Bollinger Bands®: What They Are, and What They Tell Investors

A Bollinger Band® is a technical analysis tool defined by a set of trendlines.

They are plotted as two standard deviations, both positively and negatively, away
from a simple moving average (SMA) of a security's price and can be adjusted to
user preferences.

• Bollinger Bands® is a technical analysis tool to generate oversold or

overbought signals and was developed by John Bollinger.
• Three lines compose Bollinger Bands: A simple moving average, or the
middle band, and an upper and lower band.
• The upper and lower bands are typically 2 standard deviations +/- from a 20-
day simple moving average and can be modified.
• When the price continually touches the upper Bollinger Band, it can indicate
an overbought signal.
• If the price continually touches the lower band it can indicate an oversold
signal.

What Do Bollinger Bands® Tell You?

Bollinger Bands® is a popular technique. Many traders believe the closer the
prices move to the upper band, the more overbought the market, and the closer the
prices move to the lower band, the more oversold the market. John Bollinger has
a set of 22 rules to follow when using the bands as a trading system.
The Squeeze

The "squeeze" is the central concept of Bollinger Bands®. When the bands
come close together, constricting the moving average, it is called a squeeze. A
squeeze signals a period of low volatility and is considered by traders to be a
potential sign of future increased volatility and possible trading opportunities.

Conversely, the wider apart the bands move, the more likely the chance of a
decrease in volatility and the greater the possibility of exiting a trade. These
conditions are not trading signals. The bands do not indicate when the change may
take place or in which direction the price could move.

Breakouts

Approximately 90% of price action occurs between the two bands. Any
breakout above or below the bands is significant. The breakout is not a trading
signal and many investors mistake that when the price hits or exceeds one of the
bands as a signal to buy or sell. Breakouts provide no clue as to the direction and
extent of future price movement.

Example of Bollinger Bands

In the chart below, Bollinger Bands® bracket the 20-day SMA of the stock
with an upper and lower band along with the daily movements of the stock's price.
Because standard deviation is a measure of volatility, when the markets become
more volatile the bands widen; during less volatile periods, the bands' contract.
Limitations of Bollinger Bands

Bollinger Bands® is not a standalone trading system but just one indicator
designed to provide traders with information regarding price volatility. John
Bollinger suggests using them with two or three other non-correlated indicators that
provide more direct market signals and indicators based on different types of data.
Some of his favored technical techniques are moving average
divergence/convergence (MACD), on-balance volume, and relative strength
index (RSI).

Because Bollinger Bands® are computed from a simple moving average, they
weigh older price data the same as the most recent, meaning that new information
may be diluted by outdated data. Also, the use of 20-day SMA and 2 standard
deviations is a bit arbitrary and may not work for everyone in every situation.
Traders should adjust their SMA and standard deviation assumptions accordingly
and monitor them.
What Do Bollinger Bands® Tell You?

Bollinger Bands® gives traders an idea of where the market is moving based
on prices. It involves the use of three bands—one for the upper level, another for
the lower level, and the third for the moving average. When prices move closer to
the upper band, it indicates that the market may be overbought. Conversely, the
market may be oversold when prices end up moving closer to the lower or bottom
band.

Which Indicators Work Best with Bollinger Bands®?

Many technical indicators work best in conjunction with other

ones. Bollinger Bands® are often used along with the relative strength indicator
(RSI) as well as the BandWidth indicator, which is the measure of the width of the
bands relative to the middle band. Traders use BandWidth to find Bollinger
Squeezes.

How Accurate Are Bollinger Bands?

Since Bollinger Bands® are set two use +/- two standard deviations around
an SMA, we should expect that approximately 95% of the time, the observed price
action will fall within these bands.

What Time Frame Is Best Used With Bollinger Bands?

Bollinger Bands typically use a 20-day moving average.

The Bottom Line

Bollinger Bands can be a useful tool for traders for assessing the relative level
of over- or under-sold position of a stock and provides them with insight on when
to enter and exit a position. Certain aspects of Bollinger Bands®, such as the
squeeze, work well for currency trading. Buying when stock prices cross below the
lower Bollinger Band® often helps traders take advantage of oversold conditions
and profit when the stock price moves back up toward the center moving-average
line.
 Relative Strength Index (RSI) Indicator Explained With Formula

What Is the Relative Strength Index (RSI)?

The relative strength index (RSI) is a momentum indicator used in technical

analysis. RSI measures the speed and magnitude of a security's recent price changes
to evaluate overvalued or undervalued conditions in the price of that security.

The RSI is displayed as an oscillator (a line graph) on a scale of zero to 100.

The indicator was developed by J. Welles Wilder Jr. and introduced in his seminal
1978 book, New Concepts in Technical Trading Systems.1

The RSI can do more than point to overbought and oversold securities. It can
also indicate securities that may be primed for a trend reversal or
corrective pullback in price. It can signal when to buy and sell. Traditionally, an
RSI reading of 70 or above indicates an overbought situation. A reading of 30 or
below indicates an oversold condition.

• The relative strength index (RSI) is a popular momentum oscillator

introduced in 1978.
• The RSI provides technical traders with signals about bullish and bearish
price momentum, and it is often plotted beneath the graph of an asset’s
price.
• An asset is usually considered overbought when the RSI is above 70 and
oversold when it is below 30.
• The RSI line crossing below the overbought line or above oversold line is
often seen by traders as a signal to buy or sell.
• The RSI works best in trading ranges rather than trending markets.
How the Relative Strength Index (RSI) Works

As a momentum indicator, the relative strength index compares a security's

strength on days when prices go up to its strength on days when prices go down.
Relating the result of this comparison to price action can give traders an idea of how
a security may perform. The RSI, used in conjunction with other technical
indicators, can help traders make better-informed trading decisions.

Plotting RSI

After the RSI is calculated, the RSI indicator can be plotted beneath an asset’s
price chart, as shown below. The RSI will rise as the number and size of up days
increase. It will fall as the number and size of down days increase.
 As you can see in the above chart, the RSI indicator can stay in the
overbought region for extended periods while the stock is in an uptrend. The
indicator may also remain in oversold territory for a long time when the stock is in
a downtrend. This can be confusing for new analysts, but learning to use the
indicator within the context of the prevailing trend will clarify these issues.

Why Is RSI Important?

• Traders can use RSI to predict the price behavior of a security.

• It can help traders validate trends and trend reversals.
• It can point to overbought and oversold securities.
• It can provide short-term traders with buy and sell signals.
• It's a technical indicator that can be used with others to support trading
strategies.

Using RSI With Trends

Modify RSI Levels to Fit Trends

The primary trend of the security is important to know to properly understand

RSI readings. For example, well-known market technician Constance Brown, CMT,
proposed that an oversold reading by the RSI in an uptrend is probably much higher
than 30. Likewise, an overbought reading during a downtrend is much lower than
70.

As you can see in the following chart, during a downtrend, the RSI peaks near
50 rather than 70. This could be seen by traders as more reliably signaling bearish
conditions.

Many investors create a horizontal trendline between the levels of 30 and 70

when a strong trend is in place to better identify the overall trend and extremes.

On the other hand, modifying overbought or oversold RSI levels when the
price of a stock or asset is in a long-term horizontal channel or trading range (rather
than a strong upward or downward trend) is usually unnecessary.

The relative strength indicator is not as reliable in trending markets as it is in

trading ranges. In fact, most traders understand that the signals given by the RSI in
strong upward or downward trends often can be false.
Use Buy and Sell Signals That Fit Trends

A related concept focuses on trade signals and techniques that conform to the
trend. In other words, using bullish signals primarily when the price is in a bullish
trend and bearish signals primarily when a stock is in a bearish trend may help
traders to avoid the false alarms that the RSI can generate in trending markets.

Overbought or Oversold

Generally, when the RSI indicator crosses 30 on the RSI chart, it is a bullish
sign and when it crosses 70, it is a bearish sign. Put another way, one can interpret
that RSI values of 70 or above indicate that a security is
becoming overbought or overvalued. It may be primed for a trend reversal or
corrective price pullback. An RSI reading of 30 or below indicates an oversold or
undervalued condition.

Overbought refers to a security that trades at a price level above its true (or
intrinsic) value. That means that it's priced above where it should be, according to
practitioners of either technical analysis or fundamental analysis. Traders who see
indications that a security is overbought may expect a price correction or trend
reversal. Therefore, they may sell the security.

The same idea applies to a security that technical indicators such as the
relative strength index highlight as oversold. It can be seen as trading at a lower
price than it should. Traders watching for just such an indication might expect a
price correction or trend reversal and buy the security.

Interpretation of RSI and RSI Ranges

During trends, the RSI readings may fall into a band or range. During an
uptrend, the RSI tends to stay above 30 and should frequently hit 70. During a
downtrend, it is rare to see the RSI exceed 70. In fact, the indicator frequently hits
30 or below.

