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Technical Analysis Guide

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Table of Contents
Technical Study................................................................................................................................3 Study Concepts ................................................................................................................................3 Divergence......................................................................................................................................... 3 Confirmation ...................................................................................................................................... 4 Indicator Types .................................................................................................................................. 4 Reading Studies ...............................................................................................................................4 Centered Studies ................................................................................................................................ 4 Banded Studies .................................................................................................................................. 5 Study Signals ...................................................................................................................................5 Bar Chart ..........................................................................................................................................6 Candlestick Chart .............................................................................................................................6 Candlestick Formations ....................................................................................................................... 7 Doji................................................................................................................................................ 8 Engulfing Patterns ........................................................................................................................... 8 Reversal Patterns ............................................................................................................................ 8 Moving Averages and Overlays......................................................................................................10 Simple Moving Average (SMA) ............................................................................................................11 Weighted Moving Average (WMA) .......................................................................................................12 Exponential Moving Averages (EMA)....................................................................................................12 Hamming Moving Averages (HMA) ......................................................................................................13 Modified Moving Averages (MMA) .......................................................................................................14 Uses for Moving Averages ..................................................................................................................14 Trend Directions.............................................................................................................................15 Buy/Sell Signals..............................................................................................................................15 Moving Average Envelope ..................................................................................................................16 Bollinger Bands (BB) ..........................................................................................................................17 Parabolic SAR....................................................................................................................................19 Oscillators ......................................................................................................................................20 Momentum/Price Rate of Change ........................................................................................................21 Moving Average Convergence/Divergence (MACD) ...............................................................................22 MACD Oscillator (MACDO) ..................................................................................................................23 Directional Oscillator (DO) ..................................................................................................................24 Stochastics .....................................................................................................................................24 Fast Stochastic ..................................................................................................................................25 Slow Stochastic .................................................................................................................................26 Indices ...........................................................................................................................................27 Relative Strength Index (RSI) .............................................................................................................27 Commodity Channel Index (CCI).........................................................................................................28 Directional Indicator/Directional Movement Index (DMI) .......................................................................29 Average Directional Index (ADX).........................................................................................................31 Volume ...........................................................................................................................................32 On Balance Volume (OBV)..................................................................................................................32 Volume.............................................................................................................................................33

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Technical Study
Technical Studies are mathematical models designed to offer additional perspective on real-time and historical data. The term "studies" encompasses a host of analyses: Charting techniques Conventional studies Overlays Trend lines

Study Concepts
As you begin using Technical Studies, there are a few concepts with which you should be familiar: Divergence Confirmation Indicator

Divergence
A divergence occurs when the prices of an instrument and a study line move in opposing directions. For instance, if a stock's price has been moving higher for several days but, at the same time, its RSI has been declined, divergence has occurred:

Divergences between a stock and one of its indicators are common and often occur before a stock changes direction. People often look for divergences by comparing a stock's direction to the direction of its RSI, its MACD or its Slow Stochastic. There are two kinds of divergences: Positive and Negative. A positive divergence occurs when the indicator moves higher as instrument prices decline. A negative divergence occurs when the indicator moves lower as instrument prices rise.

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Confirmation
Confirmation is an indicator signal that validates a signal given by another indicator. Traders and investors often build analysis systems that combine indicators and rate the strength of signals based on a collective assessment of constituent indicators. For example, J. Welles Wilder designed the Average Directional Index for use with the +DI and -DI. Similarly, MACD divergence may be confirmed by a subsequent moving average crossover. Confirmation is a key component of Candlestick analysis. Hammers, Bullish Engulfing and Piercing Patterns all require a subsequent advance to confirm reversal. Conversely, Shooting Stars, Bearish Engulfing and Dark Cloud Cover patterns require a subsequent decline to confirm reversal.

Indicator Types
An indicator is a value, usually derived from a stock's price or volume that an investor can use to try to anticipate future price movements. Indicators are divided into two classes: lagging and leading (sometimes referred to as "momentum" indicators). Lagging indicators tell you what prices are doing now, or in the recent past, so they are useful when stocks are trending. A moving average is an example of a lagging indicator. Leading indicators are designed to anticipate future price action and many come in the form of oscillators. RSI is an example of a momentum indicator.

Reading Studies
A study is an indicator that "oscillates" above and below a centerline or between set levels. Most studies can remain at extreme levels (overbought or oversold) for extended periods but do not trend for a sustained period. By contrast, a cumulative indicator like On-Balance-Volume (OBV) does trend. There are many types of studies, some of which belong to more than one category. The breakdown of study types begins with two types: Centered studies Banded studies

Centered Studies
Centered studies fluctuate above and below a center line, typically zero. Centered studies help identify the strength and direction of a move. A centered study's momentum is bullish when its line is above zero and rising, and bearish when it is below zero and falling. MACD is a centered study. MACD is the difference between the two exponential moving averages, one shorter than the other. The farther one moving average moves away from the other, the greater the momentum. MACD is unique in that uses two lagging indicators to create a leading indicator. Moving averages are lagging indicators. Plotting the differences between the moving averages over time renders the rate-of-change. This rate-of-change calculation makes MACD a leading indicator. The Moving Average Oscillator is another centered study.

