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Technical Studies;
Bollinger Bands, MACD, Stochastic, RSI

The LFB Team

Introduction
There are hundreds of technical studies available to the trading public. While all are valuable trading tools, there are several that consistently make their way onto trading screens Globally. These studies stand out amongst their peers due to their simplicity and reliability. They are Bollinger Bands, MACD, Stochastic, and RSI;

Two of them work well in Trending Markets, and two work well in Channeling Markets. If you already understand what makes each one work, then there notes at the bottom that explain what ones work, and why, in certain economic conditions. The Forex Market is in a sideways moving period, and as such allows less opportunity for leaving a trade to run, this may help the newer Traders to understand which Tech Study will possibly provide less 'Head-Fakes'.

Bollinger Bands



These were the creation of famed market technician John Bollinger in the early 1980’s. John created Bollinger Bands as a way to measure if a security was trading at a relatively high or low price. John was one of the first traders to realize that volatility is dynamic, not static, and devised price bands that took volatility into account.

The default setting for Bollinger Bands on most charting software plots two bands above and below a simple moving average. The upper band lies two standard deviations above the moving average, while the lower band is plotted two standard deviations below the moving average. With standard deviation being a measure of volatility, the bands adjust, widening and narrowing in response to market conditions. Widening bands are a sign of increased volatility, while converging bands signal a decline in volatility.

The first way in which traders use this tool is to analyze the width of the trading bands. A prolonged narrowing of the bands is oftentimes a signal that volatility will likely increase sharply in the near future.

Another simple way in which traders can utilize Bollinger Bands is by looking at a security’s price in relation to the upper and lower bands. A security trading near the upper band can be considered overbought, while a security trading near the lower band can be considered oversold. For this reason some traders use Bollinger Bands as levels of support and resistance.

Mr. Bollinger suggests applying Bollinger Bands to a daily chart using a 20-day simple moving average with the upper and lower bands two standard deviations from the SMA.

Moving Average Convergance/Devergance (MACD)



The study was created by Gerald Appel and has come to be known as one of the simplest and most reliable technical indicators available to the trading public.

MACD incorporates both trend recognition and momentum into a single oscillator making it a very powerful trading tool. This oscillator consists of two lines, the MACD line and the signal line. The default setting for MACD subtracts a 26-period exponential moving average from a 12-period exponential moving average to form what is known as the MACD line.

The signal line is then formed by calculating a 9-period exponential moving average of the aforementioned MACD line. These two lines are then plotted together in an oscillator with a horizontal line known as the zero line. The signal line is oftentimes red with the MACD line typically blue. When the MACD is above the zero line it means that 12-period EMA is above the 26-period EMA and vice versa.

The most common way that the MACD oscillator is used is by looking at the relationship between the MACD and signal line. A bullish signal is generated when the MACD line crosses above the signal line and a bearish signal is generated when MACD crosses below the signal line. Traders can also measure the strength of a trend by examining the relationship between the MACD and signal line.

The greater the separation between the two lines, the stronger the trend is. Oftentimes, charting software will plot this separation by means of a histogram above and below the earlier mentioned zero-line. Another way in which more advanced traders employ the MACD oscillator is to look for divergence. Negative divergence is found when a relative high for a security is not confirmed by a relative high for MACD.

It is also found when a security makes a new low, but MACD does not form a new low. This can oftentimes be a signal to a trader that a trend is running out of momentum.

The Stochastic Oscillator



It was developed by George Lane in the late 1950’s as a momentum indicator that compares a security’s closing price to its price range over a predetermined period.

The idea is that a security’s price will typically close near its high and in a downtrend will typically close near its lows. Two lines, called fast and slow stochastic, are plotted in the oscillator that has a range of zero to 100.

The most common setting for stochastic requires three inputs: the first parameter is used to create what is known as the %K line, the third parameter is used to create the %D or signal line, and the second parameter is used to smooth the %K line. The default setting on my charting software uses (14, 1, 3). While some may find these parameters useful, a minor adjustment using 3 as the middle parameter creates a smoothing factor that in our opinion makes the oscillator easier to read.

Typically two lines are drawn through this oscillator, one at 20% and the other at 80%. These lines are drawn to identify overbought and oversold conditions. The most common way in which this oscillator is used is to identify overbought and oversold conditions. When a security’s stochastic oscillator moves above 80% it is often a sign that the current trend may soon lose momentum.

The same can be said when a stochastic reading falls below 20%. It is often a signal that a downtrend is running out of steam and may soon reverse course. As was the case with MACD, many traders look at the stochastic oscillator for divergence from the security price. When a stock makes a new high and the fast and slow stochastic are already moving lower, it is a strong signal that the trend may be over.


The Relative Strength Index (RSI)



The RSI was developed by J Welles Wilder in the late 1970’s. RSI is a momentum oscillator that compares the magnitude of a security’s recent gains to the magnitude of its recent losses. Traders should note that the Relative Strength Index is different than the concept of relative strength, which measures the relative performance of an individual security to a certain benchmark such as the S&P 500.

Like the stochastic oscillator, RSI is plotted on a scale from zero to 100 and typically has two horizontal lines used to determine overbought and oversold conditions. Also like stochastic, the RSI index uses a default setting of 14-time periods, some Traders move that out to a 21 time-frame. The one difference in the parameters is that in the RSI index overbought is typically considered a move above 70%, while oversold is a move below 30%.

The RSI index is typically used to signal overbought and oversold conditions. Traders, like they do with MACD and stochastic, also look for negative divergence between the RSI index and its underlying security. Another way in which RSI is analyzed is when traders look for moves above and below 50%. Moves above 50 indicate average gains for this security have been greater than average losses for the stated time period.


Non-Trending, or Channelling Markets
Now that we have discussed some of the more popular technical indicators and how they are used it may be important to discuss the best times to use these indicators. Oscillators that are confined to a scale of 0 to 100 such as Stochastic and the RSI index work best when the market lacks a major trend. If a security is in a strong trend it will oftentimes remain in what is considered overbought or oversold territory for an extended period of time producing many false signals. However if the market lacks a clear trend, oscillators such as Stochastic and the RSI Index become invaluable tools for determining turning points in the market.

Strong Trending Markets, (not what we have right now)
When a market is in a strong trend, moving average crossovers or MACD will prove most valuable. In regards to Bollinger Bands, they have stood the test of time, producing important signals in both trending and non-trending markets. One very important thought regarding Bollinger Bands that actually relates to all technical indicators is that the longer the time frame, the more accurate the signals.

Jack
TheLFB Team ©
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