These guidelines can help traders determine trend strength and spot potential
reversals. For example, if the RSI can’t reach 70 on a number of consecutive price
swings during an uptrend, but then drops below 30, the trend has weakened and
could be reversing lower.
 The opposite is true for a downtrend. If the downtrend is unable to
reach 30 or below and then rallies above 70, that downtrend has weakened
and could be reversing to the upside. Trend lines and moving averages are
helpful technical tools to include when using the RSI in this way.

Be sure not to confuse RSI and relative strength. The first refers to
changes in the the price momentum of one security. The second compares
the price performance of two or more securities.

Example of RSI Divergences

An RSI divergence occurs when price moves in the opposite direction of the
RSI. In other words, a chart might display a change in momentum before a
corresponding change in price.

A bullish divergence occurs when the RSI displays an oversold reading

followed by a higher low that appears with lower lows in the price. This may
indicate rising bullish momentum, and a break above oversold territory could be
used to trigger a new long position.

A bearish divergence occurs when the RSI creates an overbought reading

followed by a lower high that appears with higher highs on the price.

As you can see in the following chart, a bullish divergence was identified
when the RSI formed higher lows as the price formed lower lows. This was a valid
signal, but divergences can be rare when a stock is in a stable long-term trend. Using
flexible oversold or overbought readings will help identify more potential signals.
Example of Positive-Negative RSI Reversals

An additional price-RSI relationship that traders look for is positive and

negative RSI reversals. A positive RSI reversal may take place once the RSI
reaches a low that is lower than its previous low at the same time that a security's
price reaches a low that is higher than its previous low price. Traders would
consider this formation a bullish sign and a buy signal.

Conversely, a negative RSI reversal may take place once the RSI reaches a
high that is higher that its previous high at the same time that a security's price
reaches a lower high. This formation would be a bearish sign and a sell signal .
Example of RSI Swing Rejections

Another trading technique examines RSI behavior when it is reemerging from

overbought or oversold territory. This signal is called a bullish swing rejection and
has four parts:

1. The RSI falls into oversold territory.

2. The RSI crosses back above 30.
3. The RSI forms another dip without crossing back into oversold territory.
4. The RSI then breaks its most recent high.

As you can see in the following chart, the RSI indicator was oversold, broke up
through 30, and formed the rejection low that triggered the signal when it bounced
higher. Using the RSI in this way is very similar to drawing trend lines on a price
chart.
 There is a bearish version of the swing rejection signal that is a mirror image of
the bullish version. A bearish swing rejection also has four parts:

1. The RSI rises into overbought territory.

2. The RSI crosses back below 70.
3. The RSI forms another high without crossing back into overbought territory.
4. The RSI then breaks its most recent low.

The following chart illustrates the bearish swing rejection signal. As with most
trading techniques, this signal will be most reliable when it conforms to the
prevailing long-term trend. Bearish signals during downward trends are less likely
to generate false alarms.
The Difference Between RSI and MACD

The moving average convergence divergence (MACD) is another trend-

following momentum indicator that shows the relationship between two moving
averages of a security’s price. The MACD is calculated by subtracting the 26-
period exponential moving average (EMA) from the 12-period EMA. The result of
that calculation is the MACD line.

A nine-day EMA of the MACD, called the signal line, is then plotted on top
of the MACD line. It can function as a trigger for buy and sell signals. Traders may
buy the security when the MACD crosses above its signal line and sell, or short, the
security when the MACD crosses below the signal line.

The RSI was designed to indicate whether a security is overbought or

oversold in relation to recent price levels. It's calculated using average price gains
and losses over a given period of time. The default time period is 14 periods, with
values bounded from 0 to 100.

The MACD measures the relationship between two EMAs, while the RSI
measures price change momentum in relation to recent price highs and lows. These
two indicators are often used together to provide analysts with a more complete
technical picture of a market.

These indicators both measure the momentum of an asset. However, they

measure different factors, so they sometimes give contradictory indications. For
example, the RSI may show a reading above 70 for a sustained period of time,
indicating a security is overextended on the buy side.

At the same time, the MACD could indicate that buying momentum is still
increasing for the security. Either indicator may signal an upcoming trend change
by showing divergence from price (the price continues higher while the indicator
turns lower, or vice versa).
Limitations of the RSI

The RSI compares bullish and bearish price momentum and displays the
results in an oscillator placed beneath a price chart. Like most technical indicators,
its signals are most reliable when they conform to the long-term trend.

True reversal signals are rare and can be difficult to separate from false
alarms. A false positive, for example, would be a bullish crossover followed by a
sudden decline in a stock. A false negative would be a situation where there is a
bearish crossover, yet the stock suddenly accelerated upward.

Since the indicator displays momentum, it can stay overbought or oversold

for a long time when an asset has significant momentum in either direction.
Therefore, the RSI is most useful in an oscillating market (a trading range) where
the asset price is alternating between bullish and bearish movements.

What Does RSI Mean?

The relative strength index (RSI) measures the price momentum of a stock or
other security. The basic idea behind the RSI is to measure how quickly traders are
bidding the price of the security up or down. The RSI plots this result on a scale of
0 to 100.

Readings below 30 generally indicate that the stock is oversold, while

readings above 70 indicate that it is overbought. Traders will often place this RSI
chart below the price chart for the security, so they can compare its recent
momentum against its market price.

Should I Buy When RSI Is Low?

Some traders consider it a buy signal if a security’s RSI reading moves

below 30. This is based on the idea that the security has been oversold and is
therefore poised for a rebound. However, the reliability of this signal will depend
in part on the overall context. If the security is caught in a significant downtrend,
then it might continue trading at an oversold level for quite some time. Traders in
that situation might delay buying until they see other technical indicators confirm
their buy signal.

What Happens When RSI Is High?

As the relative strength index is mainly used to determine whether a

security is overbought or oversold, a high RSI reading can mean that a security is
overbought and the price may drop. Therefore, it can be a signal to sell the
security.

What Is the Difference Between RSI and Moving Average Convergence

Divergence (MACD)?

RSI and moving average convergence divergence (MACD) are both

momentum measurements that can help traders understand a security’s recent
trading activity. However, they accomplish this goal in different ways.

In essence, the MACD works by smoothing out the security’s recent price
movements and comparing that medium-term trend line to a short-term trend line
showing its more recent price changes. Traders can then base their buy and sell
decisions on whether the short-term trend line rises above or below the medium-
term trend line.

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What Is Moving Average Convergence/Divergence (MACD)?

Moving average convergence/divergence (MACD, or MAC-D) is a trend-

following momentum indicator that shows the relationship between
two exponential moving averages (EMAs) of a security’s price. The MACD line is
calculated by subtracting the 26-period EMA from the 12-period EMA.

The result of that calculation is the MACD line. A nine-day EMA of the
MACD line is called the signal line, which is then plotted on top of the MACD
line, which can function as a trigger for buy or sell signals. Traders may buy the
security when the MACD line crosses above the signal line and sell—or short—
the security when the MACD line crosses below the signal line. MACD indicators
can be interpreted in several ways, but the more common methods
are crossovers, divergences, and rapid rises/falls.

• The moving average convergence/divergence (MACD, or MAC-D) line is

calculated by subtracting the 26-period exponential moving average (EMA)
from the 12-period EMA. The signal line is a nine-period EMA of the
MACD line.
• MACD is best used with daily periods, where the traditional settings of
26/12/9 days is the norm.
• MACD triggers technical signals when the MACD line crosses above the
signal line (to buy) or falls below it (to sell).
• MACD can help gauge whether a security is overbought or oversold,
alerting traders to the strength of a directional move, and warning of a
potential price reversal.
• MACD can also alert investors to bullish/bearish divergences (e.g., when a
new high in price is not confirmed by a new high in MACD, and vice
versa), suggesting a potential failure and reversal.
• After a signal line crossover, it is recommended to wait for three or four
days to confirm that it is not a false move.
•
Learning from MACD
MACD has a positive value (shown as the blue line in the lower chart) whenever
the 12-period EMA (indicated by the red line on the price chart) is above the 26-period
EMA (the blue line in the price chart) and a negative value when the 12-period EMA
is below the 26-period EMA. The level of distance that MACD is above or below
its baseline indicates that the distance between the two EMAs is growing.

In the following chart, you can see how the two EMAs applied to the price chart
correspond to the MACD (blue) crossing above or below its baseline (red dashed) in
the indicator below the price chart.
 MACD is often displayed with a histogram (see the chart below) that graphs
the distance between MACD and its signal line. If MACD is above the signal line,
the histogram will be above the MACD’s baseline, or zero line. If MACD is below
its signal line, the histogram will be below the MACD’s baseline. Traders use the
MACD’s histogram to identify when bullish or bearish momentum is high—and
possibly overbought/oversold.
MACD vs. Relative Strength

The relative strength index (RSI) aims to signal whether a market is

considered to be overbought or oversold in relation to recent price levels. The RSI
is an oscillator that calculates average price gains and losses over a given period of
time. The default time period is 14 periods with values bounded from 0 to 100. A
reading above 70 suggests an overbought condition, while a reading below 30 is
considered oversold, with both potentially signaling a top is forming, or vice versa
(a bottom is forming).

