Whether you use automated trading systems or trade discretionary and whether you concentrate on stock indices, commodity spreads, or other underlying assets, you probably know that the technical analysis instruments serve for building quality trading systems and defining the enter and exit conditions. Technical analysis uses indicators that say the trader when to enter and exit the market so that trader can get the probability of profitable trades on his side or, in other words, obtains a “consistent statistical advantage”. Technical indicators help us to obtain a broad overview of the current market structure and activity so that we could be able to assess when and to what position we should enter in order to maximise the likelihood of winning trades. If we worked with bar (or candle) price charts only, i.e. with “Price Patterns“, our market analysis would be, in my opinion, quite narrow and limited. On the other hand, there are traders who successfully trade by using price patterns only.
Each indicator is essentially a program that tells the computer what data to use, how to calculate, and how to display the results. Nowadays, there are hundreds, if not thousands of available indicators. The most basic ones are included in almost all software platforms. Then there are also highly specialised indicators that can be found only in some of the software. From time to time I meet traders who create their own indicators and use them in their trading systems. They believe that they gain sort of competitive advantage over the other traders. From my own experience I learned that we can usually manage with the indicators included in professional software platforms.
To get a better overview we will divide the technical analysis components into several categories and explain each category in detail.
- Price indicators
- Trend indicators using averages – e.g. Simple Moving Average (SMA)
- Oscillators – e.g. Relative Strength Index (RSI), Commodity Channel Index (CCI)
- Volatility indicators – e.g. Average True Range (ATR)
- Volume indicators (e.g. Volume)
- Open Interest indicators (e.g. COT Reports)
- Intermarket indicators (e.g. Market correlation)
- Market Internals
- Trend lines, Supports and Resistances, Patterns
Before I explain each category of technical indicators, I would like to remind traders that every coin has two sides. And this is doubly true in technical analysis. Therefore, I think I should summarise the essential advantages and disadvantages of technical analysis:
- Technical analysis is not an exact science
Remember that there are no 100% probabilities in trading. If you think that you can identify all the profitable signals by using various technical tools and correctly predict the future market development you are very much mistaken. Technical analysis helps us to sway the probability to our side, i.e. to ensure that the sum of our profitable trades will be always higher than the sum of losing trades. Each trader is comfortable with somewhat different technical approaches and tools. The point is not to underestimate the preparation and training, paper trading, and backtesting. Exchange trading is not an exact science, there are no changeless laws. The only long-term law is the application of statistical advantages based on the probability theory.
- Time required for studying technical indicators, trend lines, supports, resistances, and patterns
Every trader was a novice once. Like in any other business there are no “shortcuts”. Therefore, you have to spend enough time studying technical analysis so that you would be able to find your own long-term profitable technical trading approaches. Do not rely on others and develop your own trading style. If you want to be a discretionary trader, draw support and resistance lines, trend lines, and other formations in charts. Also observe how your favourite indicators behaved in individual cases. You will see that you will begin to create your own strategies and tactics, i.e. your own trading system, for winning the tough battle called live trading!
In you are interested in automated trading systems (ATS), starting with the same observing the markets like the discretionary traders will definitely not be amiss. It is necessary to get a certain feeling for markets and be able to see certain nuances that you will then convert into a clearly defined algorithm. Be honest with yourselves and give the study its time. Concept, preparation, and planning always eventually decide on the final success or failure. This is true in trading and anywhere else. Keep it in mind!
- Technical analysis gives us the order and consistency
Whether you are a discretionary trader or you prefer ATS, the best thing on exchange trading is that you have the freedom to choose your individual trading approach. Everybody is unique and it is wonderful that you can take the full advantage of your uniqueness in the market. The market is actually a summary of hundreds, thousands, or even millions of different trading systems with various elements of technical analysis. Some of these systems are successful and some are not. A frequent paradox in trading is that the simpler technical analysis tools we choose, the more we successful we often are. Technical indicators can bring us order in the chaotic market environment (in case we sufficiently verified and backtested their readings). They help us to wait for the right moment for entering or exiting the market. Each of the signals sometimes also leads to a loss. Yet we know that the sum of losses will be lower than the sum of profits. This knowledge will keep us “above water” and technical analysis and the variety of its tools (when properly applied) will bring us the longed-for success in the long run. The proper application of technical indicators may, for example, consist in appropriate combining of indicators and using them in a certain symbiosis.