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Banded Studies
Banded studies fluctuate between two values, typically 0 and 100. Within this range are overbought and oversold levels. The lower band represents oversold readings and the upper band represents overbought readings. These levels vary from study to study. RSI, the overbought and oversold levels are traditionally considered to be 70 and 30, respectively. Slow Stochastic uses 80 as the overbought level and 20 as oversold. Even though these levels were defined by the Wilder and Lane, many have adopted alternate levels to better suit particular instrument types.

Some banded studies are not bound by upper and lower limits. The RSI and Slow Stochastic are rangebound. Neither can generate a value less than 0, nor greater than 100. By contrast, the Commodity Channel Index (CCI) is a banded study that is not range bound.

Study Signals
Studies generate buy and sell signals in a variety of ways. Some studies generate early signals, while others generate signals after a trend has commenced. Some studies can foretell impending change. Given this signal variety, it is important to develop a system of confirmation. All indicators are designed to measure a specific characteristic of an instrument price or volume. Volume analysis, Trend analysis, Candlestick patterns, and support/resistance levels are all candidates for confirmation. Combine the analyses that best suit your needs. Divergence is a key concept in reading centered studies. Divergence can signal trend change, or give a buy or sell signal. Divergence is either positive or negative. Positive divergence occurs when a study's values increase as the subject instrument's prices decrease. Negative divergence occurs when an indicator declines and the subject instrument advances.

Banded studies are designed to identify overbought and oversold extremes. Since banded studies fluctuate between extremes, they are best used to evaluate instruments that are not trending. In a strong trend, invalid signals may result. To use banded studies, you must know the proper values for the upper and lower bands. Given traditional settings, when RSI is below 30 or the Slow Stochastic is below 20, an oversold condition exists, and when RSI is above 70 and the Slow Stochastic is above 80, an overbought condition exists. Overbought/oversold identification should signal you to look for confirmation in other indicators. Another way to identify signals using a banded study is to note when the upper and lower bands are crossed. If an instrument is overbought and moves back down below the upper band, a sell signal is generated. If an instrument is oversold and moves above the lower band, a buy signal is generated.

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Bar Chart
A bar chart is the most popular form of charting and is, therefore, the default chart type.

As time progresses, a vertical bar is drawn on the chart. The top of this bar marks the highest price during that period. The bottom of the bar marks the lowest price during that period. The opening price for the period is shown by a horizontal hash mark extending to the left of the bar, and the close is marked by a similar hash mark extending to the right of the bar. Bar analyses are interpreted in much the same way as Candlesticks. Recognizable patterns develop which aid the trader in forecasting the likely direction of prices.

Candlestick Chart
Candlestick charts are an ancient Japanese price prediction methodology. Candlesticks date back to the 1700's, when they were used for analyzing rice markets. At that time, Munehisa Homma, a legendary rice trader, gained a huge fortune using candlestick analysis and established candlestick popularity.

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Candles offer an alternate perspective on market data.

The body of the candlestick is called the real body and represents the range between the open and closing prices. A "black," or filled-in, body represents that the close during that time period was lower than the open. When the body is "white," or hollow, the close is higher than the open. The thin vertical line above and/or below the real body is called the upper/lower shadow, representing the high/low price extremes for the period. The most common uses for Candlesticks analysis are: To identify trends. Many Candlesticks patterns signify bullish or bearish trends. For example, the Hammer candlesticks pattern suggests a bullish trend when it occurs after a downward trend. To anticipate reversal. Some Candlesticks patterns often occur at tops or bottoms, where the market changes direction. For example, the Morning Star pattern usually suggests a downtrend has bottomed out.

Candlestick Formations
Trend analysis is important in identifying candlestick formations. Many formations are qualified by the existence of an upward or downward trend. Additionally, candlestick analysis relies heavily on confirmation. The following discussion is intended to provide a primer on candlestick formations. There are several important candlestick types: Black and White Marubozu. Marubozu candlesticks do not have upper or lower shadows and the high and low are represented by the open or close. A White Marubozu forms when the open equals the low and the close equals the high. This indicates that buyers controlled the price action from the first trade to the last trade. Black Marubozu form when the open equals the high and the close equals the low. This indicates that sellers controlled the price action from the first trade to the last trade. Long Black and White Real Bodys. Long white candlesticks indicate aggressive buying. Conversely, long black candlesticks show strong selling pressure. See also, Trend Day. Spinning Tops. Candlesticks with a long upper shadow, long lower shadow, and small real body are called spinning tops. Spinning tops are said to represent indecision. The small real body shows little movement from open to close, and the shadows indicate that both bulls and bears were active during the session, but neither dominated. See also, Neutral Day. Doji. Doji form when a instrument's open and close are virtually equal. Some regard open-close equality a necessary Doji qualification while others do not. The length of the upper and lower shadows can vary. Alone, doji are neutral patterns. Any bullish or bearish bias is based on preceding price action and future confirmation. With these basic candlestick types in mind, review some of the more common candlestick patterns.

