On the world's financial markets and stock exchanges. Part 3
"...Players are rewarded for buying what no one wants when no one wants it, and selling what everyone wants and when everyone needs it."
1) Technical analysis
1.1 The concept of technical analysis
Technical analysis is a study of price changes on stock, currency and commodity markets. At its basis, technical analysis rests upon an analysis of time series of prices and their graphs, or "charts". In addition to price series, technical analysis uses information about trading volumes and other statistical data.
Technical analysis has developed many different tools and methods, but all are based on the assumption that recurring patterns and trends can be detected by analyzing time series prices and trading volumes to determine the general market condition.
Technical analysis and its traditional counterpart fundamental analysis are the main schools of securities analysis. Technical analysis dominates in the forex market analysis.
There are differences in the methods of technical analysis in the Forex market, where transactions are made between banks, and the exchange, where transactions are recorded by the Chamber of Commerce - for example, in the foreign exchange market can not get the volume of all transactions, and traders look primarily at the price and then examine the volume of trade (for several brokers). Nevertheless, the general principles of technical analysis are the same in all markets.
Technical analysis does not examine the reasons why the price changes its direction (for example, because of poor returns on stocks or changes in other prices), but only the fact that the price is already moving in a certain direction. From an analyst's point of view, profits can be made in any market if you recognise the trend correctly and then close the trade in time. In other words, you should take the opportunity to buy if the price has dropped to the low side and if it has risen to the high side and turned around, you should sell without covering. Playing with the trend" - reducing and restoring positions during price swings, confirmed by trading volume, is also possible.
In addition to trends, technical analysis checks so-called patterns (patterns) - patterns that appear on charts. For example, we know from history that price rises in many cases continuously and falls in jumps (this happens due to the closing of short positions). Such observations can be used in order to open and close a trading position in time.
For some people, the analysis is simple, for others it is complicated, some people consider it to be art, some people consider it to be a science, some people frankly laugh at it, and some people deify it. There are many fans of disputing the usefulness of the analysis. And at the same time someone earns and someone loses money. Both use almost the same charts and indicators. Newbies often have wrong notions about both tehanalysis itself and its possibilities. Inexperienced people have illusion of technical analysis simplicity, magic power and foresight in making money on financial markets transmitted to anyone who starts using this type of analysis. But that is just an illusion that comes from a masterful presentation! In reality, technical analysis is just a tool to look at market dynamics from a different angle. At its core, technical analysis is simple to understand, but not easy to apply. The profile of the market, which allows us to see the analysis, is presented to everyone in a different way. It is like an artist's painting, in which everyone sees differently, and evaluates it differently.
On a practical level, thechanalysis is a set of methods for formalising the market. In books besides the formal description of some or other indicators, methods of graphic analysis, you will find numerous recommendations for their application in practice. When reading these recommendations you need to remember the saying "trust but verify". And the reason is very simple. First, the market is constantly changing. Second, the methods of market analysis are in many ways individual with a common toolkit.
This method was created for purely applied purposes, namely to generate income first on the securities markets and then on the rest of the markets. All technical analysis techniques were developed separately from each other, and only in the 1970s were they merged into a single theory with a common philosophy, axioms and basic principles.
1.2 Critique of Technical Analysis
Although many technical analysts believe their technique will give them an advantage over other traders, not all researchers share this belief. Technical analysis of price charts in the past does not allow us to guess the "reversal points" of prices in the future, and when prices develop in an already known direction, thechanalysis gives us the simplest "buy and hold" strategy.
Among the critics of thechanalysis there are quite a few successful investors. For example, Warren Buffett says the following: "I realised that technical analysis doesn't work when I turned the price charts upside down and got the same result". Peter Lynch gives an even sharper assessment: "The price charts are great for predicting the past".
1.3 In defence of technical analysis
The goal of many traders is to recognise the direction in which the market is heading. George Lane, a technical analyst, became famous with the phrase: "The trend is your friend!" You need a tool to recognise a trend. And the same tool should be used for getting out of a trading position on time. Technical analysis helps to do this (although it cannot predict anything accurately).