Today we will focus on indicators based on price ranges. We call them “Price technical indicators”. The aim of this chapter is not to teach you how to calculate various indicators but how to understand their values and how to use them in practice. Values of price indicators are derived from the price of the underlying asset. We classify them into:
a) Trend indicators using averages – e.g. Simple Moving Average (SMA)
SMA is calculated as the average asset price over a selected period in our chosen timeframe (e.g. daily timeframe, 5 min timeframe, etc.). The underlying asset´s price can be considered the, for example, OPEN, HIGH, LOW, or CLOSE price. In Fig. 1 you can see the 10-day moving average of the CLOSE price in the oil futures market.
In Fig. 2 you can see the significant difference after changing the length of the SMA period to 100.
Fig. 2: Oil market CLOSE price, 100-day moving average (blue curve)
You have surely noticed the fundamental difference between the 10-day and 100-day SMA. The 10-day SMA much more closely copies the current market price development, while the 100-day SMA is an irregular, nearly horizontal line.
SMA is a typical trend indicator designed to filter trades. It is definitely not a suitable indicator for timing position entries. Position entries are mostly timed by the use of oscillators about which we will talk later. As you can see in the charts (see Figs. 1 and 2) SMA indicators help us to identify the future market direction. If the current price is above the SMA (blue curve) we should consider entering into Long positions. In other words, we would speculate on a bull market (price increase). If the current price is below the SMA, we would speculate on a bear market (price decrease).
Moving averages definitely belong to each trader´s arsenal because as you could hear from me many times, the amazing thing about trading is that each of us can use a little different approach and yet be a successful trader. What might work for one trader may be an obstacle for another and vice versa.
Many discretionary intraday traders that I know work mainly with longer periods, i.e. SMA 100 and more. These long periods are used for identification of the long-term direction of market development. Such an identification helps them not to enter too often into positions and wait for the right opportunities.
Remember that saying “Trend is our friend.” is an essential prerequisite for a successful trend trading system and that SMA may be one of the tools that can help you to identify the trend with a certain probability. If you want to use SMA for timing of entering and exiting positions, you can try what many traders do – use crossing of SMAs with different periods (see Figure 3). However, in most cases these signals should be combined with other types of indicators which will be introduced in other paragraphs.
Fig. 3: Identification of position entries and exits by crossing of two SMAs – period 10 (blue curve) and 40 (purple line)
b) Oscillators – e.g. Relative Strength Index (RSI)
As an example of oscillators I chose the Relative Strength Index (see Figure 3). In Figure 4 you can see that the oscillator is usually displayed under the price chart. Numerical values of most oscillators range from 0 to 100. RSI measures the relative strength of the underlying asset and it is one of the oscillators that are very commonly used for timing of opening and closing positions. RSI is calculated according to this formula:
RSI(n)= 100 – [100 / (1 + U(n) / D(n))]
U(n)…sum of positive price changes over a period of length n
D(n)…sum of negative price changes over a period of length n
Fig. 4: Price chart of sugar (the upper part) with the RSI oscillator, period 14 (the lower part)
Oscillator readings are typical by “overbought” and “oversold” areas. In terms of technical analysis overbought means that the price of the underlying asset price climbed to such a level that the oscillator curve touched a certain predefined threshold. Overbought area (see Fig. 4) is the area above the level 70, oversold area is the area below the level 30. We can choose these levels at our discretion according to our own experience. In our case, (see Fig. 4) if the curve climbs above the threshold 70, the sugar market gets to the overbought area. Generally the overbought area is interpreted as a signal that the price of the underlying asset is overvalued and is very likely to fall in the near future. For the oversold area then applies a reverse analogy. Thus, if the oscillator curve falls below the specified threshold 30, the price of the underlying asset is probably undervalued and there is a high probability of a turnover, i.e. that the underlying asset price is likely to rise.