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Doji
Doji. A Doji is formed when the open and the close are the same (or very close). The length of the shadows are not important. Gravestone Doji. The Gravestone Doji is formed when the open and the close occur at the low of the day. The name, Gravestone Doji, is derived by the formation of the signal looking like a gravestone. Dragonfly Doji. Dragonfly Doji are formed when the open and close occur at the high of the day. Long Legged Doji. The Long-legged Doji has one or two very long shadows. If the open and the close are in the center of the session's trading range, the signal is referred to as a Rickshaw Man. Doji Star, Bearish. Doji Stars are considered bearish in an up trend. This pattern is said to be most reliable at a new high. A Doji Star occurs when the Doji's open and close gaps above the preceding real body. Doji Star, Bullish. Doji Stars are considered bullish in an down trend. This pattern is said to be most reliable at a new low. A Doji Star occurs when the Doji's open and close gaps below the preceding real body. Morning Star Doji. The Morning Star Doji is a bottom reversal signal. Like the morning star (Mercury) it foretells the sunrise, or the rising prices. The pattern is a three day signal. Evening Star Doji. The Evening Star is the exact opposite of the morning star. The evening star, the planet Venus, occurs just before the darkness sets in. The evening star is found at the end of the uptrend.

Engulfing Patterns
Bullish Engulfing. The Bullish Engulfing Pattern is formed at the end of a downtrend. A white body is formed that opens lower and closes higher than the black candle open and close from the previous day. This complete engulfing of the previous day's body represents overwhelming buying pressure dissipating the selling pressure. Bearish Engulfing. The Bearish Engulfing Pattern is directly opposite to the bullish pattern. It is created at the end of an up-trending market. The black real body completely engulfs the previous day's white body. This shows that the bears are now overwhelming the bulls.

Reversal Patterns
Dark Cloud Cover. The Dark Cloud Cover is a two-day bearish pattern found at the end of an upturn or at the top of a congested trading area. The first day of the pattern is a strong white real body. The second day's price opens higher than any of the previous day's trading range. Piercing Pattern. The Piercing Pattern is a bottom reversal. It is a two candle pattern at the end of a declining market. The first day real body is black. The second day is a long white body. The white day opens sharply lower, under the trading range of the previous day. The price comes up to where it closes above the 50% level of the black body. Hammer and Hanging Man. Hammer and Hanging-man are candlesticks with long lower shadows, little or no upper shadow, and small real bodies. The bodies are at the top of the trading session. This pattern at the bottom of the down-trend is called a Hammer. This pattern at the top of an up trend is a hanging man.

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Morning Star. The Morning Star is a bottom reversal signal. Like the morning star (Mercury) it foretells the sunrise, or the rising prices. The pattern is a three day signal. Evening Star. The Evening Star is the exact opposite of the morning star. The evening star, the planet Venus, occurs just before the darkness sets in. The evening star is found at the end of the uptrend. Shooting Star. The shooting star, or inverted hammer, in an up trend sends a warning that the top is near. It got its name by looking like a shooting star. At the bottom of a trend, the shooting star is considered a bullish signal. Three White Soldiers. Three white candlesticks with consecutively higher closes that close near or at their high prices. Three Black Crows. Three long black candlesticks with consecutively lower closes that close near at their low prices. Two Crows, Bearish. This pattern is considered a sell signal and is more significant at heavy resistance levels. The first black candle's real body gaps above the preceding white body. The second, larger black candle opens above the preceding candles open, and closes below its close. Two Crows, Bullish. This pattern is considered a buy signal and is more significant at strong support levels. The first white candle's real body gaps below the preceding white body. The second, larger white candle opens below the preceding candles open, and closes above its close. Tasuki Gap, Bearish. The black body of the bearish Tasuki Gap opens within the preceding white body. The two smaller bodies gap above the larger white body. Tasuki Gap, Bullish. The white body of the bullish Tasuki Gap opens within the preceding black body. The two smaller bodies gap below the larger black body. Tweezer Top. Tweezer tops have equal highs at a new high. This pattern can consist of any type of candlesticks. Tweezer Bottom. Tweezer bottoms have equal lows at market bottoms. The type of candlesticks that make up a tweezer bottom does not matter. Harami. This formation is considered Bearish following an up trend and a Bullish when following a down trend. Most often the classic Harami consists of an opposing real body color, as illustrated at left. However, the two bodies can be the same. Counter Attack, Bearish. A counter attack line formation occurs in an up trend when two opposite color candles have the same close. Counter Attack, Bullish. A counter attack line formation occurs in a down trend when two opposite color candles have the same close.

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Moving Averages and Overlays


Moving averages are smoothing techniques. They are the average price of an instrument over a certain number of periods. Faster moving averages are based on fewer periods, and slower moving averages are indicative of long-term trends. The strength of a trend is indicated by the steepness of the moving averages slope. Moving averages are always lagging indicators because they incorporate historical data. For this reason, they are used more to confirm that a change in trend has already taken place than as a way of predicting when a change will occur. There are many kinds of moving averages as below: Simple Weighted Exponential Hamming Modified

Moving averages are overlays--that is, they are plotted over, or on top of, a Bar Chart or Candlestick. Bollinger Bands, Moving Average Envelope and Parabolic SAR are also overlays.