Many market participants act on the basis of their experience, believing that "success lies on the far side of error" (quote: Thomas Watson Sr., founder of IBM). Studying prices and trading volumes is necessary to gain experience in making trades in the stock market.
1.4 Three Axioms of Technical Analysis
The price movements on the market take into account all information. According to this axiom, all information affecting the price of the commodity is already taken into account in the price and trading volume, and it is not necessary to separately study the dependence of the price on the political, economic and other factors. It is enough to focus on the study of price/volume dynamics and get information about the most likely market development.
Price movements are subject to trends. This axiom is the central axiom of technical analysis; it states that prices do not change randomly, but follow some trends, i.e. price time series can be divided into intervals, in which price changes in certain directions prevail.
History repeats itself. This axiom states that it makes sense to apply price change models developed on the basis of historical data analysis because price changes reflect a rather stable psychology of the market crowd - participants react in a similar way to similar situations.
2) Dow Theory
Dow Theory is a theory which describes how prices behave over time. The theory is based on a series of publications by Charles H. Dow (1851-1902), an American journalist, the first editor of the Wall Street Journal and one of the founders of Dow Jones and Co. After Dow's death, the theory was developed by William P. Hamilton, Charles Rhea and George Schaefer and called the "Dow Theory". Dow himself did not use this term. Dow Theory is the basis of technical analysis and consists of 6 postulates:
- There are three types of trends - in an uptrend (downtrend), each subsequent peak and each downtrend must be higher (lower) than the previous one. According to Dow's theory, there are three types of trends: primary (or long-term), secondary (or intermediate) and small (or short-term).
- Each primary trend has three phases - the accumulation phase, the participation phase and the realisation phase. During the first phase, the most astute investors start buying (selling) shares against the general market consensus. This phase is not accompanied by strong price movements because the number of such investors is quite small. At some point a new trend is detected in the market and the shrewd investors start to be followed by active traders using technical analysis. This phase is accompanied by a strong change in price. During the third phase the whole market recognizes the new trend and excitement begins. At this point, astute investors begin to realize profits and close positions.
- The market takes into account all news - prices react quickly to any new information. This applies not only to financial and economic indicators, but to any news in general. This statement of Dow theory fits well with the market efficiency hypothesis.
- Exchange indices must be consistent. This statement applies to the Dow Jones Industrial Index and the Dow Jones Transportation Index. According to Dow theory, the current trend and trend change signals must be confirmed by both indices. However, some difference in timing of signals is allowed, i.e. one of the indices can signal a trend change earlier than the other.
- Trends are confirmed by trading volumes. Dow believed that in order to recognise a trend, trading volumes must be taken into account. A change in the price of a stock when trading volume is low can be explained by many different reasons and does not characterise a current trend. If the price change occurred against a background of high trading volume, it reflects the "real" opinion of the market and describes the development of the current trend or a new trend.
- Trends are in effect until there is a clear signal of an end to them. This statement should be understood as follows: a trend has a tendency to continue and changes in prices which do not correspond to a trend should, in case of uncertainty, be interpreted as a temporary correction and not as a change in trend.
3) Ways of representing price changes on the basis of time intervals
There are several ways:
- Tick chart - gives the most detailed information about price changes because it displays every new quote. A single chart constructed in disproportion to the passage of time. Each price movement (vertical) is followed by a move by a standard segment (horizontal).
- Linear chart - displays the change in price over time, a sequence of price values at fixed points in time. The smaller is the interval, the more accurately the graph reflects all fluctuations. But we do not get price values inside time intervals! The standard time intervals in technical analysis are 1min, 5min, 15min, 30min, 1 hour, 4 hours, 1 day, 1 week, 1 month.
Technical analysis is subdivided into three methods:
- Graphical - analysis of graphical figures displaying prices;
- Mathematical - computer analysis based on indicators, oscillators and cycles.