We can see in the chart (Fig. 4) that the RSI curve fell into the oversold area only once (the red part of the curve), as well as into the overbought area (the blue part of the curve). In both cases the price development really took the direction predicted by the oscillator in the following days. Combinations of oscillators and trend indicators can be used for building quality trading systems. However, I do not recommend to employ oscillators only, because such a view on the markets would be too simplified and it would lack other additional important information about the trend direction, which is provided just by trend indicators.
c) Volatility indicators – e.g. Average True Range (ATR)
Volatility reflects the potential uncertainty or risk regarding the intensity of future changes in the price of the underlying asset. A higher volatility means that the price of the underlying asset may have a large range. In other words, the price of the underlying asset may change dramatically in any direction in the near future. A lower volatility then means that the price of the underlying asset does not dramatically fluctuate and is likely to change in a calm manner. A classic indicator measuring market volatility is undoubtedly the ATR. Its value is calculated as the exponential moving average (EMA) of values within the “True Range”. True Range is calculated as the largest of the following three values:
- Price difference between HIGH and LOW of the current bar
- Price difference between CLOSE of the previous bar and HIGH of the current bar
- Price difference between CLOSE of the previous bar and LOW of the current bar
ATR´s period is often set to 7 or 14 yet of course many traders choose another value based on their own detailed analyses. The advantage of the ATR indicator is that it is variable in time and reflects the current market dynamics. It can be applied in various ways to many strategies, such as for determining Profit Target or Stop Loss (usually as a multiple of the indicator´s value). Many traders use ATR for determination of entry values – for example in “breakout strategies” you set a “breakthrough area” (e.g. BUY on the Simple Moving Average (SMA) for the last 10 CLOSE values plus ATR (7)). It can be also used for timing of entering into positions. If we see that the current market volatility is high (see Fig. 5), we will not enter the market. If, on the contrary, we see that the market volatility is currently low, there is a fair probability that we will be able to enter the market on the desired price (slippage may be lower than in a highly volatile market).
I use the ATR indicator in my own trading systems a lot. I appreciate the most its ability to adapt to the nature of the current market. This indicator helps me to define robust trading systems – i.e. entry and exit signals – because I adjust my Profit Targets and entry areas to the current market dynamics.
Fig. 5: Sugar market, price development of sugar in the upper part and development of ATR in the lower part
d) Intermarket indicators (e.g. Market correlation)
Intermarket indicators are used for assessment of relationships between markets. As they say, in today’s globalised world of the Internet “Everything is connected to everything, something more, something less”. Correlations between markets help traders to determine the future direction of the markets they trade. Yet as it is already a very advanced technique, we will keep this issue for some of the future publications. As novice traders you should only be aware of the fact that intermarket analyses exist and that they are performed via various useful indicators.
For now we will focus on indicators the basis of which is not the price of the underlying asset. We call them “Market Internals“. The essential indicators belonging to Market Internals are Volume and Open Interest. Let´s introduce these indicators in more detail.
e) Volume indicators (e.g. Volume)
Volume is an indicator reflecting the number of contracts traded during a specific period of time within the chosen timeframe. In the chart (see Fig. 6) you can see the Volume indicator in the form of red columns. The question of course is what does the Volume indicator serve for? For traders, volume is one of the basic guidelines about the market liquidity. We have already said that the higher the market liquidity is (the more transactions there is), the higher the probability that you will be able to buy or sell a commodity or other underlying asset for the desired price (i.e. without an unnecessary slippage). The question is which daily volume guarantees a sufficient liquidity? Based on my experience, any commodity market with the number of traded contracts between 10,000 and 20,000 per day is sufficiently liquid. Yet it really depends on your trading style (positional traders are able to cope with a higher slippage, but intraday traders need to have their orders executed at the specified price). There are traders who are able to earn a lot of money on illiquid commodity markets despite significant slippages. This is because they optimised their trading systems (“tailored”) for such market conditions. In other words, based on the historical data testing these systems take the high slippage into account. We definitely recommend beginner traders to thoroughly study volumes of individual markets. By doing so you will gain a global awareness about commodity markets – or about the markets which may offer interesting opportunities in the form of low slippage. Many traders use Volume for identification of entry and exit conditions for their trading systems. Of course, each trader can see slightly different relations between the behaviour of Volume and price. Regarding my live trading, Volume plays a very important role in some of my trading systems. I consider it a very important indicator because unlike all price indicators it is not only a mere price derivative and when sophisticatedly applied it brings a significant added value.