The two most popular types of moving averages are the Simple Moving Average (SMA) and the Exponential Moving Average (EMA). They are described in more detail below.

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Simple Moving Average (SMA)


Simple moving averages are initially calculated by starting with the left most period in the data and adding up the specified prices (open, high, low, close, mid-point, or average) for the chosen number of periods. This total is then divided by the number of periods.

Formula:

Where: n Pt Pt-1 Pt-n = = = = number of bars selected calculation price selected calculation price 1 period ago selected calculation price n periods ago

This calculation can be simplified for all but the first point. Rather than using all prices to calculate each moving average value, the oldest price can be subtracted from the running total. The newest price can then be added to the difference. The resulting sum is then divided by the number of periods. The quotient is the new point, or simple moving average. Formula:

Where: n MAt-1 Pt Pt-n = = = = number of bars previous moving average value current price oldest price in series

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Weighted Moving Average (WMA)


Weighted moving averages give current data more weight than older data, thereby reducing the significance of older prices. To do this, each price in a series is multiplied by the number of periods preceding it: the older the price, the smaller the multiplier.

Formula:

Where: n Pt Pt-1 MAt = = = = number of bars current price previous price current moving average value

Exponential Moving Averages (EMA)


Exponential moving averages are another form of weighted averaging. In a standard moving average, the oldest price in a fixed series is dropped. By contrast, all prices in a chart influence an exponential moving average: older prices gradually diminish in significance.

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Formula:

Where: EMAt EMAt-1 SF Pt = = = = current moving average value previous moving average value smoothing factor: 2/(n+1) , where n is the equivalent number of days in a standard moving average. current price

The definable parameter for an exponential moving average is a smoothing factor. A smoothing factor for an exponential moving average is a number between zero and one (i.e., 0.5). While the equations governing a smoothing factor are complex, the usage of an exponential moving average is simple. Larger smoothing factors approximate shorter standard moving averages. The larger the smoothing factor, therefore, the more responsive the exponential moving average is to current prices.

Hamming Moving Averages (HMA)


The Hamming, or weighted, moving average applies weighting factors to price data based on a function borrowed from spectral analysis. This function, known as Hamming, responds to the cyclical tendencies of data better than conventional moving averages by reducing the effect of erratic prices.

Hamming was developed to analyze complex changing sounds with arbitrary frequency. The Hamming function was designed to compute the spectrum of a finite-sized block, or record, of sample wave forms. It assumes that the block of sample wave forms represents exactly one period of periodic wave form. By application, Hamming provides the exact harmonic amplitude and phase spectrum of assumed, or proceeding, wave forms. The behavior of price activity in a given market can resemble the behavior of complex sound wave forms.

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Modified Moving Averages (MMA)


Modified moving averages are similar to simple moving averages. The first point of the modified moving average is calculated the same way the first point of the simple moving average is calculated. However, all subsequent points are calculated by first adding the new price and then subtracting the last average from the resulting sum. The difference is the new point, or modified moving average.

Formula:

Where: n MAt MAt-1 Pt = = = = number of bars current moving average value previous moving average value current price

This method is convenient because it is not necessary to keep track of all past components of the average. Only the last moving average value and the new price are necessary for the calculation (keep in mind that study calculations used to be done by hand). Because of the simplicity of this calculation, the modified moving average is used extensively for internal calculations in other analyses.

Uses for Moving Averages


In general all types of moving average are used for the following: To detect trend directions To determine buy/sell signals

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Trend Directions
The position of the moving average plot can be used to indicate the trend direction of a market. Bullish

Bearish

Market Signal Bullish Bearish

Price & Moving Average Relationship Prices above moving average and moving average moving up Prices below moving average and moving average moving down

Buy/Sell Signals
Buy and sell signals are indicated as follows: If the short-term moving average comes from below and crosses above the long-term moving average, then this is a buy signal if the price action is above the moving average cross-over point. If the short-term moving average comes from above and crosses below the long-term moving average, then this is a sell signal if the price action is below the moving average cross-over point.

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The crossover is considered to be much more significant if both averages are moving in the same direction. If both averages are moving up, then it is known as a Golden Cross. If both averages are moving down, then it is known as a Death Cross.

Moving Average Envelope


The Moving Average Envelope study draws bands around a moving average to form a channel. The purpose of the bands is to show which prices are falling outside of the expected range. The Moving Average Envelope study is very similar to the Bollinger Band; the difference lies in the method used to calculate how far the bands should be drawn above and below the moving average line. The Moving Average Envelope bands are drawn above and below the moving average at a distance which is a percentage of the moving average value. For example, if the value of the moving average at a particular bar is 100 and the Percent field is set to 0.5, the top and bottom bands will be drawn at 100.5 and 99.5. Formula:

Where: UB MAt U% And: = = = upper band current moving average value upper percentage value

Where: LB MAt L% = = = lower band current moving average value lower percentage value

The moving average in a moving average envelope can be calculated using any of the moving averages. Notes The Moving Average Envelope overlay is a member of the "envelope" class of studies. Envelopes consist of three lines, a center line and two outer bands. Envelope theory holds that price has the greatest probability of falling within the boundaries of the envelope. Prices falling outside the envelope boundaries are considered anomalies. The major differences between envelope types can be found in the calculation of the lines, in the spacing between the lines or bandwidth, and how they are interpreted.

