of 0.03 will produce more. Be careful with the latter, as it can cause PSAR to reverse too frequently rather than actually follow trending price action.

Another way to fine-tune the acceleration factor is to change its maximum value. A lower maximum value, for example 0.10, will produce fewer reversals than a higher maximum value. Changing the maximum value of the acceleration factor has less of an immediate effect, and less of an effect on short trends, than changing the step.

How to Trade Using PSAR

When PSAR, typically plotted as a series of dots on a chart, is below the stock price over a set of intervals, that indicates that the price is trending upward. When PSAR is above the stock price, it indicates that the price is trending downward. The key to PSAR is that when its value flips from greater than the stock price to less than the stock price, or vice versa, it may indicate that a reversal has taken place or is about to. PSAR flips can thus signal entry and exit points to capture the bulk of a trend but to exit before the reversal fully takes hold.

When trading with PSAR, the most important thing to remember is that it is only effective as a buy and sell indicator for swing trading when a stock is trending strongly. In a sideways market, PSAR will flip above and below the stock price repeatedly and it may be difficult to identify true signals without using additional indicators such as MACD, RSI, moving averages, and others. A PSAR breakout is much more convincing when, for example, a stock is considered oversold by RSI or is valued below a long-term moving average. Trendlines and moving averages can also help to determine when a strong trend is present as opposed to highly volatile or sideways price action, and manipulating the calculation of PSAR using the acceleration factor as described above can help to minimize fall signals.

Stop Losses

One of the best and most popular uses of PSAR is to set stop losses during a trend. As the price of a stock trends upward, it is important to protect profits by continuously adjusting stop losses upward. The PSAR represents a choice value for stop losses at the end of each time interval since if the price breaks below the PSAR it is likely indicating a reversal and the PSAR will flip from below to above the stock price accordingly. For downtrending stocks, PSAR can also be used to protect profits when short-selling by similarly setting the PSAR as an exit point if the price of the stock exceeds its value.

Indicator Comparison

The PSAR is most similar to the MACD in that they are both trend following indicators and both can indicate a potential reversal – PSAR by flipping from below to above the stock price or vice versa, and MACD by exhibiting a signal line crossover. MACD can also, like PSAR, give information about the direction of a price trend based on whether its value is positive or negative. However, MACD does not provide price information that can be used to set stop losses or profit protections in the same way that PSAR does.

PSAR Examples

The first example shows the power of PSAR to be used both for indicating reversals and for setting trailing stops. Both reversals on the chart are captured accurately by PSAR since this stock is trending strongly over the period in question. Notably, the second, larger reversal is also signaled by a signal line crossover in the MACD chart to confirm the exit signal from PSAR. Most important, traders who are using PSAR to set trailing stop-losses while following the two uptrends would have been rewarded – these stop losses would have protected the bulk of profits from following the uptrends, whereas leaving stop losses at levels near the start of the uptrends would have negated nearly all profits.

The second example shows a situation in which PSAR is not nearly as effective and must be interpreted with caution – volatile, sideways price action. In the absence of strong trends, PSAR values may flip erroneously and the price trends indicated by PSAR may be unfounded. There are numerous examples in this chart (a few are noted) where trading on PSAR alone would lead to s. In this situation, it is possible to desensitize PSAR by lowering the acceleration factor step, although PSAR is in general not the indicator of choice for trading during periods of sideways price action.

Conclusion

PSAR is a popular and useful indicator for identifying the direction of a price trend and potential entry and exit points as well as for setting trailing stops to protect profits. Although PSAR does not perform well during volatile or sideways price action, it can be paired with other indicators, including RSI, MACD, and moving averages, to confirm a trend or reversal. In addition, it is possible to manipulate the acceleration factor at the heart of PSAR to make it more or less sensitive to price action depending on the strength of a trend.

About Fibonacci Retracements

Fibonacci retracements are a set of ratios, defined by the mathematically important Fibonacci sequence, that allow traders to identify key levels of support and resistance for stocks. Unlike moving averages, Fibonacci retracements are fixed, making them easy to interpret. When combined with additional momentum indicators, Fibonacci retracements can be used to identify potential entry and exit points to trade on trending stocks.

Type of Indicator

Fibonacci retracements are used to indicate levels of support and resistance for a stock’s price. Although they are similar to moving averages in this respect, Fibonacci retracements are set by the extent of the previous bullish or bearish run and do not change each day in the current trend as moving averages do. Therefore, it can be significantly easier to identify and anticipate support and resistance levels from Fibonacci sequences.

Calculating Fibonacci Retracements

Fibonacci retracements are based on the Fibonacci sequence, in which each number in the sequence can be added to the previous number to produce the following number in the sequence. Dividing any number in the sequence by the following number yields 1.6180 – known as the Golden Ratio – while dividing any number by its predecessor yields 0.6180. Dividing any number in the sequence by a number two positions in advance yields 0.3820, while dividing any number by a number three positions in advance yields 0.2360. These ratios emanating from the Fibonacci sequence are found throughout nature, mathematics, and architecture.