4) Graphic analysis
The graphical method is based on the analysis of price charts - a representation of price changes over a period of time on a graph. There are several ways to display prices in graphical analysis:
- Japanese candlesticks;
The method of displaying prices in the form of Japanese candlesticks is one of the most popular, because it allows you to clearly display the nature of price changes. A Japanese candlestick displays four important price values within a given time frame:
- Open Price - Open
- Close price - Close
- Minimum value - Low
- Maximum value - High
The wide part of the candle is called the real body. The body represents the price range of the trading session between the opening and closing prices. If the body of a candlestick is black, it means that the closing price was less than the opening price of the session. If the body of the candlestick is white, it means that the closing price was higher than the opening price.
The thin lines above and below the body are called shadows. The shadows indicate the extreme prices of the trading session. The shadow above the body is called the upper shadow, while the shadow below the body is called the lower shadow. The high point of the upper shadow gives the session's maximum price, and the low point of the lower shadow - the session's minimum price. Looking at the candlestick chart, we understand the origin of the name "candle": the individual lines on these charts are really similar to candles with wick ends sticking out of them. If a candlestick doesn't have its upper shadow, it's said to have a shaven head. If a candlestick lacks a shadow, it is said to have a shaven bottom. The Japanese think that the body of a candlestick reflects the most significant price movements. The shadows are usually treated as unimportant price movements.
Some readers may be familiar with the terms "yin" and "yang". This is what the Chinese call Japanese candles. "Yin" is the name for a black candle, "yang" for a white one.
The Japanese attach great importance to the ratio of opening and closing prices, as these prices correspond to the two most emotional points of the trading day. A Japanese proverb says: "By the dawn's hour all day is equal". Similarly, the opening price determines the further development of the trading session. It gives us an idea of the possible price movement during the day. At this time, all the evening news and rumors are already filtered and combined in one time point.
Candlestick analysis is popular not only because it allows you to visualise price movements within a given time frame, but also because it allows you to look at some of the typical configurations which influence the behaviour of prices later on.
Any directional movement can end, stop and/or change its direction. Trend reversal patterns can help in this case. A trend reversal signal indicates that there is a possibility of a change in trend direction, but not necessarily the opposite. And this is important to understand. Compare an uptrend to a car travelling at 30 kilometres per hour. The red brake lights come on and the car stops. The red light is a kind of reversal indicator which shows that the previous trend (the car's forward movement) is about to end. But now that the car is standing still, will the driver want to drive in the opposite direction? Will he stay where he is? Will he go in the previous direction? Without further signals, we cannot answer these questions.
The Hammer and the Hanging Man are single candlesticks which send out important signals about the "health" of the market. However, most of the signals that appear on Japanese candlestick charts are not based on single candlesticks, but rather on combinations of candlesticks. One of these combinations of candlesticks is the engulfment pattern. It is one of the most important reversal signals, and is formed by two candles with differently coloured bodies.
The next reversal pattern is the 'veil of dark clouds' (see figure). This pattern consists of two candles appearing after an uptrend (or at the top of the trading corridor) and is a reversal signal at the top.
While the "dark cloud veil" pattern is a reversal signal at the top, its opposite, a gap in the clouds, is a reversal signal at the base (see figure). It consists of two candles and appears in a falling market. The first candle has a black body and the second has a long white body." The white candle opens well below the price low of the preceding black candle. The price then rises, forming a relatively long white body which closes above the middle of the black candle's body.The stars represent one of the most mysterious reversal signals. A star is a small-bodied candlestick that forms a price gap with the previous large-bodied candlestick. The main condition for the formation of a star is the gap between its body and the body of the previous candle, while the intersection of shadows is allowed. The color of the star doesn't matter. Stars appear at tops and bottoms (sometimes a star that appears during a downtrend is called a "raindrop"). If a star is a doji (ie instead of a body it has a horizontal line - the opening and closing prices are equal), it is called a “doji star” (see fig.).
The stars are included in four reversal patterns:
- evening Star;
- morning Star;
- doji star;
- falling star.