The MACD lines, however, do not have concrete overbought/oversold levels

like the RSI and other oscillator studies. Rather, they function on a relative basis.
That’s to say an investor or trader should focus on the level and direction of the
MACD/signal lines compared with preceding price movements in the security at
hand, as shown below.
 MACD measures the relationship between two EMAs, while the RSI
measures price change in relation to recent price highs and lows. These two
indicators are often used together to give analysts a more complete technical picture
of a market.

These indicators both measure momentum in a market, but because they

measure different factors, they sometimes give contrary indications. For example,
the RSI may show a reading above 70 (overbought) for a sustained period of time,
indicating a market is overextended to the buy side in relation to recent prices, while
MACD indicates the market is still increasing in buying momentum. Either
indicator may signal an upcoming trend change by showing divergence from price
(price continues higher while the indicator turns lower, or vice versa).

Limitations of MACD and Confirmation

One of the main problems with a moving average divergence is that it can
often signal a possible reversal, but then no actual reversal happens—it produces a
false positive. The other problem is that divergence doesn’t forecast all reversals.
In other words, it predicts too many reversals that don’t occur and not enough real
price reversals.

This suggests confirmation should be sought by trend-following indicators,

such as the Directional Movement Index (DMI) system and its key component,
the Average Directional Index (ADX). The ADX is designed to indicate whether a
trend is in place or not, with a reading above 25 indicating a trend is in place (in
either direction) and a reading below 20 suggesting no trend is in place.

Investors following MACD crossovers and divergences should double-check

with the ADX before making a trade on an MACD signal. For example, while
MACD may be showing a bearish divergence, a check of the ADX may tell you
that a trend higher is in place—in which case you would avoid the bearish MACD
trade signal and wait to see how the market develops over the next few days.

On the other hand, if MACD is showing a bearish crossover and the ADX is
in non-trending territory (<25) and has likely shown a peak and reversal on its own,
you could have good cause to take the bearish trade.
 Furthermore, false positive divergences often occur when the price of
an asset moves sideways in a consolidation, such as in a range or triangle
pattern following a trend. A slowdown in the momentum—sideways
movement or slow trending movement—of the price will cause MACD to pull
away from its prior extremes and gravitate toward the zero lines even in the
absence of a true reversal. Again, double-check the ADX and whether a trend
is in place before acting.

Example of MACD Crossovers

As shown on the following chart, when MACD falls below the signal line, it
is a bearish signal indicating that it may be time to sell. Conversely, when MACD
rises above the signal line, the indicator gives a bullish signal, suggesting that the
price of the asset is likely to experience upward momentum. Some traders wait for
a confirmed cross above the signal line before entering a position to reduce the
chances of being faked out and entering a position too early.

Crossovers are more reliable when they conform to the prevailing trend. If
MACD crosses above its signal line after a brief downside correction within a
longer-term uptrend, it qualifies as a bullish confirmation and the likely
continuation of the uptrend.
 If MACD crosses below its signal line following a brief move higher within
a longer-term downtrend, traders would consider that a bearish confirmation.

Example of Divergence

When MACD forms highs or lows that that exceed the corresponding highs
and lows on the price, it is called a divergence. A bullish divergence appears when
MACD forms two rising lows that correspond with two falling lows on the price.
This is a valid bullish signal when the long-term trend is still positive.

Some traders will look for bullish divergences even when the long-term
trend is negative because they can signal a change in the trend, although this
technique is less reliable.
 When MACD forms a series of two falling highs that correspond with two
rising highs on the price, a bearish divergence has been formed. A bearish
divergence that appears during a long-term bearish trend is considered confirmation
that the trend is likely to continue.

Some traders will watch for bearish divergences during long-term bullish
trends because they can signal weakness in the trend. However, it is not as reliable
as a bearish divergence during a bearish trend.
Example of Rapid Rises or Falls
When MACD rises or falls rapidly (the shorter-term moving average pulls
away from the longer-term moving average), it is a signal that the security is
overbought or oversold and will soon return to normal levels. Traders will often
combine this analysis with the RSI or other technical indicators to verify overbought
or oversold conditions.
 It is not uncommon for investors to use the MACD’s histogram the same way
that they may use the MACD itself. Positive or negative crossovers, divergences,
and rapid rises or falls can be identified on the histogram as well. Some experience
is needed before deciding which is best in any given situation, because there are
timing differences between signals on the MACD and its histogram.

How do traders use moving average convergence/divergence (MACD)?

Traders use MACD to identify changes in the direction or strength of a

stock’s price trend. MACD can seem complicated at first glance, because it relies
on additional statistical concepts such as the exponential moving average (EMA).
But fundamentally, MACD helps traders detect when the recent momentum in a
stock’s price may signal a change in its underlying trend. This can help traders
decide when to enter, add to, or exit a position.

Is MACD a leading indicator or a lagging indicator?

MACD is a lagging indicator. After all, all the data used in MACD is based
on the historical price action of the stock. Because it is based on historical data, it
must necessarily lag the price. However, some traders use MACD histograms to
predict when a change in trend will occur. For these traders, this aspect of MACD
might be viewed as a leading indicator of future trend changes.

What is an MACD bullish/bearish divergence?

A MACD positive (or bullish) divergence is a situation in which MACD does

not reach a new low, despite the fact that the price of the stock reached a new low.
This is seen as a bullish trading signal—hence, the term “positive/bullish
divergence.” If the opposite scenario occurs—the stock price reaches a new high,
but MACD fails to do so—this would be seen as a bearish indicator and termed
“negative/bearish divergence.” In both cases, the setups suggest that the move
higher/lower will not last, so it is important to look at other technical studies, like
the relative strength index (RSI) discussed above.
The Bottom Line

MACD is a valuable tool of the moving-average type, best used with daily
data. Just as a crossover of the nine- and 14-day SMAs may generate a trading signal
for some traders, a crossover of the MACD above or below its signal line may also
generate a directional signal.

MACD is based on EMAs (more weight is placed on the most recent data),
which means that it can react very quickly to changes of direction in the current
price move. But that quickness can also be a two-edged sword. Crossovers of
MACD lines should be noted, but confirmation should be sought from other
technical signals, such as the RSI, or perhaps a few candlestick price charts. Further,
because it is a lagging indicator, it argues that confirmation in subsequent price
action should develop before taking the signal.

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Stochastic Oscillator: What It Is, How It Works, How To
Calculate
What Is a Stochastic Oscillator?
A stochastic oscillator is a momentum indicator comparing a particular closing
price of a security to a range of its prices over a certain period of time. The
sensitivity of the oscillator to market movements is reducible by adjusting that
time period or by taking a moving average of the result. It is used to
generate overbought and oversold trading signals, utilizing a 0–100 bounded
range of values.

• A stochastic oscillator is a popular technical indicator for generating

overbought and oversold signals.
• It is a popular momentum indicator, first developed in the 1950s.
• Stochastic oscillators tend to vary around some mean price level since
they rely on an asset's price history.
• Stochastic oscillators measure the momentum of an asset's price to
determine trends and predict reversals.
• Stochastic oscillators measure recent prices on a scale of 0 to 100, with
measurements above 80 indicating that an asset is overbought and
measurements below 20 indicating that it is oversold.

Understanding the Stochastic Oscillator

The stochastic oscillator is range-bound, meaning it is always between 0 and
100. This makes it a useful indicator of overbought and oversold conditions.

Traditionally, readings over 80 are considered in the overbought range, and

readings under 20 are considered oversold. However, these are not always
indicative of impending reversal; very strong trends can maintain overbought
or oversold conditions for an extended period. Instead, traders should look to
changes in the stochastic oscillator for clues about future trend shifts.

Stochastic oscillator charting generally consists of two lines: one reflecting

the actual value of the oscillator for each session, and one reflecting its three-
day simple moving average. Because price is thought to follow momentum,
the intersection of these two lines is considered to be a signal that a reversal
may be in the works, as it indicates a large shift in momentum from day to
day.
Divergence between the stochastic oscillator and trending price action is also
seen as an important reversal signal. For example, when a bearish trend
reaches a new lower low, but the oscillator prints a higher low, it may be an
indicator that bears are exhausting their momentum and a bullish reversal is
brewing.

Formula for the Stochastic Oscillator

%K=(C−L14H14−L14)×100where:C = The most recent closing priceL14 = The
lowest price traded of the 14 previoustrading sessionsH14 = The highest price t
raded during the same14-
day period%K = The current value of the stochastic indicator
%K=(H14−L14C−L14
)×100where:C = The most recent closing priceL14 = The lowest pric
e traded of the 14 previoustrading sessionsH14 = The highest price tra
ded during the same14-
day period%K = The current value of the stochastic indicator
Notably, %K is referred to sometimes as the fast stochastic indicator. The
"slow" stochastic indicator is taken as %D = 3-period moving average of %K.

The general theory serving as the foundation for this indicator is that in a
market trending upward, prices will close near the high, and in a market
trending downward, prices close near the low. Transaction signals are
created when the %K crosses through a three-period moving average, which
is called the %D.