Retracement levels for a stock are drawn based on the prior bearish or bullish movement. To plot the retracements, draw a trendline from the low to the high within a continuous price movement – Fibonacci retracement lines should be placed at 61.80%, 38.20%, and 23.60% of the height of the line. In a bullish movement the retracement lines start from the top of the movement (i.e. the 23.60% line is closest to the top of the movement), whereas in a bearish movement the retracements are calculated from the bottom of the movement (i.e. the 23.60% line is closest to the bottom of the movement).

How to Trade with Fibonacci Retracements

Once you have drawn a set of Fibonacci retracements on a chart, it is possible to anticipate potential reversal points where support or resistance will be encountered. If the retracements are based on a bullish movement, the retracements should indicate potential support levels where a downtrend will reverse bullishly. If the retracements are based on a bearish movement, the retracements should indicate potential resistance levels where a rebound will be reversed bearishly.

The most common reversals based on Fibonacci retracements occur at the 38.20%, 50%, and 61.80% levels (50% comes not from the Fibonacci sequence, but from the theory that on average stocks retrace half their prior movements). Although retracements do occur at the 23.60% line, these are less frequent and require close attention since they occur relatively quickly after the start of a reversal. In general, retracement lines can be considered stronger support and resistance levels when they coincide with a key moving average like a 50- or 200-day simple moving average.

Whenever applying Fibonacci retracements, keep in mind that retracement lines represent potential support and resistance levels – they represent price levels at which to be alert rather than hard buy and sell signals. It is important to use additional indicators, in particular MACD, to identify when support or resistance is actually being encountered and a reversal is likely. The more that additional indicators are pointing towards a reversal, the more likely one is to occur. Also note that failed reversals, especially at the 38.20% and 50% retracement levels, are common.

Indicator Comparison

Fibonacci retracements are somewhat similar to moving averages in that they can both be used to identify levels of support and resistance. However, the theories underlying these two indicators are entirely different. Fibonacci retracements are based on the mathematically-defined Fibonacci sequence and its ubiquity throughout nature, art, and science, whereas moving averages simply follow the price movements of a stock. As a result, Fibonacci retracements are fixed price levels following an initial price movement, whereas moving averages change over time as the price continues to fluctuate following the initial price movement and the following reversal. When Fibonacci retracement levels and moving averages coincide, the level of support or resistance is typically stronger.

Examples

The first example shows how Fibonacci retracements can be used to identify multiple levels of support that can help predict the sawtooth pattern of an overall bullish movement. In this case, the stock price of Apple (AAPL) experiences an initial bounce at the 23.8% retracement level – a bounce that happened so quickly that it could not be predicted by MACD, and without this confirmation would be a risky trade for most traders. However, the 50% and 61.80% retracement levels later provide additional support after larger pullbacks, and reversals at both of these support levels could be confirmed by a bullish signal line crossover in the MACD.   

The second example demonstrates how Fibonacci retracements can be used to identify exit points when buying against an overall bearish trend. The chart of Petmed Express (PETS) shows a large bearish movement from January to May, at the end of which the stock price bounced significantly. For traders who had bought at the bottom – indicated by the bullish MACD signal line crossover and rise in RSI above 30 – selling at the top of the retracement is desired. While resistance is encountered at the 23.8% retracement level and supported by an RSI above 70, this reversal is not supported by the MACD and fails. Instead, a reversal at the 61.8% retracement level is supported by both an RSI above 70 and a bearish signal line crossover in the MACD – altogether providing a relatively strong indication for traders to exit their positions at this resistance level.

Get Started Now

Fibonacci retracements are commonly used by traders as an easy way to identify levels of support and resistance in trending stocks. Unlike moving averages, Fibonacci retracement levels are static and defined according to ratios found in the ubiquitous Fibonacci sequence. Whenever using Fibonacci retracements, retracement levels should be interpreted cautiously and always in conjunction with additional indicators like MACD to confirm a reversal.

Bollinger Bands

Bollinger Bands, developed by financial analyst John Bollinger, are a technical indicator that account for volatility to indicate when a stock is overbought or oversold. Bollinger Bands describe lines corresponding to twice the standard deviation of the 20-day simple moving average of a stock’s price, such that the bands are farther apart as volatility increases and close together as volatility decreases. This indicator is a favorite among traders since it has many built-in signals and works well with other technical indicators like the MACD.

Bollinger Bands Type of Indicator

Bollinger Bands are above all else an indicator of volatility. When the price of a security is highly volatile, the upper and lower bands will be far apart from one another, while the bands will narrow as price volatility decreases. In addition, many traders use Bollinger Bands to identify overbought and oversold conditions in the market. In this case, when the price approaches the upper band the stock is thought to be overbought, while when the price approaches the lower band it is thought to be oversold.