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Buy & Sell Signal from Moving Average Envelope Buy Signal Price touches the lower band. Sell Signal Price touches the upper band.

Bollinger Bands (BB)


Bollinger bands are lines drawn at a fixed interval around a moving average as a function of a markets volatility. The lines, or Bollinger Bands, are plotted above and below the chosen moving average at a distance equal to two times the root mean square of the deviations, or Standard Deviation, from the moving average. The length of the data used in the equations is equal to the length of the simple moving average employed. Standard Deviation is a method of measuring the volatility or dispersion of a data series. To calculate Standard Deviation, you need a data series and a constant number of periods. First, you add the values of the data points in the data series. Then, proceed with the following steps: 1. Divide the sum by the number of data points, or Periods. The quotient is the Arithmetic Mean. 2. Subtract the Arithmetic Mean from each data point. The results are the Raw Deviations. 3. Square each Raw Deviation. The products are the Squared Deviations. (Squared Deviations eliminate negative numbers.) 4. Add the Squared Deviations. The sum is the Total Squared Deviation. 5. Divide the Total Squared Deviation by the number of data points, or Periods. The quotient is the Mean Squared Deviation. 6. Calculate the square root of the Mean Squared Deviation. The result is the Standard Deviation. Formula: 1. 2. 3. 4. 5. 6.

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Where: SD TSD MSD D D2 AM P DP Notes Developed by John Bollinger, Bollinger Bands compare volatility to price over time. The overlay consists of three bands. A moving average center line An upper band (SMA plus n standard deviations) A lower band (SMA minus n standard deviations) = = = = = = = = standard deviation total squared deviation mean squared deviation raw deviation squared deviation arithmetic mean number of periods data point

The upper and lower bands balloon during periods of erratic price change and narrow during periods of low volatility. The Bollinger Bands overlay is a member of the "envelope" class of studies. Envelopes consist of three lines, a center line and two outer bands. Envelope theory holds that price has the greatest probability of falling within the boundaries of the envelope. Prices falling outside the envelope boundaries are considered anomalies. The major differences between envelope types can be found in the calculation of the lines, in the spacing between the lines or bandwidth, and how they are interpreted. Bollinger recommended using a 20-day simple moving average for the center band and 2 standard deviations for the outer bands. The length of the moving average and number of deviations can be adjusted.

Bullish signal is given when prices penetrate the lower band and remain above the lower band after a subsequent low forms. Bearish signal is given when prices peak above the upper band and a subsequent peak fails to break above the upper band.

Sharp price changes can occur after the bands have tightened, but Bollinger Bands do not give forecast trend. Market direction must be determined using other types of analysis. Use Bollinger Bands to identify the market volatility and price extremes.

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Precious Shipping (PSL) provides an example of the bands tightening before a big move. By end May, the bands were the tightest in over 2 months (red circle). A little over a week later, the stock exploded for a 10+ point gain in less than 1 week.

Parabolic SAR
The parabolic study is a "true reversal" indicator in that it is always in the market. Whenever a position is closed-out, it is also reversed. The point at which a position is reversed is called a Stop and Reverse (SAR). Although "stops" are plotted for each bar, a trade is reversed only when the SAR is penetrated by a price. Formula:

Where: SARt+1 SARt AF EPtrade = = = = next periods SAR current SAR begins at .02 and increases by .02 to a maximum of .20 extreme price (high if long; low if short)

The initial SAR or SIP (SAR Initial Point) of a long move is found by looking for the first bar with a higher high and a higher low than the previous bar. The converse of this is used to find the SIP for a short move. The acceleration factor changes as the trade progresses, starting at .02 and increasing in increments of .02 for each bar in which a new extreme occurs. Notes The Parabolic System, a.k.a. Stop and Reverse (SAR), is was created by J. Welles Wilder Jr. The Parabolic system is different to almost all technical trend following systems in that it is a function not only of price change but also of time. Once a position is assumed, long or short, the Parabolic generates SARs based on market acceleration. If the market has leveled out, the Parabolic increments SARs only slightly, giving the market time to establish a new trend. The Stop may at intervals stand still as the trend consolidates, but the Stop never backs up or reverses. After a specified time has elapsed (ten new price highs in bull markets or ten new lows in bear markets) the progression of the Stop becomes a function only of price. When the Stop is triggered it was originally intended to be an automatic reverse trade. However, the SAR is a trend following system and in a range market the whipsaws can be murderous. So Wilder later qualified the use of SAR signals with his ADX system so that only SAR signals in the direction of the trend should be taken to open positions. Closure of positions by the SAR are not to be taken as entry of reverse trades. Because of the importance of correlating the SAR signals with the appropriate market environment as indicated by the ADX, you may want to study the Average Directional Index (ADX).