The difference between the slow and fast Stochastic Oscillator is the Slow
%K incorporates a %K slowing period of 3 that controls the internal
smoothing of %K. Setting the smoothing period to 1 is equivalent to plotting
the Fast Stochastic Oscillator.

Example of the Stochastic Oscillator

The stochastic oscillator is included in most charting tools and can be easily
employed in practice. The standard time period used is 14 days, though this
can be adjusted to meet specific analytical needs. The stochastic oscillator is
calculated by subtracting the low for the period from the current closing price,
dividing by the total range for the period, and multiplying by 100.

As a hypothetical example, if the 14-day high is $150, the low is $125 and the
current close is $145, then the reading for the current session would be: (145-
125) / (150 - 125) * 100, or 80.

By comparing the current price to the range over time, the stochastic
oscillator reflects the consistency with which the price closes near its recent
high or low. A reading of 80 would indicate that the asset is on the verge of
being overbought.

Relative Strength Index (RSI) vs. Stochastic Oscillator

The relative strength index (RSI) and stochastic oscillator are both price
momentum oscillators that are widely used in technical analysis. While often
used in tandem, they each have different underlying theories and methods.
The stochastic oscillator is predicated on the assumption that closing prices
should move in the same direction as the current trend.

Meanwhile, the RSI tracks overbought and oversold levels by measuring the
velocity of price movements. In other words, the RSI was designed to
measure the speed of price movements, while the stochastic oscillator
formula works best in consistent trading ranges.
In general, the RSI is more useful during trending markets, and stochastics
more so in sideways or range-bound markets.

Limitations of the Stochastic Oscillator

The primary limitation of the stochastic oscillator is that it has been known to
produce false signals. This is when a trading signal is generated by the
indicator, yet the price does not actually follow through, which can end up as
a losing trade. During volatile market conditions, this can happen quite
regularly. One way to help with this is to take the price trend as a filter, where
signals are only taken if they are in the same direction as the trend.

How Do You Read the Stochastic Oscillator?

The stochastic oscillator represents recent prices on a scale of 0 to 100, with
0 representing the lower limits of the recent time period and 100 representing
the upper limit. A stochastic indicator reading above 80 indicates that the
asset is trading near the top of its range, and a reading below 20 shows that it
is near the bottom of its range.

What Does %K Represent on the Stochastic Oscillator?

On a stochastic oscillator chart, %K represents the current price of the
security, represented as a percentage of the difference between its highest
and lowest values over a certain time period. In other words, K represents the
current price in relation to the asset's recent price range.

What Does %D Represent on the Stochastic Oscillator?

On a stochastic oscillator chart, %D represents the 3-period average of %K.
This line is used to show the longer-term trend for current prices, and is used
to show the current price trend is continuing for a sustained period of time.

Average Directional Index (ADX): Definition

and Formula
What Is the Average Directional Index (ADX)?
The average directional index (ADX) is a technical analysis indicator used by
some traders to determine the strength of a trend.

The trend can be either up or down, and this is shown by two accompanying
indicators, the negative directional indicator (-DI) and the positive directional
indicator (+DI). Therefore, the ADX commonly includes three separate lines.
These are used to help assess whether a trade should be taken long or short,
or if a trade should be taken at all.

• Designed by Welles Wilder for commodity daily charts, the ADX is now
used in several markets by technical traders to judge the strength of a
trend.
• The ADX makes use of a positive (+DI) and negative (-DI) directional
indicator in addition to the trendline.
• The trend has strength when ADX is above 25; the trend is weak or the
price is trendless when ADX is below 20, according to Wilder.
• Non-trending doesn't mean the price isn't moving. It may not be, but the
price could also be making a trend change or is too volatile for a clear
direction to be present.
The Average Directional Index (ADX) Formulae
The ADX requires a sequence of calculations due to the multiple lines in the indicator.

+DI=(Smoothed +DMATR )×100-DI=(Smoothed -DMATR )×100DX=(∣+DI−-

DI∣∣+DI+-
DI∣)×100ADX=(Prior ADX×13)+Current ADX14where:+DM (Directional Mov
ement)=Current High−PHPH=Previous High-
DM=Previous Low−Current LowSmoothed +/-
DM=∑�=114DM−(∑�=114DM14)+CDMCDM=Current DMATR=Average
True Range+DI=(ATR Smoothed +DM)×100-DI=(ATR Smoothed -
DM)×100DX=(∣+DI+-DI∣∣+DI−-DI∣
)×100ADX=14(Prior ADX×13)+Current ADX
where:+DM (Directional Movement)=Current High−PHPH=Previous
High-DM=Previous Low−Current LowSmoothed +/-DM=∑t=114
DM−(14∑t=114DM)+CDMCDM=Current DMATR=Average True Range

Calculating the Average Directional Movement Index (ADX)

1. Calculate +DM, -DM, and the true range (TR) for each period. Fourteen
periods are typically used.
2. +DM = current high - previous high.
3. -DM = previous low - current low.
4. Use +DM when current high - previous high > previous low - current
low. Use -DM when previous low - current low > current high - previous
high.
 5. TR is the greater of the current high - current low, current high -
previous close, or current low - previous close.
6. Smooth the 14-period averages of +DM, -DM, and TR—the TR formula
is below. Insert the -DM and +DM values to calculate the smoothed
averages of those.
7. First 14TR = sum of first 14 TR readings.
8. Next 14TR value = first 14TR - (prior 14TR/14) + current TR.
9. Next, divide the smoothed +DM value by the smoothed TR value to get
+DI. Multiply by 100.
10. Divide the smoothed -DM value by the smoothed TR value to get
-DI. Multiply by 100.
11. The directional movement index (DMI) is +DI minus -DI, divided
by the sum of +DI and -DI (all absolute values). Multiply by 100.
12. To get the ADX, continue to calculate DX values for at least 14
periods. Then, smooth the results to get ADX.
13. First ADX = sum 14 periods of DX / 14.
14. After that, ADX = ((prior ADX * 13) + current DX) / 14.

What Does the Average Directional Index (ADX) Tell You?

The ADX, negative directional indicator (-DI), and positive directional indicator
(+DI) are momentum indicators. The ADX helps investors determine trend
strength, while -DI and +DI help determine trend direction.

The ADX identifies a strong trend when the ADX is over 25 and a weak trend
when the ADX is below 20. Crossovers of the -DI and +DI lines can be used
to generate trade signals. For example, if the +DI line crosses above the -DI
line and the ADX is above 20, or ideally above 25, then that is a potential
signal to buy. On the other hand, if the -DI crosses above the +DI, and the
ADX is above 20 or 25, then that is an opportunity to enter a
potential short trade.

Crosses can also be used to exit current trades. For example, if long, exit
when the -DI crosses above the +DI. Meanwhile, when the ADX is below 20
the indicator is signaling that the price is trendless and that it might not be an
ideal time to enter a trade.
The Average Directional Index (ADX) vs. The Aroon Indicator
The ADX indicator is composed of a total of three lines, while the Aroon
indicator is composed of two.

The two indicators are similar in that they both have lines representing
positive and negative movement, which helps to identify trend direction. The
Aroon reading/level also helps determine trend strength, as the ADX does.
The calculations are different though, so crossovers on each of the indicators
will occur at different times.

Limitations of Using the Average Directional Index (ADX)

Crossovers can occur frequently, sometimes too frequently, resulting in
confusion and potentially lost money on trades that quickly go the other way.
These are called false signals and are more common when ADX values are
below 25. That said, sometimes the ADX reaches above 25, but is only there
temporarily and then reverses along with the price.

Like any indicator, the ADX should be combined with price analysis and
potentially other indicators to help filter signals and control risk.
On-Balance Volume (OBV): Definition,
Formula, and Uses as Indicator
What Is On-Balance Volume (OBV)?
On-balance volume (OBV) is a technical trading momentum indicator that
uses volume flow to predict changes in stock price. Joseph Granville first
developed the OBV metric in the 1963 book Granville's New Key to Stock
Market Profits.1

Granville believed that volume was the key force behind markets and
designed OBV to project when major moves in the markets would occur
based on volume changes. In his book, he described the predictions
generated by OBV as "a spring being wound tightly." He believed that when
volume increases sharply without a significant change in the stock's price, the
price will eventually jump upward or fall downward.
KEY TAKEAWAYS

• On-balance volume (OBV) is a technical indicator of momentum, using

volume changes to make price predictions.
• OBV shows crowd sentiment that can predict a bullish or bearish
outcome.
• Comparing relative action between price bars and OBV generates more
actionable signals than the green or red volume histograms commonly
found at the bottom of price charts.

Calculating OBV
On-balance volume provides a running total of an asset's trading volume and
indicates whether this volume is flowing in or out of a given security or
currency pair. The OBV is a cumulative total of volume (positive and
negative). There are three rules implemented when calculating the OBV.
They are:

1. If today's closing price is higher than yesterday's closing price, then:

Current OBV = Previous OBV + today's volume

2. If today's closing price is lower than yesterday's closing price, then: Current
OBV = Previous OBV - today's volume
3. If today's closing price equals yesterday's closing price, then: Current OBV
= Previous OBV

What Does On-Balance Volume Tell You?

