Charting Made Easy Part 5 potx

Trading signals are givenwhen the two lines cross.A buy signal is given when the fasterline crosses above the slower line from below 20.A sell signal isgiven when the faster line crosses

the bottom of the price chart and fluctuates within ahorizontal band When the oscillator line reaches the upperlimit of the band, a market is said to be overbought and vulner-able to a short-term setback.When the line is at the bottom ofthe range, the market is oversold and probably due for a rally.The oscillator helps to measure market extremes and tells thechartist when a market advance or decline has become over-extended

Relative Strength Index (RSI)

This is one of the most popular oscillators used by technical

traders.The RSI scale is plotted from 0 to 100 with horizontal

lines drawn at the 70 and 30 levels.An RSI reading above 70 isconsidered to be overbought An RSI reading below 30 is con-sidered to be oversold.The most popular time periods for theRSI are 9 and 14 days (See Figure 13-1)

Stochastics

This oscillator is also plotted on a scale from 0 to 100.However, the upper and lower lines (marking the overbought

and oversold levels) are at the 80 and 20 levels In other words,readings above 80 are overbought, while readings below 20 areoversold One added feature of stochastics is that there are twooscillator lines instead of one (The slower line is usually a 3-daymoving average of the faster line) Trading signals are givenwhen the two lines cross.A buy signal is given when the fasterline crosses above the slower line from below 20.A sell signal isgiven when the faster line crosses beneath the slower line fromabove 80.The time period used by most chart analysts is four-teen days (See Figure 13-2).

Any Time Dimension

As is the case with most technical indicators, these oscillators

can be employed in any time dimension.That means they can

be used on weekly, daily, and intraday charts It’s a good idea touse the same time span in all time dimensions When plotting

The 14-day stochastics oscillator applied to the S&P 500 The last two bottoms in the S&P were marked by oversold stochastic readings below 20 Readings over 80 coin- cided with several short-term peaks.

Overbought

Oversold 14-Day Stochastics

the stochastics lines, for example, use 14 weeks on the weeklychart, 14 days on the daily chart, and 14 hours on an hourlychart, etc.Another reason for keeping the same numbers is thatcomputers allow you to switch back and forth between week-

ly, daily, and intraday charts with a keystroke Using the sametime spans in all time dimensions makes your work a lot easier

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RATIOS AND RELATIVE STRENGTH

Technical analysis can be applied to ratio charts.

Trend-lines and moving averages, for example, can help sure trends on ratios and can alert the user to changes

mea-in those trends.A close monitormea-ing of the ratio charts can add avaluable dimension to market analysis

Stock Ratios

Once you’ve identified a winning group, you can apply ratio

analysis to the stocks in that group Simply divide the

individ-52 Trade Secrets

ual stocks in the group by the group index itself.The stockswith rising ratio lines are the strongest stocks in the group.Theidea here is to find the stocks in the group that are showing thegreatest relative strength That way you’ll be buying thestrongest stocks in the strongest groups

Market Ratios

Ratio analysis can also be used to compare major market ages By dividing the Nasdaq Composite Index by the S&P 500,for example, you can determine if technology stocks are leading

aver-or lagging the rest of the market.You can use the Russell 2000

versus the S&P to gauge the relative strength (or weakness) of

smaller stocks (See Figure 14-1)

The rising Nasdaq/S&P 500 ratio shows remarkable relative strength in the technology sector during the last quarter of 1999 and the first quarter of 2000 The breaking of the

up trendlines, however, signalled new relative weakness in technology Ratio charts are a good way to spot sector rotations within the stock market.