Fig. 6: Daily chart of sugar including Volume indicator, each column represents the total daily Volume
f) Open Interest
Open Interest (OI) is often misinterpreted as Volume. OI represents the total number of futures contracts that are not closed or physically delivered on a given day. In other words, it is the number of open contracts in a given time period. It says how much open positions there are at the moment. I know that it may be difficult for you to distinguish the real difference between Volume and Open Interest, so let’s try to explain it on a concrete example: On September 1, the value of OI before the market opening was 200,000. Thus we knew that before that there were a total of 200,000 opened futures contracts from previous days. Before the market opening the value of Volume = 0 because obviously no futures contract have been traded yet. Now imagine that on September 1 you were the first speculator and you bought 50 futures contracts (you opened a Long position). Now because for every buyer there must be a seller, and vice versa, there was a counterparty that sold us these 50 contracts (they opened a Short position). Please note that this trader did not enter into the Short position with aim to close an opened position. OI thus consisted of 50 Long futures contracts and 50 Short futures contracts, i.e. its value increased from the original 200,000 by 50 to 200,050. At this moment, the value of Volume on September 1 was 50. Then if you sold these 50 futures contracts and the buyer also closed his Short position be these contracts, the value of OI would return to 200,000 and the value of Volume would increase from 50 to 100.
Let’s show OI and Volume in the graphical form. On Fig. 7 you can see the daily chart of E-mini S&P 500 with OI (purple line) and VOLUME (red bars) in the lower part.
Fig. 7: E-mini S&P 500 daily chart showing the daily Volume (red bars) and Open Interest (purple line)
We can see one interesting phenomenon here. On some days the OI value exceeds Volume, i.e. the red bars are higher than the purple curve. This gives us a clear information about the E-mini S&P 500 market – there are many short-term speculators who open and close their positions within a single day which logically does not increase OI. This is because E-mini S&P 500 offers a very attractive liquidity and thus low slippages. This liquidity is created by “Market Makers”. I will tell you more about these entities further in this chapter. Now let’s have a look at the wheat market (see Fig. 8) where on the contrary OI is many times bigger than Volume. This gives us a clear information that the wheat market, like all markets of physical commodities, is dominated by producers, raw material processors, and long-term speculators who hold their positions for many days.
Fig. 8: Daily chart of wheat showing the daily Volume (red bars) and Open Interest (purple line)
However, Figures 7 and 8 have one thing in common. As you can see, when a futures contract is nearing its expiration, OI rapidly decreases. In E-mini S&P 500 this decrease occurred basically overnight, whereas the wheat contract´s OI was decreasing for several days. In charts chronologically joining contracts a sharp sudden rise in OI indicates transition to the next expiration period.
Discretionary traders do not use only indicators, but also the trend lines, support and resistance lines, or patterns. These tools are incorporated into charts shown in software platforms. They serve for identification and definition of position entries and exits. For traders using automated trading systems (ATS) trend lines and support and resistance lines have no practical use. Patterns can be used by ATS traders because they are relatively easy to program, i.e. to transfer into an algorithmic code.
Let’s introduce all three aforementioned elements of technical analysis in a little more detail.
A trend line is basically a straight line connecting major highs (in case of downtrend) or lows (in case of uptrend) in a chart. Drawing of trend lines is a very subjective matter which requires a long-term training and practice. Trend lines help us to visualise trends. Trend line breakouts may indicate opportunities for opening or closing positions because they often prefigure a trend reversal. In Fig. 9 you can see an uptrend trend line and a breakout signalising beginning of a downtrend. In Fig. 10 you can see a downtrend trend line and a breakout signalising beginning of an uptrend. Trend line breakouts thus represent buy or sell signals. In order to be able to confirm the trend´s validity, it is necessary to see at least three or more points where the price touched the trend line. Of course, the touches do not have to be accurate. Trend lines are frequently used elements of technical analysis and they have been known for decades.
Fig. 9: Uptrend, trend line and crossing signalling transition to downtrend
Fig. 10: Downtrend, trend line and crossing signalling transition to uptrend
h) Support and Resistance lines (S/R)
We can say without exaggeration that S/Rs are the very basic and essential elements of discretionary technical analysis. Basically, S/R determine points where the price bounces back and rejects to move further up (in the case of uptrend) or down (in the case of downtrend). When a price decrease of an underlying asset stops at some point and the price rebounds upwards we speak about a “Support“. It means that traders are not willing to sell under this price. On the contrary, when a price increase of an underlying asset stops at a certain point and then rebounds we speak about a “Resistance“. Trader are not willing to buy above this price.