The theory behind OBV is based on the distinction between smart money –
namely, institutional investors – and less sophisticated retail investors. As
mutual funds and pension funds begin to buy into an issue that retail
investors are selling, volume may increase even as the price remains
relatively level. Eventually, volume drives the price upward. At that point,
larger investors begin to sell, and smaller investors begin buying.

Despite being plotted on a price chart and measured numerically, the actual
individual quantitative value of OBV is not relevant. The indicator itself is
cumulative, while the time interval remains fixed by a dedicated starting point,
meaning the real number value of OBV arbitrarily depends on the start date.
Instead, traders and analysts look to the nature of OBV movements over
time; the slope of the OBV line carries all of the weight of analysis.

Analysts look to volume numbers on the OBV to track

large, institutional investors. They treat divergences between volume and
price as a synonym of the relationship between "smart money" and the
disparate masses, hoping to showcase opportunities for buying against
incorrect prevailing trends. For example, institutional money may drive up the
price of an asset, then sell after other investors jump on the bandwagon.

Example of How to Use On-Balance Volume

Below is a list of 10 days' worth of a hypothetical stock's closing price and
volume:

1. Day one: closing price equals $10, volume equals 25,200 shares
2. Day two: closing price equals $10.15, volume equals 30,000 shares
3. Day three: closing price equals $10.17, volume equals 25,600 shares
4. Day four: closing price equals $10.13, volume equals 32,000 shares
5. Day five: closing price equals $10.11, volume equals 23,000 shares
6. Day six: closing price equals $10.15, volume equals 40,000 shares
7. Day seven: closing price equals $10.20, volume equals 36,000 shares
8. Day eight: closing price equals $10.20, volume equals 20,500 shares
9. Day nine: closing price equals $10.22, volume equals 23,000 shares
10. Day 10: closing price equals $10.21, volume equals 27,500 shares
As can be seen, days two, three, six, seven and nine are up days, so these
trading volumes are added to the OBV. Days four, five and 10 are down days,
so these trading volumes are subtracted from the OBV. On day eight, no
changes are made to the OBV since the closing price did not change. Given
the days, the OBV for each of the 10 days is:

1. Day one OBV = 0

2. Day two OBV = 0 + 30,000 = 30,000
3. Day three OBV = 30,000 + 25,600 = 55,600
4. Day four OBV = 55,600 - 32,000 = 23,600
5. Day five OBV = 23,600 - 23,000 = 600
6. Day six OBV = 600 + 40,000 = 40,600
7. Day seven OBV = 40,600 + 36,000 = 76,600
8. Day eight OBV = 76,600
9. Day nine OBV = 76,600 + 23,000 = 99,600
10. Day 10 OBV = 99,600 - 27,500 = 72,100

The Difference Between OBV and Accumulation/Distribution

On-balance volume and the accumulation/distribution line are similar in that
they are both momentum indicators that use volume to predict the movement
of “smart money”. However, this is where the similarities end. In the case of
on-balance volume, it is calculated by summing the volume on an up-day and
subtracting the volume on a down-day.

The formula used to create the accumulation/distribution (Acc/Dist) line is

quite different than the OBV shown above. The formula for the Acc/Dist,
without getting too complicated, is that it uses the position of the current price
relative to its recent trading range and multiplies it by that period's volume.

Limitations of OBV
One limitation of OBV is that it is a leading indicator, meaning that it may
produce predictions, but there is little it can say about what has actually
happened in terms of the signals it produces. Because of this, it is prone to
produce false signals. It can therefore be balanced by lagging indicators. Add
a moving average line to the OBV to look for OBV line breakouts; you can
confirm a breakout in the price if the OBV indicator makes a concurrent
breakout.

Another note of caution in using the OBV is that a large spike in volume on a
single day can throw off the indicator for quite a while. For instance, a
surprise earnings announcement, being added or removed from an index, or
massive institutional block trades can cause the indicator to spike or
plummet, but the spike in volume may not be indicative of a trend.

Ichimoku Kinko Hyo Indicator & FIve

Components Explained
What Is the Ichimoku Kinko Hyo?
The Ichimoku Kinko Hyo, or Ichimoku for short, is a technical indicator that is
used to gauge momentum along with future areas of support and resistance.
The all-in-one technical indicator is comprised of five lines called the tenkan-
sen, kijun-sen, senkou span A, senkou span B and chikou span.

Understanding Ichimoku Kinko Hyo

The Ichimoku Kinko Hyo indicator was originally developed by a Japanese
newspaper writer to combine various technical strategies into a single
indicator that could be easily implemented and interpreted. In Japanese,
"ichimoku" translates to "one look," meaning traders only have to take one
look at the chart to determine momentum, support, and resistance.

Ichimoku may look very complicated to novice traders that haven't seen it
before, but the complexity quickly disappears with an understanding of what
the various lines mean and why they are used.
The Ichimoku indicator is best used in conjunction with other forms
of technical analysis despite its goal of being an all-in-one indicator.

Ichimoku Kinko Hyo Interpretation

There are five key components to the Ichimoku indicator:

• Tenkan-sen: The tenkan-sen, or conversion line, is calculated by

adding the highest high and the lowest low over the past nine periods
and then dividing the result by two. The resulting line represents a key
support and resistance level, as well as a signal line for reversals.
• Kijun-sen: The kijun-sen, or base line, is calculated by adding the
highest high and the lowest low over the past 26 periods and dividing
the result by two. The resulting line represents a key support and
resistance level, a confirmation of a trend change, and can be used as
a trailing stop-loss point.
• Senkou Span A: The senkou span A, or leading span A, is calculated
by adding the tenkan-sen and the kijun-sen, dividing the result by two,
and then plotting the result 26 periods ahead. The resulting line forms
one edge of the kumo - or cloud - that's used to identify future areas of
support and resistance.
• Senkou Span B: The senkou span B, or leading span B, is calculated
by adding the highest high and the lowest low over the past 52 periods,
dividing it by two, and then plotting the result 26 periods ahead. The
resulting line forms the other edge of the kumo that's used to identify
future areas of support and resistance.

Example of an Ichimoku Kinko Hyo Chart

The following is an example of an Ichimoku indicator plotted on a chart:
In this example, the Ichimoku cloud is the area that's shaded in orange, which
represents a key area of support and resistance. The chart shows that the
SPDR S&P 500 ETF remains in a bullish uptrend since the current price is
trading above the cloud. If the price were to enter the cloud, traders would
watch for a potential reversal of the trend.

Introduction to the Parabolic SAR

The parabolic SAR attempts to give traders an edge by highlighting the
direction an asset is moving, as well as providing entry and exit points. In this
article, we'll look at the basics of this indicator and show you how you can
incorporate it into your trading strategy. We'll also look at some of the
drawbacks of the indicator.
KEY TAKEAWAYS

• The parabolic SAR indicator, developed by J. Welles Wilder Jr., is used

by traders to determine trend direction and potential reversals in price.
• The technical indicator uses a trailing stop and reverse method called
"SAR," or stop and reverse, to identify suitable exit and entry points.
• The parabolic SAR indicator appears on a chart as a series of dots,
either above or below an asset's price, depending on the direction the
price is moving.
• A dot is placed below the price when it is trending upward, and above
the price when it is trending downward.
The Indicator
The parabolic SAR is a technical indicator used to determine the price
direction of an asset, as well as draw attention to when the price direction is
changing. Sometimes known as the "stop and reversal
system," the parabolic SAR was developed by J. Welles Wilder Jr., creator of
the relative strength index (RSI).1

On a chart, the indicator appears as a series of dots placed either above or

below the price bars. A dot below the price is deemed to be a bullish signal.
Conversely, a dot above the price is used to illustrate that the bears are in
control and that the momentum is likely to remain downward. When the dots
flip, it indicates that a potential change in price direction is under way. For
example, if the dots are above the price, when they flip below the price, it
could signal a further rise in price.

As the price of a stock rises, the dots will rise as well, first slowly and then
picking up speed and accelerating with the trend. The SAR starts to move a
little faster as the trend develops, and the dots soon catch up to the price.

The following chart shows that the indicator works well for capturing profits
during a trend, but it can lead to many false signals when the price moves
sideways or is trading in a choppy market. The indicator would have kept the
trader in the trade while the price rose. When the price is moving sideways,
the trader should expect more losses and/or small profits.
The following chart shows a downtrend, and the indicator would have kept
the trader in a short trade (or out of longs) until the pullbacks to the upside
began. When the downtrend resumed, the indicator got the trader back in.

The parabolic SAR is also a method for setting stop-loss orders. When a
stock is rising, move the stop-loss to match the parabolic SAR indicator. The
same concept applies to a short trade—as the price falls, so will the indicator.
Move the stop-loss to match the level of the indicator after every price bar.
This indicator is mechanical and will always be giving new signals to get long
or short. It is up to the trader to determine which trades to take and which to
leave alone. For example, during a downtrend, it is better to take only the
short sales like those shown in the chart above, as opposed to taking the buy
signals as well.

