Proper usage of Technical Indicators

        

Earning Channel

 

Summary

  • In John Murphy’s classical “Technical Analysis of the Financial Markets”. He mentioned, “As Wilder points out,
    • One of the two major problems in constructing a momentum line (using price differences) is the erratic movement often caused by sharp changes in the value being drop off. Some smoothing is, therefore, necessary to minimize these distortions.
    • The second problem is that there is the need for a constant range for comparison purposes.”
  • In “All about Market Indicators”, Michael Sincere summarized how indicators may be misused. He suggested that users need to become very sophisticated to make the indicators working for them.
  • This article will discuss how to make use of the technical indicators properly and without pain. The general practice is simply to comply with the bigger picture, the trend, and principles of channel trading.

 

  1. The limitation of technical indicators

Mr. Wilder pointed out the limitations of most if not all of the indicators. An indicator is often based on an average of prices, an average of the difference of prices, or so, for a period of time.

 

Once there is a spike, either overshoot or undershoot, the average will be distorted for a period of time, especially at the beginning and ending of the period when the spike is counted.

 

E.g. 5,6,7,20,9,8,7,6,8,9,11,7,6,8

The “20” will distort the average for a period of time.

 

The distortion is even worse when the calculation takes into account not just the closing prices but the intraday highs and lows.

 

Smoothing techniques, such as exponential averaging, are then applied to smooth out the spike. Which results in the delay of the signals.

 

  1. The advice from Michael Sincere

The following advice is repeated by the author of “All about Market Indicators”, and by many creators of indicators, interviewed and quoted by the author.

  • The indicators are not actionable trades, but only guidelines.
  • Observe indicators in different market conditions.
  • Experiment with the default settings. Be flexible.
  • The indicators may be too noisy or too slow.
  • Several indicators are used to find oversold (OS) and overbought (OB)
  • Overbought and oversold are relative terms.
  • The indicators may stall (stay overbought, oversold, or in the middle). “walk the band” “chronically overbought” “the market in the danger zone doesn’t mean it will reverse anytime soon.”
  • Combine multiple indicators and rules and you might stumble across something works really well.
  • “if you follow this (death cross) supposedly bearish signal, you will lose money 72 % of the time.”
  • “RSI divergences work less than 50% of the time.”
  • “The best advice this author can give is to use Stochastics with care.”
  • “Don’t ever forget that reading these indicators is an art form.
  • “Have a mixture of indicators, such as price, breadth, and volume.”

 

Quite discouraging, isn’t it?

 

How could an ordinary investor gain benefits from these indicators?

Probably not even for most of those who devoted a lot of time in studying the conventional technical analysis. We speak from our experience in servicing hundreds of thousands of individual investors in the past 20 years.

So, are you ready to give up?

 

No! Please don’t.

Many of the indicators are created in the 70’s or 80’s when the computers were not available or had limited power. Today, we can use a computer to help us find the visual trends and to draw them for us. With the visible trend, you can apply the indicators properly. In fact, most of the time, you don’t even need to use these indicators.

 

However, as there are many investors already familiar with technical indicators, let’s see how we can avoid common misusages, and apply the indicators to our benefits.

 

  1. Properly using the indicators with the channels

Please remember, the purpose of using indicators is to help us identify where the trend is going. Michael Sincere said it very well,

 

“Keep in mind that traders put market indicators on a chart for one main reason: it creates a powerful visual. One look at a chart (a picture is worth a 1,000 words) and you can see where the market is headed.”

 

So, what could be more obvious when the price movement forms a channel, either up, down, or sideway?

 

It is strongly recommended to buy or short stocks with the fundamentals matching the price movements, and the price movements form channels.

 

Earning Channel implements the principles of channel trading.

 

In the finding of channels, Earning Channel tries to find the longest visible channels. In doing so, the system would eliminate some of the spikes. The system also allows users to adjust the channel to meet their purposes.

 

The finding and drawing of the channel already overcome the shortcoming of the fundamental of technical indicators – the inclusion and the smoothing of spikes.

 

So, Earning Channel firstly provides the bigger picture – the trend.

Secondly, it removes most of the spikes and the necessity for smoothing,

 

Now, the third important part.

  • “The indicators are not actionable trades, but only guidelines.

 

Channel boundaries are guidelines as well.

 

What makes the guidelines into useful actions are the four trading lines and two trading points provided by the Earning Channel. The definitions and usages of the channel and channel trading are repeated at the end of this article for your convenience.

 

The fourth points, the stalling of the signals, or the chronical overbought, that renders the momentum indicators into useless. For instance, when the price movement forms a strong up-channel, the momentum indicators may stay in the overbought region. In another case, when the channel is moving up steadily but not sharply, the indicators never reached the alerting zone. In both cases, the momentum indicators could not give you signals to trade. However, if you follow the channel trading lines, you wouldn’t be bothered by the stalling of indicators.

 

The fifth points, the indicators are often misunderstood or misused, by novices, and also by people who used them for a long time but never really understood them.

 

The usefulness of the indicators is not just in the readings of the indicators themselves, but even more so on the crosses, the deviations, and the bias of the indicators.

 

When used in conjunction with the principles of the channel trading, it is less likely these indicators will be misused. They could, in fact, become quite intuitive and useful.

 

Before going further, let’s review the top three rules of channel trading.

Rule 1: A channel must have two peaks and two dips. Don’t act before a channel is formed. Stay on the sidelines when the trend is unclear.