Calculating Bollinger Bands

Bollinger Bands are straightforward to calculate, as they are simply twice the standard deviation from the 20-day simple moving average. Thus, if you calculate the 20-day simple moving average, the upper band is that average plus twice the standard deviation of the stock price over that same time period, while the lower band is the average minus twice the standard deviation.

The use of the standard deviation of the price as the defining variable in calculating Bollinger Bands is what allows them to serve as an indicator of volatility. Note that while Bollinger Bands are traditionally calculated from the 20-day simple moving average, there is no reason that the time period or calculation of the moving average, or even the multiplicative number of standard deviations away from the moving average used in the bands’ calculation, cannot be modified. Bollinger recommends increasing the multiplier to 2.1 when using a 50-day moving average and decreasing it to 1.9 when using a 10-day moving average.

How to Trade Using Bollinger Bands

Bollinger Bands can be excellent indicators, although without consulting other technical indicators they are not in themselves the best at signaling potential trades.

As discussed before, many traders consider a stock to be overbought when the price approaches the upper band and oversold when the price approaches the lower band. However, there is no trading signal inherent in this interpretation and overbought and oversold conditions should be confirmed with RSI.

Squeeze

The distance between the bands, which is related to the volatility in a stock’s price over the previous 20 days, can also be informative but not conclusive on its own. When volatility decreases and the bands get close together – known as a squeeze, since they are “squeezing” the 20-day simple moving average line – this is considered to indicate that volatility will increase in the future. Conversely, when the bands move far apart as volatility increases, it is expected that volatility will decrease into the future. However, there is no time constraint on when the change in volatility may occur from Bollinger Bands alone.

Breakouts and Walking the Bands

Breakouts above or below the Bollinger Bands are important events for a stock, since approximately 90% of price movements should occur between the bands. However, Bollinger Bands alone do not provide information about whether a breakout will lead to a positive or negative price shift, and thus should not be considered a signal in the absence of other technical indicators.

In cases when a stock is moving strongly bullishly or bearishly, the price can also “walk the bands” – that is, repeatedly touch or mildly break either the upper or lower band. In the case of walking the upper band, this is typically a sign of strength since it takes significant strength to continue to push this resistance level, even if in other conditions the stock would be considered overbought. The converse is true for walking the lower band. In this case, it is important to check other indicators, especially the RSI, to identify when buying and selling opportunities will occur as the stock price repeatedly rebounds off of one of the bands.

W-Bottoms and M-Tops

A bullish W-bottom is considered to have formed when four consecutive steps occur. First, a stock’s momentum shifts and the price drops to near or often below the lower Bollinger Band. Second, the stock price rebounds to approximately the price of the 20-day simple moving average. Third, the price drops to a lower low, but remains above the lower Bollinger Band this time. Finally, the price should bounce up and then experience a positive breakout once it passes the previous high in the W pattern. The breakout can be confirmed with additional indicators, in particular a signal line crossover in the MACD.

The M-top is essentially the bearish converse of the W-bottom. This occurs when a stock’s price breaks above or nearly above the upper Bollinger Band before dropping towards the 20-day simple moving average and then failing to break above the upper Bollinger Band on the subsequent bullish movement. An M-top can similarly be confirmed with a bearish MACD signal line crossover and indicates that the stock price will decline precipitously.

Indicator Comparison

Bollinger Bands are highly similar to Keltner Channels. The two indicators differ primarily in how they calculate volatility bands – Bollinger Bands use the standard deviation of the simple moving average, whereas Keltner Channels use the average true range and an exponential moving average as their centerline. These differences lead Keltner Channels to be smoother than Bollinger Bands since the standard deviation is more volatile than the average true range of a stock’s price. In addition, the exponential moving average is more sensitive to recent price changes than the simple moving average, so Keltner Channels respond to price action more quickly than Bollinger Bands.

Examples

The first example shows how RSI and Bollinger Bands can be used in tandem to identify buying and selling opportunities in a bullishly trending stock. Mastercard is walking the upper Bollinger Band, breaking it repeatedly over the course of a several-month period before falling back towards the simple moving average. While the Bollinger Bands themselves do not give any information about when to consolidate gains, the RSI provides an overbought signal that triggers relatively reliably ahead of a sell-off.

The second example shows a W-bottom. Apple’s stock price drops below the lower Bollinger Band on March 21st before rebounding somewhat strongly. On the second drop, even as the price sets a lower low, the closing price remains above the lower Bollinger Band (only the closing price is important because the Bollinger Bands are calculated with closing prices). The stock breaks out once it surpasses the previous high in the W pattern, and the breakout is confirmed with a bullish signal line crossover in the MACD.

Conclusion

Bollinger Bands are a popular technical indicator for evaluating volatility. Although Bollinger Bands only provide trading signals on their own in very specific cases such as W-Bottoms and M-Tops, they can be paired with other indicators such as the RSI and MACD to enhance more widely applicable trading strategies.