Indicators to Complement to the Parabolic SAR

In trading, it is better to have several indicators confirm a certain signal than
to rely solely on one specific indicator. Complement the SAR trading signals
by using other indicators such as a stochastic, moving average, or the ADX.

For example, SAR sell signals are much more convincing when the price is
trading below a long-term moving average. The price below a long-term
moving average suggests that the sellers are in control of the direction and
that the recent SAR sell signal could be the beginning of another wave lower.

Similarly, if the price is above the moving average, focus on taking the buy
signals (dots move from above to below). The SAR indicator can still be used
as a stop-loss, but since the longer-term trend is up, it is not wise to take
short positions.

A counter-argument to the parabolic SAR is that using it can result in a lot of

trades. The chart above shows multiple trades. Some traders would argue
that using the moving average alone would have captured the entire up move
all in one trade. Therefore, the parabolic SAR is typically used by active
traders who want to catch a high-momentum move and then get out of the
trade.

The parabolic SAR performs best in markets with a steady trend. In ranging
markets, the parabolic SAR tends to whipsaw back and forth, generating
false trading signals.

Important The parabolic SAR is 'always on,' and constantly generating

signals, whether there is a quality trend or not. Therefore, many signals may
be of poor quality because no significant trend is present or develops following
a signal.

The Bottom Line

The parabolic SAR is used to gauge a stock's direction and for placing stop-
loss orders. The indicator tends to produce good results in a trending
environment, but it produces many false signals and losing trades when the
price starts moving sideways. To help filter out some of the poor trade
signals, only trade in the direction of the dominant trend. Some other
technical tools, such as the moving average, can aid in this regard.

What Are Fibonacci Retracement Levels,

and What Do They Tell You?
What Are Fibonacci Retracement Levels?
Fibonacci retracement levels—stemming from the Fibonacci sequence—are
horizontal lines that indicate where support and resistance are likely to occur.

Each level is associated with a percentage. The percentage is how much of a

prior move the price has retraced. The Fibonacci retracement levels are
23.6%, 38.2%, 61.8%, and 78.6%. While not officially a Fibonacci ratio, 50%
is also used.

The indicator is useful because it can be drawn between any two significant
price points, such as a high and a low. The indicator will then create the
levels between those two points.

Suppose the price of a stock rises $10 and then drops $2.36. In that case, it
has retraced 23.6%, which is a Fibonacci number. Fibonacci numbers are
found throughout nature. Therefore, many traders believe that these numbers
also have relevance in financial markets.
Fibonacci retracement levels were named after Italian mathematician
Leonardo Pisano Bigollo, who was famously known as Leonardo
Fibonacci. However, Fibonacci did not create the Fibonacci sequence.
Instead, Fibonacci introduced these numbers to western Europe after
learning about them from Indian merchants.1 Fibonacci retracement levels
were formulated in ancient India between 450 and 200 BCE.

KEY TAKEAWAYS

• Fibonacci retracement levels connect any two points that the trader
views as relevant, typically a high point and a low point.
• The percentage levels provided are areas where the price could stall or
reverse.
• The most commonly used ratios include 23.6%, 38.2%, 50%, 61.8%,
and 78.6%.
• These levels should not be relied on exclusively, so it is dangerous to
assume that the price will reverse after hitting a specific Fibonacci level.
• Fibonacci numbers and sequencing were first used by Indian
mathematicians centuries before Leonardo Fibonacci.
Numbers First Formulated in Ancient India
Despite its name, the Fibonacci sequence was not developed by its
namesake. Instead, centuries before Leonardo Fibonacci shared it with
western Europe, it was developed and used by Indian mathematicians.

Most notably, Indian mathematician Acarya Virahanka is known to have

developed Fibonacci numbers and the method of their sequencing around
600 A.D.2 Following Virahanka’s discovery, other subsequent generations of
Indian mathematicians—Gopala, Hemacandra, and Narayana Pandita—
referenced the numbers and method. Pandita expanded its use by drawing a
correlation between the Fibonacci numbers and multinomial co-efficients.

It is estimated that Fibonacci numbers existed in Indian society as early as

200 B.C.3
The Formula for Fibonacci Retracement Levels
Fibonacci retracement levels do not have formulas. When these indicators
are applied to a chart, the user chooses two points. Once those two points
are chosen, the lines are drawn at percentages of that move.

Suppose the price rises from $10 to $15, and these two price levels are the
points used to draw the retracement indicator. Then, the 23.6% level will be
at $13.82 ($15 - ($5 × 0.236) = $13.82). The 50% level will be at $12.50 ($15
- ($5 × 0.5) = $12.50).

How to Calculate Fibonacci Retracement Levels

As discussed above, there is nothing to calculate when it comes to Fibonacci
retracement levels. They are simply percentages of whatever price range is
chosen.

However, the origin of the Fibonacci numbers is fascinating. They are based
on something called the Golden Ratio. Start a sequence of numbers with zero
and one. Then, keep adding the prior two numbers to get a number string like
this:
 • 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377, 610, 987...with the
string continuing indefinitely.

The Fibonacci retracement levels are all derived from this number string.
After the sequence gets going, dividing one number by the next number
yields 0.618, or 61.8%. Divide a number by the second number to its right,
and the result is 0.382 or 38.2%. All the ratios, except for 50% (since it is not
an official Fibonacci number), are based on some mathematical calculation
involving this number string.

The Golden Ratio, known as the divine proportion, can be found in various
spaces, from geometry to human DNA.

Interestingly, the Golden Ratio of 0.618 or 1.618 is found in sunflowers,

galaxy formations, shells, historical artifacts, and architecture.

What Do Fibonacci Retracement Levels Tell You?

Fibonacci retracements can be used to place entry orders, determine stop-
loss levels, or set price targets. For example, a trader may see a stock
moving higher. After a move up, it retraces to the 61.8% level. Then, it starts
to go up again. Since the bounce occurred at a Fibonacci level during
an uptrend, the trader decides to buy. The trader might set a stop loss at the
61.8% level, as a return below that level could indicate that the rally has
failed.

Fibonacci levels also arise in other ways within technical analysis. For
example, they are prevalent in Gartley patterns and Elliott Wave theory. After
a significant price movement up or down, these forms of technical analysis
find that reversals tend to occur close to certain Fibonacci levels.

Important: Market trends are more accurately identified when other

analysis tools are used with the Fibonacci approach.

Fibonacci retracement levels are static, unlike moving averages. The static
nature of the price levels allows for quick and easy identification. That helps
traders and investors to anticipate and react prudently when the price levels
are tested. These levels are inflection points where some type of price action
is expected, either a reversal or a break.
Fibonacci Retracements vs. Fibonacci Extensions
While Fibonacci retracements apply percentages to a pullback, Fibonacci
extensions apply percentages to a move in the trending direction. For
example, a stock goes from $5 to $10, then back to $7.50. The move from
$10 to $7.50 is a retracement. If the price starts rallying again and goes to
$16, that is an extension.

Limitations of Using Fibonacci Retracement Levels

While the retracement levels indicate where the price might find support or
resistance, there are no assurances that the price will actually stop there.
This is why other confirmation signals are often used, such as the price
starting to bounce off the level.

The other argument against Fibonacci retracement levels is that there are so
many of them that the price is likely to reverse near one of them quite often.
The problem is that traders struggle to know which one will be useful at any
particular time. When it doesn’t work out, it can always be claimed that the
trader should have been looking at another Fibonacci retracement level
instead.

Why are Fibonacci retracements important?

In technical analysis, Fibonacci retracement levels indicate key areas where
a stock may reverse or stall. Common ratios include 23.6%, 38.2%, and 50%,
among others. Usually, these will occur between a high point and a low point
for a security, designed to predict the future direction of its price movement.

What are the Fibonacci ratios?

The Fibonacci ratios are derived from the Fibonacci sequence: 0, 1, 1, 2, 3, 5,
8, 13, 21, 34, 55, 89, 144, 233, and so on. Here, each number is equal to the
sum of the two preceding numbers. Fibonacci ratios are informed by
mathematical relationships found in this formula. As a result, they produce
the following ratios: 23.6%, 38.2%, 50%, 61.8%, 78.6%, 100%, 161.8%,
261.8%, and 423.6%. Although 50% is not a pure Fibonacci ratio, it is still
used as a support and resistance indicator.

How do you apply Fibonacci retracement levels in a chart?

As one of the most common technical trading strategies, a trader could use a
Fibonacci retracement level to indicate where they would enter a trade. For
instance, a trader notices that after significant momentum, a stock has
declined 38.2%. As the stock begins to face an upward trend, they decide to
enter the trade. Because the stock reached a Fibonacci level, it is deemed a
good time to buy, with the trader speculating that the stock will then retrace,
or recover, its recent losses.

How do you draw a Fibonacci retracement?

Fibonacci retracements are trend lines drawn between two significant points,
usually between absolute lows and absolute highs, plotted on a chart.
Intersecting horizontal lines are placed at the Fibonacci levels.