In all these models, the star's body can be either white or black.
The Morning Star (see figure) is a bottom reversal pattern. Its name originated from the morning star in the sky (planet Mercury), which heralds the sunrise, as this pattern signals a possible increase in prices. The morning star pattern consists of a candlestick with a long black body, followed by a candlestick with a small body breaking down (these two candles form the simplest star pattern). On the third day, a white candlestick appears, the body of which covers a significant part of the black body of the first day.The evening star is the bearish counterpart of the morning star. Its name arose by analogy with the evening star in the sky (planet Venus), which appears before dark. The evening star pattern is a signal of a reversal at the top, and therefore it becomes a signal for action only if it appears after an uptrend. A doji is called a "doji star" if it breaks up with the body of the previous candle in an uptrend, or breaks below the body of the previous candle in a downtrend. Doji stars are forerunners that the previous trend is changing its direction. The trading session after the doji should confirm the reversal signal.
A Shooting Star is a two-candlestick pattern that warns of the possible end of price growth. Its appearance is quite consistent with the name. Unlike the evening star, the shooting star is not one of the most important reversal signals.
In addition to the listed types of displaying prices on a chart, there were several other methods previously - point-to-digital charts, which are currently practically not used.
A specific schedule, for practical use, is recommended only after mastering all other methods of analysis. The main difference of this presentation of information is that there is no time axis, and a new price column is built after the appearance of another direction of dynamics.
A cross is drawn if prices have dropped by a certain number of points (for example, 20). If prices have increased, then a zero is drawn.
The point-and-figure chart allows you to accurately display support and resistance levels, which will be discussed below.
Renko charts are believed to be named after the Japanese word renga, meaning brick. Renko charts are very similar to three-line breakout charts, with the only difference that the brick line on the Renko chart continues to draw in the direction of the previous price movement only if prices change by a certain minimum value (cell price). All bricks are the same size. Thus, on the Renko chart with a cell price of 5 points, a price increase of 20 points is depicted as four bricks 5 points high.
The main signal of a trend reversal is the appearance of a new white or black brick. A new white brick marks the beginning of a new uptrend, and a new black brick marks a new downtrend. Like other trend-following systems, Renko charts sometimes give false signals if the trend is short-lived. At the same time, they retain the main advantage of such systems - they allow covering the main part of any significant trend.
Because Renko charts highlight the mainstream by screening out minor price changes, they are also useful for identifying support and resistance levels.
The following figure shows a classic bar chart for Intel stock and a renko chart with a 2.5 pip box. The arrows “buy” and “sell” on both charts mark the moments of trend reversals on the “Renko” chart. As you can see, although the signals came with some lag, they did indeed provide a trade in the direction of the main trend.
Renko charts are based only on the closing prices. The price of a cell corresponding to the minimum price change reflected in the chart is set by the user.
When building a Renko, today's closing price is compared with the high and low of the previous brick (white or black).
If the closing price is higher than the high of the previous brick by at least the size of the cell price, then one or more white bricks are plotted on the chart. The height of these bricks is always equal to the price of the cell.
If the closing price is below the low of the previous brick by at least the value of the cell price, then one or more black bricks are plotted on the chart. The height of the bricks is always equal to the price of the cell.
If the price changes by an amount that exceeds the price of the square, but not enough to build two new bricks, then only one new brick is built. So, if on the Renko chart with the price of a cell of 2 points the prices rise from 100 to 103, then only one white brick will be built, which corresponds to a change from 100 to 102. The rest of the movement - from 102 to 103 - reflections on the Renko chart "Will not receive.
Kagi charts appeared in the 70s of the last century - at the initial stage of the formation of the Japanese stock market. Kagi charts are a series of interconnected vertical lines, the thickness and direction of the increment of which are determined by price dynamics. The time on the Kagi charts is not counted.
If prices continue to move in one direction, the length of the vertical line on the chart increases. If the price gates at a certain pre-selected value (reversal coefficient), a new vertical line is plotted on the chart in the next column. When prices break above their previous high or low, the line thickness on the Kagi chart changes.