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A buy signal is given when the upper SAR crosses the price line. A sell signal is given when the lower SAR crosses the price line.

Oscillators
Momentum/Price Rate of Change Moving Average Convergence Divergence (MACD) MACD Oscillator Directional Oscillator

An oscillator is a conventional study that is, an oscillator is not plotted on top of a bar chart. Oscillators are commonly used to identify Overbought and Oversold conditions, and Trend Reversals. According to John J. Murphy, there are three situations in which the oscillator is most useful: 1. When its value reaches an extreme reading near the upper or lower end of its boundary, indicating overbought and oversold conditions, respectively. 2. When divergence occurs between the oscillators and the price action and while oscillator is an extreme position. 3. When the oscillator crosses the zero line, signaling the direction of price trend. The following sections explain the oscillator studies.

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Momentum/Price Rate of Change


Momentum is generally thought of as the difference between prices. A momentum study is calculated by subtracting a previous price from the current price. If the previous price is greater than the current price, the study yields a negative value; conversely, if the previous price is less than the current price, the difference is a positive value.

Formula:

Where: MOM Pt Pt-n = = = current momentum value current price price n periods ago

Momentum studies are to indicate the rate of change in prices, trends, and price extremes. High positive and negative values are commonly interpreted as overbought and oversold conditions, respectively.

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Moving Average Convergence/Divergence (MACD)


The MACD is an oversold/overbought indicator that looks at the relationship between a long term and a short term moving average. The MACD line is the difference between the two moving averages. A second line, the signal line, is a short-term moving average of the MACD line. By default in Apex, the MACD employs a smoothing factor in an Exponential Moving Average. Formula:

Where: EMA1t EMA2t EMA1t-1 EMA2t-1 SF1 SF2 MACDt MACDt-1 SLSF = = = = = = = = = current value of 1st exponential moving average current value of 2nd exponential moving average previous value of 1st exponential moving average previous value of 2nd exponential moving average smoothing factor for EMA1 smoothing factor for EMA2 current MACD value previous MACD value signal line smoothing factor

When using the standard MACD, A buy signal is commonly interpreted when the MACD line crosses the Signal line from below. A sell signal is commonly interpreted when the MACD line crosses the Signal line from above.

Notes MACD uses moving averages, which are lagging indicators, to create a leading indicator. The MACD consists of two lines, an MACD line and a Signal Line. The MACD line is the difference between two moving averages. The Signal Line is an exponential moving average of the MACD line. The resulting study is a pair of lines that oscillates above and below zero, with no upper or lower limit.

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The common MACD is the difference between a 26-day and a 12-day exponential moving average. Gerald Appel and others have offered alternate moving average lengths that are specific to different instrument types. The lengths of the MACD moving averages can be adjusted. MACD produces the following types of signals: Divergence Positive divergence occurs when the MACD advances while the instrument is still in a downtrend. Negative divergence occurs when the MACD falls while the instrument is in an uptrend. Moving average crossover A bullish moving average crossover occurs when MACD moves above the Signal line. A bearish moving average crossover occurs when MACD moves below the Signal line. Centerline crossover A bullish centerline crossover occurs when the MACD moves above the zero line into positive territory. A bearish centerline crossover occurs when the MACD moves below the zero line into negative territory.

MACD Oscillator (MACDO)


The MACD Oscillator converts the two lines of the MACD into a single line that fluctuates above and below zero. The MACD oscillator is calculated by subtracting the signal line value from the MACD line value. When the MACD line crosses the signal line, a buy or sell signal is generated. The signals provided by the MACD or the MACD oscillator are identical. The choice of one over the other is simply a matter of user preference.

Formula: MACD Oscillator = MACD Signal

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Directional Oscillator (DO)


The directional movement oscillator converts the two lines of the DMI (Directional Movement Index) into a single oscillator that fluctuates above and below zero. A Directional Movement Oscillator is calculated by subtracting the -DI from the +DI.

Formula: Directional Oscillator = DI Positive DI Negative If +DI is greater than -DI, the directional movement oscillator value is positive. If +DI is less than -DI, the value is negative. The signals provided by the Directional Movement Oscillator and the DMI are identical. For more information on the DMI study and its formula, see Directional Movement Index.

Stochastics
A stochastic study is an oscillator that measures the placement of the current price within a range. Fast Stochastic Slow Stochastic

Stochastic is a method of analysis developed by George Lane. Lane observed that as prices increase, closing price tend to be closer to the upper end of bars; similarly, as price decrease, closing prices are closer to the lower end of bars. Lane developed stochastic to discern the relationship between the closing price and the high and low of a bar.

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Fast Stochastic
Two lines make up a stochastic study: %K and %D. These lines oscillate on a vertical scale between 0 and 100. A divergence between the %D line and the price of the underlying instrument produces a signal. A divergence below 15 is commonly thought of as a signal to buy. A divergence above 85 is commonly thought of as a signal to sell.

Formula:

F%D = 3 period modified moving average of F%K Where: F%K = fast %K F%D = fast %D Fast Stochastic are initially calculated by starting with the left-most bar in a range. Fast %K is calculated by subtracting the lowest low from the current close, dividing the difference by the difference of the highest high less the lowest low, and multiplying the quotient by 100. The common period is 14 days. Buy signal is given when %K crosses above %D. Sell signal is given when %K crosses below %D. The %D line is a 3 period modified moving average of the %K line.