The Bottom Line

Fibonacci retracements are useful tools that help traders identify support and
resistance levels. With the information gathered, traders can place orders,
identify stop-loss levels, and set price targets. Although Fibonacci
retracements are useful, traders often use other indicators to make more
accurate assessments of trends and make better trading decisions.

What is EMA? How to Use Exponential

Moving Average With Formula
What Is an Exponential Moving Average (EMA)?
An exponential moving average (EMA) is a type of moving average (MA) that
places a greater weight and significance on the most recent data points. The
exponential moving average is also referred to as the
exponentially weighted moving average. An exponentially weighted moving
average reacts more significantly to recent price changes than a simple
moving average simple moving average (SMA), which applies an equal
weight to all observations in the period.

KEY TAKEAWAYS

• The EMA is a moving average that places a greater weight and

significance on the most recent data points.
• Like all moving averages, this technical indicator is used to produce
buy and sell signals based on crossovers and divergences from the
historical average.
• Traders often use several different EMA lengths, such as 10-day, 50-
day, and 200-day moving averages.
Simple Vs. Exponential Moving Averages

While there are many possible choices for the smoothing factor, the most
common choice is:

• Smoothing = 2

That gives the most recent observation more weight. If the smoothing factor
is increased, more recent observations have more influence on the EMA.

Calculating the EMA

Calculating the EMA requires one more observation than the SMA. Suppose
that you want to use 20 days as the number of observations for the EMA.
Then, you must wait until the 20th day to obtain the SMA. On the 21st day,
you can then use the SMA from the previous day as the first EMA for
yesterday.
The calculation for the SMA is straightforward. It is simply the sum of the
stock's closing prices during a time period, divided by the number of
observations for that period. For example, a 20-day SMA is just the sum of
the closing prices for the past 20 trading days, divided by 20.

Next, you must calculate the multiplier for smoothing (weighting) the EMA,
which typically follows the formula: [2 ÷ (number of observations + 1)]. For a
20-day moving average, the multiplier would be [2/(20+1)]= 0.0952.

Finally, the following formula is used to calculate the current EMA:

• EMA = Closing price x multiplier + EMA (previous day) x (1-multiplier)

The EMA gives a higher weight to recent prices, while the SMA assigns equal
weight to all values. The weighting given to the most recent price is greater
for a shorter-period EMA than for a longer-period EMA. For example, an
18.18% multiplier is applied to the most recent price data for a 10-period
EMA, while the weight is only 9.52% for a 20-period EMA.

There are also slight variations of the EMA arrived at by using the open, high,
low, or median price instead of using the closing price.
What Does the EMA Tell You?
The 12- and 26-day exponential moving averages (EMAs) are often the most
quoted and analyzed short-term averages. The 12- and 26-day are used to
create indicators like the moving average convergence divergence (MACD)
and the percentage price oscillato (PPO). In general, the 50- and 200-day
EMAs are used as indicators for long-term trends. When a stock price
crosses its 200-day moving average, it is a technical signal that
a reversal has occurred.

Traders who employ technical analysis find moving averages very useful and
insightful when applied correctly. However, they also realize that these
signals can create havoc when used improperly or misinterpreted. All the
moving averages commonly used in technical analysis are lagging indicators.

Consequently, the conclusions drawn from applying a moving average to a

particular market chart should be to confirm a market move or to indicate its
strength. The optimal time to enter the market often passes before a moving
average shows that the trend has changed.

An EMA does serve to alleviate the negative impact of lags to some extent.
Because the EMA calculation places more weight on the latest data, it “hugs”
the price action a bit more tightly and reacts more quickly. This is desirable
when an EMA is used to derive a trading entry signal.

Like all moving average indicators, EMAs are much better suited for trending
markets. When the market is in a strong and sustained uptrend, the EMA
indicator line will also show an uptrend and vice-versa for a downtrend. A
vigilant trader will pay attention to both the direction of the EMA line and the
relation of the rate of change from one bar to the next. For example, suppose
the price action of a strong uptrend begins to flatten and reverse. From
an opportunity cost point of view, it might be time to switch to a more bullish
investment.

Examples of How to Use the EMA

EMAs are commonly used in conjunction with other indicators to confirm
significant market moves and to gauge their validity. For traders who
trade intraday and fast-moving markets, the EMA is more applicable. Quite
often, traders use EMAs to determine a trading bias. If an EMA on a daily
chart shows a strong upward trend, an intraday trader’s strategy may be to
trade only on the long side.

The Difference Between EMA and SMA

The major difference between an EMA and an SMA is the sensitivity each
one shows to changes in the data used in its calculation.

More specifically, the EMA gives higher weights to recent prices, while the
SMA assigns equal weights to all values. The two averages are similar
because they are interpreted in the same manner and are both commonly
used by technical traders to smooth out price fluctuations.

Since EMAs place a higher weighting on recent data than on older data, they
are more responsive to the latest price changes than SMAs. That makes the
results from EMAs more timely and explains why they are preferred by many
traders.1

Limitations of the EMA

It is unclear whether or not more emphasis should be placed on the most
recent days in the time period. Many traders believe that new data better
reflects the current trend of the security. At the same time, others feel that
overweighting recent dates creates a bias that leads to more false alarms.

Similarly, the EMA relies wholly on historical data. Many economists believe
that markets are efficient, which means that current market prices already
reflect all available information. If markets are indeed efficient, using historical
data should tell us nothing about the future direction of asset prices.

What Is a Good Exponential Moving Average?

The longer-day EMAs (i.e. 50 and 200-day) tend to be used more by long-
term investors, while short-term investors tend to use 8- and 20-day EMAs.

Is Exponential Moving Average Better Than Simple Moving Average?

The EMA focused more on recent price moves, which means it tends to
respond more quickly to price changes than the SMA.

How Do You Read Exponential Moving Averages?

Investors tend to interpret a rising EMA as a support to price action and a
falling EMA as a resistance. With that interpretation, investors look to buy
when the price is near the rising EMA and sell when the price is near the
falling EMA.

Moving Average (MA): Purpose, Uses,

Formula, and Examples
What Is a Moving Average (MA)?
In finance, a moving average (MA) is a stock indicator commonly used
in technical analysis. The reason for calculating the moving average of a
stock is to help smooth out the price data by creating a constantly
updated average price.

By calculating the moving average, the impacts of random, short-term

fluctuations on the price of a stock over a specified time frame are mitigated.
Simple moving averages (SMAs) use a simple arithmetic average of prices
over some timespan, while exponential moving averages (EMAs) place
greater weight on more recent prices than older ones over the time period.
KEY TAKEAWAYS

• A moving average (MA) is a stock indicator commonly used in technical

analysis.
• The moving average helps to level the price data over a specified
period by creating a constantly updated average price.
• A simple moving average (SMA) is a calculation that takes the
arithmetic mean of a given set of prices over a specific number of days
in the past.
• An exponential moving average (EMA) is a weighted average that gives
greater importance to the price of a stock in more recent days, making
it an indicator that is more responsive to new information.
Understanding a Moving Average (MA)
Moving averages are calculated to identify the trend direction of a stock or to
determine its support and resistance levels. It is a trend-following or lagging,
indicator because it is based on past prices.

The longer the period for the moving average, the greater the lag. A 200-day
moving average will have a much greater degree of lag than a 20-day MA
because it contains prices for the past 200 days. 50-day and 200-day moving
average figures are widely followed by investors and traders and are
considered to be important trading signals.

Investors may choose different periods of varying lengths to calculate moving

averages based on their trading objectives. Shorter moving averages are
typically used for short-term trading, while longer-term moving averages are
more suited for long-term investors.

While it is impossible to predict the future movement of a specific stock, using

technical analysis and research can help make better predictions. A rising
moving average indicates that the security is in an uptrend, while a declining
moving average indicates that it is in a downtrend.

Similarly, upward momentum is confirmed with a bullish crossover, which

occurs when a short-term moving average crosses above a longer-term
moving average. Conversely, downward momentum is confirmed with a
bearish crossover, which occurs when a short-term moving average crosses
below a longer-term moving average.1
Types of Moving Averages
Simple Moving Average
A simple moving average (SMA), is calculated by taking the arithmetic mean
of a given set of values over a specified period. A set of numbers, or prices of
stocks, are added together and then divided by the number of prices in the
set. The formula for calculating the simple moving average of a security is as
follows:

Charting stock prices over 50 days using a simple moving average may look
like this:
Exponential Moving Average (EMA)
The exponential moving average gives more weight to recent prices in an
attempt to make them more responsive to new information. To calculate an
EMA, the simple moving average (SMA) over a particular period is calculated
first.

Then calculate the multiplier for weighting the EMA, known as the "smoothing
factor," which typically follows the formula: [2/(selected time period + 1)].

For a 20-day moving average, the multiplier would be [2/(20+1)]= 0.0952. The
smoothing factor is combined with the previous EMA to arrive at the current
value. The EMA thus gives a higher weighting to recent prices, while the SMA
assigns an equal weighting to all values.

Simple Moving Average (SMA) vs. Exponential Moving Average (EMA)

The calculation for EMA puts more emphasis on the recent data points.
Because of this, EMA is considered a weighted average calculation.