Kagi charts illustrate the forces of supply and demand:
A sequence of thick lines indicates that demand exceeds supply (the market is growing);
the sequence of thin lines reflects the superiority of supply over demand (the market falls);
alternation of thick and thin lines indicates that the market is in equilibrium (supply equals demand).
The main trading signal on the Kagi chart is the change in line thickness: when the line changes from thin to thick, you should buy; when the line changes from thick to thin, sell.
A series of successively increasing highs and lows indicates the strength of the upward movement; declining highs and lows indicate market weakness.
The following figure shows a Kagi chart with a reversal ratio of 0.02 pips and a classic Eurodollar bar chart. The “buy” arrows on the bar chart mark the places where the line on the Kagi chart changes from thin to thick, and the “sell” arrows mark the places where the line changes from thick to thin.
If today's closing price is less than or equal to the starting price, then a thin vertical line is drawn from the starting price to the new closing price.
To draw each subsequent line, you need to compare the current closing price with the extreme point (lower or upper) of the previous Kagi line:
If the price continues to move in the direction of the previous line on the chart, the line increments in the same direction, regardless of the magnitude of the price change.
If there is a price reversal by at least the reversal coefficient (this may take several days), then a short horizontal line is drawn on the chart to the next column, and a new vertical line is drawn in it to the level of the last closing price.
If the reversal value is less than the reversal ratio, no new lines are drawn.
If the thin line on the Kagi chart breaks above the previous high, it becomes thick. If the thick Kagi line falls below the previous low, it becomes thin.
An increase in the volume of traded money is a strong signal confirming the direction of price movement. But the current rules allow you to see only more or less activity, i.e. the number of transactions made during a certain period.
It is obligatory for application as a confirmatory one. It can be built starting from several minutes and more. It is most informative starting from an hour or more. Volume shows the market activity level.
Graphical representation of information reveals the behavior of the market crowd in the past. The analysis of graphs allows to find the regularities in the crowd behavior. When these patterns reappear, traders make decisions. People who base their trading decisions on the analysis of charts alone are called "chartists.
5) Trend Analysis
Graphical analysis also includes analysis of price trends. The main task when analyzing trend lines and models is not only to identify the direction of the trend, but also the life cycle of the trend (LTC).
The following varieties of the trend life cycle are distinguished:
- short-term trend - from 1 day to 3 months;
- medium-term trend - from 3 months to 1 year;
- Long-term trend - from 1 year.
All trends have a different lifetime, which also differs by the period of time for which the analysis is made. It is possible to determine the lifespan of a trend by using the analysis of the LTC, in which case it is important to accurately determine the length of the cycle and its amplitude:
- beginning of life - birth, childhood, adolescence;
- The middle of the term - maturity;
- The end of the trend - old age and death.
It is difficult to recognize the beginning of the life of a trend, and this is not the most important thing. It is much more important to get at least in the middle of a trend, which is usually much more profitable than the first phase of the trend due to speculative warming.
In general, when analyzing trends, it is possible to distinguish the following rules for the recognition of the LTC.
The beginning of the cycle is characterized by an increase in the number of transactions (the volume of transactions or open interest - for stock trading). At this time the oscillators, which we will talk about later, begin to deceive you. In general, the beginning of the trend will take about one-third of the total length of the cycle. During the first period of the beginning of the LTC, prices change on average from 1/4 to 1/3 of the total swing and roll back from 1/5 to 1/4 respectively. The new trend is shaped by capital spillovers between countries. In the middle of the first cycle, the first speculative capitals join the fundamental movement associated with changes in the mode of investment in different countries.
In the middle of the LTC, the first signs of market fatigue begin to appear. The market is "overheated" and wants to "rest". There is some decline in activity, but it is usually not accompanied by a return to previous quotes. As I noted above, there are often sharper price changes in the middle of a cycle than at the beginning of the LTC. This is due to the fact that it is at this point that an army of speculators, huge in number and in weight, begins to join the pioneers of a new trend. And the overheating of the market, in connection with this, is much more significant than in the first period of the LTC. This at the end of the second period leads to a decrease in the quotations to the level close to the one from which it began. As a rule, the quotations during the second period change from a whole to 3/4 of the whole sum of fluctuations, and then roll back from 3/4 to 1/2, respectively.