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Slow Stochastic
The Slow Stochastic is a smoothed variation of the Fast Stochastic. The Slow Stochastic is more commonly used and is often referred to as the stochastic. The Slow Stochastic draws buy and sell signals the same way fast stochastic do--all rules apply. Formula:

F%D = 3 period modified moving average of F%K S%K = F%D S%D = 3 period modified moving average of S%K Where: F%K = current fast %K F%D = current fast %D S%K = current slow %K S%D = current slow %D Notes Developed by George C. Lane in the late 1950s, the Slow Stochastic is a momentum indicator that plots between 0 and 100. The Stochastic value shows the location of the current close relative to the high/low range over a selected number of periods. Closing levels that are consistently near the top of the range indicate accumulation (buying pressure) and those near the bottom of the range indicate distribution (selling pressure).

Readings below 20 are considered Oversold and readings above 80 are considered Overbought. However, Lane did not believe that a reading above 80 was necessarily bearish or a reading below 20 bullish. A security can continue to rise after the Stochastic Oscillator has reached 80 and continue to fall after the Stochastic Oscillator has reached 20. Lane believed that some of the best signals occurred when the oscillator moved from overbought territory back below 80 and from oversold territory back above 20. Buy signal is given when %K crosses above %D. Sell signal is given when %K crosses below %D. However, crossover signals are quite frequent and can result in a lot of whipsaws.

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One of the most reliable signals is to wait for a divergence to develop from overbought or oversold levels. Once the oscillator reaches overbought levels, wait for a negative divergence to develop and then a cross below 80. This usually requires a double dip below 80, the second dip being the bearish signal. For a bullish signal, wait for a positive divergence to develop after the indicator moves below 20. Disregard the first break above 20. After the positive divergence forms, the second break above 20 is bullish.

Indices
Apex enables you to display four types of index studies: Relative Strength Index (RSI) Commodity Channel Index (CCI) Directional Indicator/Directional Movement Index (DMI) Average Directional Index (ADX)

Relative Strength Index (RSI)


The Relative Strength Index is an overbought/oversold indicator plotted on a vertical scale from 0 to 100. Developed by J. Welles Wilder, the RSI originally employed a fourteen-period calculation. Wilder considered RSI values under 30 as oversold conditions, and RSI values over 70 as overbought conditions. Now, five-to fourteen-period calculations are commonly applied, depending on the market, and 80 and 20 are often used to delineate overbought and oversold conditions, respectively.

Formula:

A low number of periods yields frequent buy and sell signals. A high number of periods yields fewer buy and sell signals.

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Notes Developed by J. Welles Wilder, the Relative Strength Index (RSI) remains a popular, much-used momentum oscillator. The RSI compares gains to losses to calculate a value between 0 to 100. Wilder recommended using a 14 period RSI based on the close. RSI is a banded oscillator. RSI produces the following types of signals: Overbought/Oversold Wilder also recommended using 70 and 30 and overbought and oversold levels, respectively. As the RSI falls below 30, overbought conditions exist. Rising from below 30 to above 30 is considered bullish. Conversely, as the RSI rises above 70, overbought conditions exist, and falling back below 70 is considered bearish. Divergences Buy and sell signals can also be generated by looking for positive and negative divergences between the RSI and the underlying stock. Centerline Crossover The centerline for RSI is 50. Generally, a reading above 50 indicates dominant buying, below 50 dominant selling.

Commodity Channel Index (CCI)


The Commodity Channel Index is an indicator designed for use in markets that follow definite cyclical patterns. While the CCI does not determine cycle lengths, if you have an idea of cycle length, the CCI can be a valuable timing tool. Formula:

Where: n TPt MAt MD Pn = = = = = number of periods the current typical price: current simple moving average mean deviation price

Donald R. Lambert, who originated the CCI, suggests using a number of periods less than one-third of the cycle length. Using this calculation, seventy to eighty percent of random price fluctuations should fall within the +100% to -100% range. If the CCI yields a value above +100%, a long position may be indicated. When the CCI value falls below +100%, closing a long position should be considered. Short positions may be interpreted using the converse of this technique at the -100% level. Notes Developed by Donald Lambert, the Commodity Channel Index (CCI) was designed to identify commodity cycles. CCI is a leading indicator. The assumption of the CCI is that commodities (and other instruments) move in cycles--that is, highs and lows occur at regular intervals. Given this assumption, Lambert recommended setting the number of periods to a third of the cycle length. In other words, if a cycle, low to low or high to high, is 90 days, the number of periods should be 30.

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Lambert defined buy and sell signals as movements above +100 and below -100, respectively, which makes the CCI a banded oscillator. A move over +100 is considered a bullish signal. Conversely, a move under 100 is a bearish signal. Buy signal is given when CCI crosses above -100. Sell signal is given when CCI crosses below +100. The CCI can also be used to identify overbought and oversold levels. An instrument is deemed oversold when the CCI dips below -100, and overbought when it exceeds +100. Traders and investors also use the CCI to help identify price reversals, price extremes, and trend strength. As with all studies, signals given by the CCI should be confirmed by other technical indicators.