In the figure below, the number of periods used in each average is 15, but the
EMA responds more quickly to the changing prices than the SMA. The EMA
has a higher value when the price is rising than the SMA and it falls faster
than the SMA when the price is declining. This responsiveness to price
changes is the main reason why some traders prefer to use the EMA over the
SMA.
Example of a Moving Average
The moving average is calculated differently depending on the type: SMA or
EMA. Below, we look at a simple moving average (SMA) of a security with
the following closing prices over 15 days:

• Week 1 (5 days): 20, 22, 24, 25, 23

• Week 2 (5 days): 26, 28, 26, 29, 27
• Week 3 (5 days): 28, 30, 27, 29, 28

A 10-day moving average would average out the closing prices for the first 10
days as the first data point. The next data point would drop the earliest price,
add the price on day 11 and take the average.

Example of a Moving Average Indicator

A Bollinger Band® technical indicator has bands generally placed
two standard deviations away from a simple moving average. In general, a
move toward the upper band suggests the asset is becoming overbought,
while a move close to the lower band suggests the asset is
becoming oversold. Since standard deviation is used as a statistical measure
of volatility, this indicator adjusts itself to market conditions.

What Does a Moving Average Indicate?

A moving average is a statistic that captures the average change in a data
series over time. In finance, moving averages are often used by technical
analysts to keep track of price trends for specific securities. An upward trend
in a moving average might signify an upswing in the price or momentum of a
security, while a downward trend would be seen as a sign of decline.

What Are Moving Averages Used for?

Moving averages are widely used in technical analysis, a branch of investing
that seeks to understand and profit from the price movement patterns of
securities and indices. Generally, technical analysts will use moving averages
to detect whether a change in momentum is occurring for a security, such as
if there is a sudden downward move in a security’s price. Other times, they
will use moving averages to confirm their suspicions that a change might be
underway.

What Are Some Examples of Moving Averages?

The exponential moving average (EMA) is a type of moving average that
gives more weight to more recent trading days. This type of moving average
might be more useful for short-term traders for whom longer-term historical
data might be less relevant. A simple moving average is calculated by
averaging a series of prices while giving equal weight to each of the prices
involved.

What Is MACD?
The moving average convergence divergence (MACD) is used by traders to
monitor the relationship between two moving averages, calculated by
subtracting a 26-day exponential moving average from a 12-day exponential
moving average. The MACD also employs a signal line that helps identify
crossovers, and which itself is a nine-day exponential moving average of the
MACD line that is plotted on the same graph. The signal line is used to help
identify trend changes in the price of a security and to confirm the strength of
a trend.

When the MACD is positive, the short-term average is located above the
long-term average and is an indication of upward momentum. When the
short-term average is below the long-term average, it's a sign that the
momentum is downward.
What Is a Golden Cross?
A golden cross is a chart pattern in which a short-term moving average
crosses above a long-term moving average. The golden cross is a bullish
breakout pattern formed from a crossover involving a security's short-term
moving average such as the 15-day moving average, breaking above its
long-term moving average, such as the 50-day moving average. As long-term
indicators carry more weight, the golden cross indicates a bull market on the
horizon and is reinforced by high trading volumes.

The Bottom Line

A moving average (MA) is a stock indicator commonly used in technical
analysis, used to help smooth out price data by creating a constantly updated
average price. A rising moving average indicates that the security is in an
uptrend, while a declining moving average indicates a downtrend. The
exponential moving average is generally preferred to a simple moving
average as it gives more weight to recent prices and shows a clearer
response to new information and trends.

Percentage Price Oscillator (PPO):

Definition and How It's Used
What Is the Percentage Price Oscillator (PPO)?
The percentage price oscillator (PPO) is a technical momentum indicator that
shows the relationship between two moving averages in percentage terms.
The moving averages are a 26-period and 12-period exponential moving
average (EMA).

The PPO is used to compare asset performance and volatility,

spot divergence that could lead to price reversals, generate trade signals,
and help confirm trend direction.

KEY TAKEAWAYS

• The PPO typically contains two lines: the PPO line, and the signal line.
The signal line is an EMA of the PPO, so it moves slower than the
PPO.
• The PPO crossing the signal line is used by some traders as a trade
signal. When it crosses above from below that is a buy, and when it
crosses below from above that is a sell.
 • When the PPO is above zero that helps indicate an uptrend, as the
short-term EMA is above the longer-term EMA.
• When the PPO is below zero, the short-term average is below the
longer-term average, which helps indicate a downtrend.
Formula and Calculation for the Percentage Price Oscillator (PPO)
Use the following formula to calculate the relationship between two moving
averages for a holding.

1. Calculate the 12-period EMA of the asset's price.

2. Calculate the 26-period EMA of the asset's price.
3. Apply these to the PPO formula to get the current PPO value.
4. Once there are at least nine PPO values, generate the signal line by
calculating the nine-period EMA of the PPO.
5. To generate a histogram reading, take the PPO value and subtract the
current signal line value. The histogram is an optional visual
representation of the distance between these two lines.

How the Percentage Price Oscillator (PPO) Works

The PPO is identical to the moving average convergence divergence (MACD)
indicator, except the PPO measures percentage difference between two
EMAs, while the MACD measures absolute (dollar) difference. Some traders
prefer the PPO because readings are comparable between
assets with different prices, whereas MACD readings are not comparable.
For example, regardless of the asset's price, a PPO result of 10 means the
short-term average is 10% above the long-term average.

The PPO generates trade signals in the same way the MACD does. The
indicator generates a buy signal when the PPO line crosses above the signal
line from below, and generates a sell signal when the PPO line crosses below
the signal from above. The signal line is created by taking a nine-period EMA
of the PPO line. Signal line crossovers are used in conjunction with where the
PPO is relative to zero/centerline.

When the PPO is above zero that helps confirm an uptrend since the short-
term EMA is above the longer-term EMA. Conversely, when the PPO is
below zero, the short-term EMA is below the longer-term EMA, which is an
indication of a downtrend. Some traders prefer to only take signal line buy
signals when the PPO is above zero, or the price shows an overall upward
trajectory. Similarly, when the PPO is below zero, they may ignore buy
signals, or only take short-sell signals.

Centerline crossovers also generate trading signals. Traders consider a move

from below to above the centerline as bullish, and a move from above to
below the centerline as bearish. The PPO crosses the centerline when the
12-period and 26-period moving average cross.

Traders can also use the PPO to look for technical divergence between the
indicator and price. For example, if the price of an asset makes a higher high
but the indicator makes a lower high, it may indicate the upward momentum
is subsiding. Conversely, if an asset's price makes a lower low but the
indicator makes a higher low, it could suggest that the bears are losing their
traction and the price could head higher soon.
Comparing Assets with the Percentage Price Oscillator (PPO)
The PPO’s percentage value allows traders to use the indicator to compare
different assets in terms of performance and volatility. This is particularly
useful if the assets vary significantly in price.

For example, a trader comparing Apple and Amazon could compare the
indicator’s oscillating range for each stock to determine which one is more
volatile.

If the PPO’s range for Apple is between 3.25 and -5.80 for the last year, and
Amazon’s PPO range is between 2.65 and -4.5, it is evident that Apple is
more volatile because it has a 9.05 point range compared to Amazon’s 7.15
point range. This is a very rough comparison of volatility between the two
assets. The indicator is only measuring and reflecting the distance between
two moving averages, not actual price movement.

The PPO indicator is also useful for comparing momentum between assets.
Traders simply need to look at which asset has a higher PPO value to see
which has more momentum. For instance, if Apple has a PPO of three and
Amazon has a PPO value of one, then Apple has had more recent strength
since its short-term EMA is further above the longer-term EMA.

The Percentage Price Oscillator (PPO) vs. the Relative Strength Index (RSI)
The PPO measures the distance between a shorter and longer-term EMA.
The relative strength index (RSI) is another type of oscillator that measures
recent price gains and losses.

The RSI is used to help assess overbought and oversold conditions, as well
as spot divergences and confirm trends. The indicators are calculated and
interpreted differently, so they will each provide different information to
traders.

Limitations of the Percentage Price Oscillator (PPO)

The PPO is prone to providing false crossover signals, both in terms of signal
line crossovers and centerline crossovers. Assume the price is rising, but
then moves sideways. The two EMAs will converge during the sideways
period, likely resulting in a signal line crossover and potentially a centerline
crossover. Yet the price hasn't actually reversed or changed direction, it just
paused. Traders using the PPO must keep this in mind when using the PPO
to generate trade signals.
Two or more crossovers may occur before a strong price move develops.
Multiple crossovers without a significant price move are likely to result in
multiple losing trades.

The indicator is also used to spot divergences, which may foreshadow a

price reversal. Yet divergence is not a timing signal. It can last a long time,
and won't always result in a price reversal.

The indicator is composed of the distance between two EMAs (the PPO), and
an EMA of the PPO (signal line). There is nothing inherently predictive in
these calculations. They are showing what has occurred, and not necessarily
what will happen in the future.