Figure 14-1 RATIOS AND RELATIVE STRENGTH Nasdaq/S&P 500 Ratio

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obliga-tion, to purchase (in the case of a call) or sell (in the case of a put) an underlying market entity at a specif-

ic price within a specified period of time In its simplest cation, a trader who is bullish on a market can simply purchase

appli-a cappli-all; appli-a trappli-ader who is beappli-arish cappli-an simply purchappli-ase appli-a put The main advantage in options trading is limited risk The op- tion trader pays a premium to purchase the option If the market

doesn’t move as expected, the option simply expires.The mum loss the option trader can suffer is the size of the premium.There are countless option strategies that can be utilized byoption traders However, most option strategies require a mar-ket view In other words, the option trader must first determinewhether the market price of the underlying market contract isgoing to rise, fall, or stay relatively flat.This is because the majorfactor influencing the value of an option is the performance ofits underlying market In determining an appropriate option

maxi-strategy, it’s important to remember that the principles of

mar-ket analysis are not applied to the option itself, but to the underlying market.

Therefore, it can be seen that the principles of chart analysiscovered in the preceding pages and their application to thefinancial markets play an important role in options trading

54 Trade Secrets

Option Put/Call Ratio

Trading activity in the options markets is used to generate a

popular stock market sentiment indicator — called the put/call

ratio This ratio is actually a ratio of put volume divided by call

volume It is generally applied to the S&P 100 (OEX) index tion traded on the Chicago Board Options Exchange (CBOE) orthe CBOE Equity put/call ratio, which uses option volume inindividual stocks

op-Contrary Indicator

The S&P 100 or the CBOE Equity put/call ratio is a contrary

indicator In other words, a high put/call ratio is consideredbullish for the market (because it shows too much bearish sen-timent) In the same way, a low put/call ratio (which betraysstrong bullish sentiment) is considered bearish for the market.The reasoning behind the put/call ratio being used as a contraryindicator is based on the idea that option traders get too bullishnear market tops and too bearish near market bottoms

CBOE Volatility Index (VIX)

This contrary indicator is based on the volatility of the S&P

100 (OEX) index option Since it is a contrary indicator, a risingVIX index implies greater volatility and growing concern aboutdownside movement in the stock market By contrast, a fallingVIX implies less volatility and more confidence in the market.The VIX usually trades in a band between 30 and 20.Dips below

20 are usually associated with market peaks Moves above 30are usually associated with market bottoms

THE PRINCIPLE OF CONFIRMATION

tech-nical evidence supporting a given analysis, the strongerthe conclusion becomes In the study of an individualmarket, for example, all of the technical signs should be point-ing in the same direction If some signs are pointing up and theothers down, be suspicious Consult other stocks in the samegroup.A bullish analysis in a stock would be less than convinc-ing if the other stocks in its group were trending lower Sincestocks in the same group tend to move together, make sure thatthe other stocks agree with the one being studied

Look at the various technical indicators to see if they agree.Arethe chart patterns being confirmed by the volume? Do the mov-ing averages and oscillators confirm the chart analysis? What dothe weekly and monthly charts show? While it is seldom that all

of these technical factors will point in the same direction, it pays

to have as many of them in your corner as possible

SUMMARY AND CONCLUSION

analysis as it is applied to the financial markets.We’ve discussed briefly the major tools utilized bythe chartist, including: basic chart analysis, the study of volume,moving averages, oscillators, ratios, weekly, and intraday charts.The successful trader learns how to combine all these elementsinto one coherent theory of market analysis

The many software and Internet-based products available onthe market today also provide powerful tools that make chart-ing and technical analysis much easier — and far more accessi-ble to general investors — than ever bef ore For example, manysoftware and Internet-based products include a full suite oftechnical analysis tools that allow you to create charts easily,have instant access to historical data, and have the ability to cre-ate, backtest and optimize self-designed trading systems with-out any programming knowledge or experience

▲ ▲ ▲ ▲ ▲ ▲

Technical analysis provides an excellent vehicle for market

forecasting, either with or without fundamental input Wheretechnical analysis becomes absolutely essential, however, is in

58 Trade Secrets

the area of market timing Market timing is purely technical in

nature, so successful participation in the markets dictates someapplication of technical analysis

It’s not necessary to be an expert chartist to benefit fromchart analysis However, chart analysis will go a long way inkeeping the trader on the right side of the market and in help-ing to pinpoint market entry and exit points, which are so vital

to trading success.Whether the participant is a day trader or along-term investor, it’s to his or her advantage to learn aboutchart analysis

Resource Guide

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