Rule 2: Go away, when a channel is broken. Back to rule 1.

Rule 3: Don’t establish a position in the wrong direction. Don’t buy on the way down. Don’t short on the way up.

 

Let’s see the definition of crosses and the correct usage of them in channel trading.

 

Definitions of crosses

Crosses happen when the indicators have a faster and a slower one. E.g. MA20/MA50, %K/%D, MACD/Sig9. The slower one could be the one with a longer duration or one that is the (exponential) moving average of the faster one.

  • A golden cross happens when the faster indicator moves across and above the slower indicator. It indicates the recent price movement is upward.
  • A death cross happens when the faster indicator moves across and below the slower indicator. It indicates the recent price movement is downward.

 

Novices use them literally, that is to buy whenever there is a golden cross, and to sell when there is a death cross.

 

To do it right, first apply rule 3 of channel trading:

Rule 3: Don’t establish positions in the wrong direction. Don’t buy on the way down. Don’t short on the way up.

 

Using crosses with the channel

  • In an up-channel
    • When the golden crosses are close to channel-buy-lines, they are buying signals
    • When the death crosses are close to channel-sell-lines, they are selling signals
  • In a down channel
    • When the death crosses are close to channel-short-lines, they are shorting signals
    • When the golden crosses are close to channel-cover-lines, they are covering signals.

 

Let’s take RSI for example.

The conventional usage for RSI is:

  • Detect overbought and oversold
  • Work better for short-term, individual stocks, and in trading range (wide flat channel)
    • RSI < 30 buy
    • RSI > 70 sell
  • Generate a lot of signals (noises)

 

When used with channel trading, the RSI becomes a confirming aid and is less likely a noise.

  • Don’t use in the wrong direction
    • RSI < 30 buy – only when the previous down-channel has been reversed (a short-term up-channel is formed), otherwise, it will be a false bottom fishing.
    • RSI > 70 sell – only when the up-channel has been reversed (a short-term down-channel is formed), otherwise, it will be a wash-up or selling too early.

 

In the example below, it is quite tempting to buy at the point, when the RSI < 30.

However, at that point, the previous downtrend has not been reversed yet.

So, if we apply channel trading, in the following figure, we can see that the sudden drop passed the channel break-down line of a down-channel. It is the time to take profit for a short position, but not the time to go long.

 

Remember rule 1 of channel trading: don’t buy until a channel is formed. Please see that even from the lowest RSI to the intermediate peak at the green arrow, the original down-channel has not been broken, and the upward movement has not yet formed an up-channel. So, if one buy at RSI<30, he or she will run into a false bottom fishing, unless he/she is a day trader.

Not to make our reader too tiresome, we’ll discuss stochastics, divergence, and others in other articles.

 

Hope this article is useful to you. Good luck on your trading and investment.

 

Appendix

 

What is a channel?

A channel is a specific form of an obvious trend.

  • A channel is formed when the price moves in a waveform and has at least two peaks and dips (troughs) touching the resistance and supporting lines, and these two lines are about parallel.
  • A channel indicates, in the period of time, people (little guys as well as institutions) think and act alike and are not in a panicking mode (the price movement is not straight up nor straight down).
  • The longer the channel, the more touches the peaks and dips, the more reliable the channel is.

 

Channel trading actions.

How to make use of the channel to trade?

 

Earning Channel added four trading lines and two trading points to capture optimal timing for channel trading. The four lines are:

  • Channel buy/sell lines for an up-channel, and channel short/cover lines for a down-channel
  • Channel break-up line and break-down line.

 

A buy/cover line and a sell/short line are within the boundary of the two walls of the channel. A channel sell/short point is reached when the price touched the upper wall and bounces back to the channel sell/short line. A channel buy/cover point is when the price touched the lower wall and bounces back to the channel buy/cover line. A channel buy/short point is the optimal timing for you to build up a long/short position. A channel sell/cover point is a time for you to regulate your long/short position, and to take some profits.

 

The two other lines, channel breakout upward (break-up) and downward (break-down), are used mainly to guard the trading either for establishing a long position in an up-channel or a short position in a down-channel.

 

Please notice that all four trading lines are related to the channel lines, and thus when the price touches these lines it has nothing to do with your personal cost. It has to do only with the cost of all participants that moves the price. The default values of these lines in Earning Channel are percentages of the channel width.

 

Channel Trading Principles:

Rule 1: A channel must have at least two peaks and two dips. Don’t act before a channel is formed. Stay on the sidelines when the trend is unclear.

Rule 2: Go away, when a channel is broken. Back to rule 1.

Rule 3: Don’t establish a position in the wrong direction. Don’t buy on the way down. Don’t short on the way up.

Rule 4-1: Within a channel, use channel buy/short points to build up a long/short position.

Rule 4-2: Within a channel, use sell/cover points to regulate a long/short position.

Rule 5: Use channel break-up (break-down) to take proper profits from a long-term up-channel (down-channel).

Rule 6: Always use channel break-down (break-up) to stop losses and to protect your positions in an up-channel (down-channel).

The Earning Channel software, as well as the articles, tutorials and suggestions in the website and social media, are provided as tools and references to help users develop their own market analyses and make their own investment decisions. Users are ultimately responsible for the way in which they use this information to invest in the stock market. Nothing associated with the Earning Channel or the information presented in articles and tutorials should be interpreted as direct advice on buying or selling of securities.