Fig. 11: Partial Supports and Resistances
Fig. 12: Strong Supports and Resistances
In Fig. 11 you can see the individual Supports and Resistances. Fig. 12 shows also a “Flip” which is a point from which a Support starts to act as a Resistance, or vice versa.
S/R can serve for optimisation of position entries and exits, setting stop-loss and profit targets. Beginners who would like to profile themselves rather as discretionary traders should definitely learn to analyse S/R in the charts first. They need to learn to perfectly perceive and recognise S/Rs. The more markets a beginner “gets familiar with”, the easier it should be for him to identify S/R and set suitable entry and exit points, profit targets and safe stop-losses. Of course, it is ideal to combine S/R with for example indicators for identification of the best entry and exit points.
Please note that S/Rs are the essential elements of technical analysis for many discretionary traders (often also for ATS traders who can program S/R). Significant past S/Rs, as shown in Fig. 12, are often important for our future trading. It is because the market has a tendency to return to these important prices.
There are always only two options when the price reaches S/R: It can either bounce or break the S/R. The key is to understand that due to an increased supply and demand in the historically strong S/R these points often prefigure upcoming major movements with strong momentum which may have a high profit potential.
i) Patterns – e.g. Gap
Patterns are graphic price formations that repeatedly occur in charts. Each trader must “get them under the skin”. The ability to see formations is very different from trader to trader. The classic patterns include Double Bottom, Double Top, Head & Shoulders, and Gaps.
For now we will explain only Gaps. You can easily find Gaps in nearly every chart. Gaps are spaces that can be seen between the individual price bars in the chart. It is an area in which practically no trades were made. Gap represents the difference between the closing price of the previous day and the opening price of the current day. Gaps can be found especially in daily charts, but they also appear in for example one-minute charts of not too liquid markets (where large Bid-Ask spreads appear). Daily-chart gaps appear when an unexpected event, such as a natural disaster or a sudden change in the weather, appear during the night when the futures market is closed. Lots of traders then begin to submit their orders for the next business day´s open even before opening of markets. This huge amount of trading orders then causes that the opening price is higher or lower than the previous closing price. Gaps often appear after weekends when the markets were closed and some unexpected and unplanned fundamental event appeared.
Fig. 13: Daily chart of sugar
Fig. 13 shows a gap resulting from a major event (e.g. a natural disaster, change of weather, etc.) and caused by a huge amount of orders submitted in advance to market open.
Gaps can be a very valuable technical help for traders because they usually get filled in the future. It often turns out that the order accumulation caused by various unexpected fundamental influences was a false alarm and markets return to their yesterday’s closing prices, i.e. the gap is filled – see Fig. 13. Yet this is definitely not an unchangeable rule. Remember that there are no 100% rules in trading. It is always about the ability to get long-term probabilities on your side. However, each trader should be aware of the fact that gaps occasionally appear. Especially in multiple-day positional trading you need to have the possibility of gaps incorporated in your trading system. Gaps can be good friends if your open positions are in their direction, but otherwise they are really an enemy to your account. I. e. they can bring you good profits, but also unexpected losses. Many traders base their trading systems purely on a speculation that gaps will be filled again in the future when the panic in the market ceases. You can be very successful with this approach as there are many paths to the desired success in trading. You will encounter almost no gaps in intraday trading of futures on stock indices, largely because of the high liquidity of these markets.
Above we have explained the basic principles of the discipline which can be an essential part of our successful trading. We have also divided indicators according to their intrinsic characteristics into several categories and clarified what are the basic advantages and disadvantages of using technical analysis. Then we have explained the importance of various types of price indicators which constitutes one of the fundamental pillars of technical analysis. In my trading I insert price indicators into my automated trading systems (ATS) via algorithmic codes.
We have introduced two very important indicators which are essential for each trader – Volume and Open Interest. Even if you do not use them in your trading system, you have to know these indicators in order to be able to monitor market liquidity. The final part of the chapter contains introduction to Trend Lines, Supports, Resistances, and Price Patterns, specifically Gaps. These tools are primarily used in discretionary trading systems, often in combination with indicators. However, there are also traders who claim that a successful trader can get by only with chart, trend lines, supports, resistances, and possibly with some price patterns. Another group of traders takes the view that one cannot do without indicators in trading. Technical analysis must be seen as a means to get long-term statistical advantage called “edge” and not as a holy grail that will always tell you the future direction of the market.
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