In the last period of the LTC the amount of free speculative capital begins to decrease. This is reflected in a decrease in the number of transactions concluded. Sharp price fluctuations (in comparison with the second period) practically do not occur. Prices, reaching their extremum (maximum or minimum), stay there insignificantly and for a short period of time, and the last fluctuations occur near the maximum. At the end of the last LTC, nervousness grows in the market, expressed in sharp multidirectional fluctuations of prices. Preparation for a new trend begins.
It is recommended to make long-term deals starting from the second one, capturing the first half of the last one.
A trend line implies joining of several relative highs or relative lows. If there are only 2 such points, a trend line can be drawn accurately. However, if it is necessary to connect three or more points, as often happens in reality, an accurate line will be possible only in that rare case when the relationship between them is strictly linear. In reality, the drawn trend line will precisely pass through one or two relative maxima (minima) at best, bypassing the others at the same time. The "most correct" trend line exists only in the imagination of the one who looks at the chart.
For a trend line to be defined accurately and unambiguously, it must be based strictly on two points. Trend lines should be drawn from right to left as recent price activity is more important than past movement.
Determining trend lines based on the most recent relative highs and lows allows trend lines to be continually adjusted as new relative highs and lows occur.
The main and most important characteristic of a trend line is its slope angle. When the trend line is upward sloping, the bulls are in control and we should look for a buying opportunity. When the trend line is sloping downward, the bears are in control and we should look for ways to sell. You can classify trend lines according to their importance using five indicators: time scale, duration, number of times prices have touched the trend line, slope angle and volume of trades.
The greater the time scale, the more important the trendline. The trend line on the weekly chart shows a more significant trend than on the daily chart. The trend line on the daily chart is more important than on the hourly chart, and so on.
The longer the trend line, the more reliable it is. A short trend line reflects the behavior of the masses over a short time interval. A longer line reflects their behavior over a longer period of time. The longer the trend line lasts, the greater its inertia. A serious bull market can follow its trend for several years.
The greater the number of price contacts with the trend line, the more reliable it is. In an uptrend, a return to the line means a rebellion among the "bears". In a downtrend, a jump in prices to the trend line means a rebellion among the bulls. When prices reach the trend line and then move back, you know that the dominant group in the market has defeated the rebels.
The preliminary trend line is drawn through only two points. A third point of contact makes it more reliable. Four or five points of contact show that the market-dominating crowd is firmly in the grains of power. The angle between the trend line and the horizontal reflects the intensity of emotion among the dominant market crowd. A steep trend line indicates that the dominant crowd is dynamic. A relatively flat trend line indicates that the dominant crowd is turning slowly.
6) Support and resistance levels
The ball falls to the floor and bounces. He falls, hitting the ceiling. Support and resistance are like a floor and a ceiling between which prices are sandwiched. Understanding the role of support and resistance is essential to understanding trend and chart patterns. Assessing their strength will allow you to decide which is more likely to continue or reverse the trend.
Support is a price level at which buy positions are strong enough to stop or reverse a downtrend in the opposite direction. When a downtrend reaches a support level, it behaves like a diver who hits the bottom and bounces off of it. Support is depicted on the chart as a horizontal or near-horizontal line connecting multiple lows
Resistance is a price level at which sell positions are strong enough to stop or reverse an uptrend in the opposite direction. When an uptrend reaches a resistance level, it stops and falls down like a man hitting his head on a branch while climbing a tree. Resistance is plotted on a chart as a horizontal or near-horizontal line connecting multiple highs.
It is better to draw support and resistance lines at the edges of the Congestion Zones, rather than through the minimum or maximum values. They show where most players have changed their minds, and the lows and highs reflect only the panic among the weakest players.