Directional Indicator/Directional Movement Index (DMI)


The Directional Movement Index was developed by J. Welles Wilder for identifying whether a market is in trend mode. In other words, the DMI helps identify whether there is a definable trend in a market, and in which direction that trend is moving. Formula:

Where: +DI -DI +DMn -DMn TRn Thighn Tlown = = = = = = = Current positive directional indicator value Current negative directional indicator value Current modified moving average +DM Current modified moving average DM Current modified moving average of the True Range value The greater of the current high and the previous price The lesser of todays low and the previous price

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Wilder defines +DI as the percentage of the true range that is up. -DI is the percentage of the true range that is down. According to Wilder, when the +DI value is greater than the -DI, a long (buy) position is indicated. Conversely, when the -DI is greater than +DI, a short (sell) position is indicated. The DMI can be used alone or with the Average Directional Movement Index (ADX). For more information on ADX, see Average Directional Index. Notes The Directional Indicator is traditionally assessed beside the Average Directional Index (ADX). The Directional Indicator and ADX compliment each other in a remarkable way. The Directional Indicator's +DI value represents a market's bullish force, and its -DI value represents a market's bearish force.

Directional Indicator signals are generated when +DI crosses -DI, or vice versa (the higher value being the dominant force). Caution should be given to literal application of this principle, for whipsaw activity is common in non-trending markets. A buy signal (bullish) occurs when +DI moves above DI. A sell signal (bearish) occurs when -DI moves above +DI. +DI/-DI crosses should be confirmed by other indicators. J. Welles Wilder Jr. confirmed this study with the ADX , which identifies trend strength. The ADX combines +DI and -DI values and then smoothes the lot in a moving average. The result is trend strength (regardless of trend direction). Generally, ADX readings above 40 indicate a strong trend while readings below 20 indicate a weak trend.

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Average Directional Index (ADX)


The average directional movement index is designed for use with the directional movement index. Calculating ADX is a two-step process. First, the difference of +DI and -DI is divided by the sum of +DI and DI, and the quotient is multiplied by 100; the result is known as DX. Second, ADX is calculated by taking a modified moving average of DX. Formula: ADX = modified moving average of DX

Where: n +DI -DI DX = = = = number of periods current positive directional index current negative directional index current DX

The ADX fluctuates between 0 and 100, with the higher values reflecting stronger trends. Notes J. Welles Wilder Jr. developed the Average Directional Index (ADX) to measure trend strength. It is important to detemine whether the market is trending or plaining (moving sideways), for ADX interpretation depends on what a market is doing.

ADX is an oscillator that fluctuates between 0 and 100. Even though the scale is from 0 to 100, readings above 60 are relatively rare. Low readings below 20 indicate trend weakness while high readings above 40 indicate a trend strength. (Given these levels, you can consider the ADX a banded oscillator.) The indicator does not grade a trend as bullish or bearish, but merely assesses a trend's strength. A reading above 40 can indicate a strong downtrend as well as a strong uptrend. ADX is also useful to identify when a market is abandoning or commencing a trend. When ADX begins to strengthen by crossing from below 20 to above 20, a trading plain may be giving way to a trend. Make it a habit to look for confirmation by other indicators.

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Volume
Volume-base studies: On Balance Volume Volume

Volume is useful in forecasting price activity. Some general principles for using volume studies includes: Increases in volume suggest a continuation of a price trend. Decreases in volume suggest a change in a price trend.

On Balance Volume (OBV)


On balance volume is an indicator that attributes volume (tick volume on intraday charts) during up and down trading periods. A close greater than the previous close represents buying. A close lower than the previous period represents selling. The calculation is a simple accumulation process. If a period closes up, its volume is added to the total. If a period closes down, its volume is subtracted from the total.

Formula:

If x is positive, add x to the close. If x is negative, subtract x from the close. Where: Ct-1 C x = = = previous close current close volume

The direction of the OBV line is more important than the volume level at any particular point. The OBV line assumes an arbitrary positive integer as a starting point; this ensures a positive OBV value. The OBV follows any market trend, except when a reversal occurs. A divergence is often interpreted as a signal of a trend reversal.

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Notes Joe Granville introduced the On Balance Volume (OBV) indicator in his 1963 book, Granville's New Key to Stock Market Profits. OBV was among the first, if not most popular, indicators to measure positive and negative volume flow. Volume precedes price is the principle behind OBV. A simple indicator, OBV adds a period's volume when the close is up and subtracts the period's volume when the close is down. A cumulative total of the volume additions and subtractions forms the OBV line. Compare the OBV to the price action of an instrument to identify divergence.

Volume
Volume is the number of shares traded in a given time period.

A volume study measures the intensity of a price move. Volume ordinarily reacts to the direction of a price trend. In an uptrend, volume should increase as prices rise; in a downtrend, volume decreases as prices fall. Divergence is commonly interpreted as a signal of a possible trend reversal.

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