Weak support and resistance cause the trend to stop, and strong support to reverse. Players buy at the support price level and sell at the resistance price level, making their impact a self-justifying prediction.
7) Mathematical analysis. Indicators, oscillators, cycles
With the help of a computer, we can analyze the markets more thoroughly. Drawing charts by hand can give you an intuitive, physical sense of prices. You can buy lined paper and paint multiple stock markets or commodities every day. Once you stop at one of the charts, write down at what price level you will buy or sell, when to stop playing, and where to place the precautions. After spending some time like this, you may be tempted to analyze more markets using technical indicators.
Indicators allow you to detect trends and moments of their change. They provide a better understanding of the balance of power between bulls and bears. Indicators are more objective than drawn charts.
The problem with indicators is that they contradict each other. Some work better in a trend, others in a calm market. Some are better at detecting turning points, while others are better at identifying trends.
Most hobbyists are looking for a single indicator: the silver bullet that kills all doubts in the market. Others collect many indicators and try to average their signals. In any case, a reckless newbie with a computer is like a teenager with a sports car, you have to wait for a disaster. The serious player needs to know which indicators perform best under certain conditions. Before using an indicator, you must know what it measures and how it works. Only then can you confidently use their signals.
Players divide indicators into three groups: trend indicators (Trend Following), oscillators (Oscillator) and others. Trend indicators work well when the market is moving, but give dangerous signals if the market is standing still. Oscillators show turning points in a stationary market, but give premature and dangerous signals when the market starts to move. Other indicators give a better understanding of mass psychology. The secret of a successful game is to combine several indicators from different groups so that their negative qualities mutually compensate, and the positive ones remain intact. This is the purpose of the Triple Screen System (see chapter 9.1).
Trend indicators include the Moving Average indicator, MACD (principles of approach/divergence of the average rate movement), MACD-histogram. Directional System, On Balance Volume, Accumulation / Distribution and others. These trend indicators are lagging indicators, they move when the trend has changed.
Oscillators help identify turning points. These include Stochastic, Rate of Change, Smoothed Rate of Change, Momentum, Relative Strength Index (RSI), Elder-Ray, Force Index Index), commodity market range index (CCI) and others. Oscillators are synchronous or leading indicators, they often move ahead of prices.
Other indicators allow you to assess the opinion of the market and its proximity to "bulls" or "bears". Among them, the index of new highs and lows (New High-New Low), the ratio of supply and demand (Put-Call Ratio), the consensus of the bulls (Bullish Consensus), the direction of play, the index of rise/fall (Advance / Decline), the index of players (Traders Index) and so on. They can be synchronous or leading indicators.
We will learn more about indicators, oscillators and cycle theories in the next specialized lectures.
Divergence is not a separate technical study, but divergence is used so often that a detailed description of the concept will be helpful.
Divergence is a situation when the direction of price movement and technical indicators does not coincide. Divergence is considered a strong sign of a trend reversal. Distinguish between bullish and bearish divergence.
Divergence research has a long history, dating back to at least the 1890s, when Charles Dow first formulated what later became known as Dow Theory. The Dow Theory relies on confirmations between major Dows to provide signals that detect trends in the stock markets. Before the advent of derivative technical research, intermarket relationships, volume and open interest studies were essentially the only tools for divergence research. They are still very popular and are the basis for a huge amount of interesting and practical work (for example, Bill Oham's 3D tables and Titanic tables for stock markets). Most traders today are significantly more interested in divergences between technical research and downstream * markets than in the more classic Dow Theory divergences.
It is difficult to give a detailed description of the divergence. A possible reason for this could be that these divergences are relatively subjective types of trading signals. Similar to the classic Edwards and Magee charts, divergence is easy to detect in hindsight, but it is always very difficult to see it during deployment. It is also very difficult to efficiently calculate test trading patterns based on divergences.
8.1. Divergences between technical research and markets
Divergences are usually best recognized using some types of oscillators such as the Stochastic Oscillator, RSI, or MACD. Let's just say: when the market creates a new peak or trough, and the technical research built on it does not do that, then we have a divergence. By definition, this means that both technical research and the market will exhibit styloid peaks or troughs that should be easily recognized.
In practice, this is not always easy. Oftentimes, a large divergence formation that correctly indicated a market turn will contain several smaller divergences that seem insignificant to consider but seem more important over time. Several small false signals often occur for each major correct signal. The problem, of course, is to recognize the divergence that carries meaning and the one that does not. Most technical analysts use a slightly different kind of chart analysis for confirmation, such as classic patterns, or analysts rely on multiple divergences, comparing different technical studies and believing that they will find safety behind the numbers. We are not sure that there is any advantage in anticipating the divergence of many indicators. Due to the fact that oscillators are usually similar in their actions, multiple divergences will occur as often as single ones.
You can see divergences in trend following indicators such as the DMI and even moving averages, but they are not as correct as those that appear when using oscillators.
8.2. Trending versus non-trending (flat) markets
One way to distinguish false divergences is to determine if you are in a trending or flat market and interpret the signal accordingly. There are indicators to help measure the trend, such as Wilder's ADX, linear regression. Even just watching the chart, you can assess the trend.
The main difference between the two types of markets is that in a flat market, divergence can be traded in either direction, while in a trending market, divergence signals against the trend should generally be ignored (with the possible exception of trying to catch major peaks and depressions). The direction of a trend, assuming a trend exists, can be understood using simple indicators like a relatively long-term moving average.
8.3. Basic trading rules
Divergences are extremely dangerous signals because you are usually trying to catch a peak or bottom of some kind. The most important thing to remember when trading divergences is to wait for the divergence to be confirmed by a close or series of closes in the direction of a new trend. Don't be ahead of the curve. Most charts are littered with leftovers of potential divergence, which as a result, turn into continuation of the trend. If you rush into an entry, you run the risk of being on the wrong side of a significant market move, especially if the divergence is at a trough or peak, putting you on the wrong side of a breakout.
The best exits in divergence trading, assuming you got in correctly, depend on the type of market you are in. In trending markets, if you manage to get on the right side of the trend, your entry is no different (other than the earlier one) from a normal trend-following entry. Set your exits using a technique of relatively free exits that will keep you trending but not profitable too much - for example, Wilder's Parabolic Stop or a relatively distant tracking stop, or both. If you catch a short-term peak or bottom in a volatile market, use very close tracking stops, or a trade target, or both.
8.4. Serial divergences
Divergences often occur as a series at short intervals in a single market. Obviously, only the last divergence in the series means at least something, and the longer the series, the stronger the signal. One observation says that the divergences gather in triplets, the so-called ABC divergences and George Lane's "three pointers to the top". Our observation suggests that double and triple divergences occur in trending markets, while perfectly correct single divergences occur in flat markets.
It is difficult, if not impossible, to know when to accept the first divergence as a signal and when to wait. Many large market reversals in recent years have been predicted by single divergences. About the same amount was determined by multiple divergences.
8.5. Divergences in related markets
It is important to be prepared that divergences between related markets, or between the cash market and an associated futures market, are as useful and correct as divergences between technical research and markets. As we argued earlier, Dow Theory is based on the divergences of linked markets.
Related market divergences offer excellent entry signals and should not be ignored.
Examples of divergences!
8.6. Installation model
George Lane identifies a form of divergence he calls "bull and bear setups." Such patterns form when the oscillator sets a new peak or bottom, and prices do not confirm this. Lane concludes that when a bearish setup occurs after an uptrend, the next consolidation could occur at an important top. Use reverse logic for bullish setups after a downtrend.
There are also situations where a bearish setup is often followed by an explosive upside breakout. There is some truth in both observations, which can lead to a combination of unusually profitable trades. If you buy a consolidation following a bearish setup, you can get very explosive bull trades. This big trade in the up direction will be followed by the top that George Lane was looking for, after which you can expect a profitable trade in the down direction.