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Section 5: Putting It All Together

Weve seen a myriad of tools that can help us find trends. In fact, you may now have too much information to use effectively. In our next and final section, were going to look at streamlining your use of these indicators and patterns. Our goal is to fully understand the advantages and drawbacks of each tool, so youll be able to determine which ones work for you and your plan and which ones dont. Some of this discussion moves into theory rather than application, and well also lay out some of the common parameters used in technical analysis. Lets discuss some concepts first. There are two types of indications or chart patterns; leading, and lagging. A leading indicator gives a buy signal before the new trend or reversal occurs. A lagging indicator, as you may guess, gives a signal after the trend has been initiated, and trend momentum is established. Your first thought may be that leading indicators are more profitable, since you would be able to capitalize on a new trend right at the onset. This is correct you would catch all of the trend. However, you would also experience more fake-outs, since many leading indications are quite subject to erroneous signals. The alternative is to use lagging indicators, which arent as prone to errors. Lagging indicators only give signals after the price change is clearly forming a trend, but in doing so, you experience a delay in entering a position. Often the biggest gains of a trend occur in the first few days, so by using a lagging indicator you would miss out on much of the potential profit. This concept is critical to understand, if only to allow us to logically organize our technical analysis tools. For the purpose of this book, lets broadly categorize all of our technical indicators into one of two categories: oscillators, and momentum indicators. Oscillators are leading indicators, and momentum indicators are lagging indicators. While the two can be supportive of each other, they can frequently conflict. This is not to say that one or the other should be used exclusively, but you must understand the potential pitfalls of each. Oscillators/Leading Indicators An oscillator is any object or data that moves back and forth between two points. In other words, its an item that is going to always fall somewhere between point A and point B. For the purposes of this discussion, think of our technical indicators as either being on or off. More specifically, an oscillator will usually signal buy or sell, with the only exception being instances when the oscillator is not clearly at either end of the buy/sell range. Does this sound familiar? It should. Stochastics, parabolic SAR, and the Relative Strength Index (NOT Relative Strength) are all oscillators. Our sentiment indicators (Rydex ratio, put/call ratio, and the VIX) are also oscillators. Each of these indicators is designed to signal a likely reversal, where the previous trend has run its course and the price is ready to change direction. Lets take a look at a few examples.

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On our chart of H&R Block below, we have added a parabolic SAR indicator, as well as an RSI and stochastic oscillator. As we have already learned, when the stochastic and RSI charts begin to leave their oversold region, that is a buy signal. Here we got sell signals in early January. The parabolic SAR marker also indicated that the uptrend had been exhausted when it moved below the price bars. All three of these sell signals occurred within three days of each other, and this would have been an excellent trade. Notice how we actually got a stochastic sell signal in late December as well. That is why we want to confirm reversals with other indications.

We also got a buy signal from all three indicators in mid-February. As before, one of the indicators (the RSI indicator) gave a buy signal a little too soon. It then gave an accurate signal a bit later, which coincided with signals from the stochastics and parabolic SAR signal. Notice how these signals occurred before the new trend started. That is the advantage of leading oscillators.

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Lets take a look at the same leading oscillators going awry, just to realize that these signals are not infallible. Our buy signal was accurate, getting us in very near the bottom (around $28.00) for Pfizer (PFE). Within nine days of the original signal, stochastics was giving as a sell signal, RSI was not giving a new signal at all, and the parabolic SAR was still giving bullish indications.

What happened to such a good set of indicators? The answer lies in the method of calculation for each one. Stochastics is based on the high-to-low range on a daily basis, yet doesnt account for changes from one day to the next. The Relative Strength Index (RSI) uses changes from one closing price to the next. Parabolics has its own unique calculations that can further create conflict. In this particular example, stochastics went to the overbought area too soon because it was affected by a lot of price change within a short amount of time. RSI was not. Thats the nature of oscillators they assume that a particular chart pattern always results in the same reversal. Of course, thats not the case.

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While being aware of why a leading indicator may be in error, there is no particular way to avoid them. More often than not, if youre getting mixed signals on a particular stock or index, youre better off doing nothing than taking a best guess. In other words, if a chart doesnt meet all your criteria, dont force the trade move on to the next one that does meet your criteria. That said, there are optimal settings that are commonly used for these indicators that we just looked at. They are as follows: Parabolic SAR: Step: 0.02 Limit: 0.2 Dont worry about these in detail; just understand that they are sensitivity adjustments RSI: Length: 14 bars (try 10 bars as an alternative) Oversold: 30-35 Overbought: 65-70 More often than not, youre better off adjusting the oversold and overbought settings rather than trying to make the RSI line move in greater distances. To make the RSI line move faster into or and out of the oversold or overbought areas, some traders will shorten the length (or reduce the number of bars in the calculation). This is not advisable, as it creates an erratic line. Stochastics: Length: 14 bars (as an alternative, you may try between 9 and 21) Smoothing Length: 3 Oversold: 20 Overbought: 80 The smoothing length is simply a calculation that allows you to draw a smoother slowK or slowD line, without causing a lag. If you wish to make your stochastic lines move at a different pace, adjust the length or the %K and %D (or length). Unlike RSI, with stochastics you can adjust your oversold and overbought setting without sacrificing accuracy. Some traders use 30 and 70 as their thresholds.

Lagging/Momentum Indicators So how do we spot momentum? Our indicators that can do so have already been identified as MACD, ADX/DMI, momentum, relative strength (not RSI), and moving averages. These indicators will spot trends once they have been established, at the expense of delayed entry. The advantage is a lowered likelihood for errors.

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Merrill Lynch (MER) shares rallied from a low 34 to 56 over a three month period. MACD, DMI/ADX, and an EMA crossover all gave a signal at some point during the upturn, although none occurred at the same time. The signals were all accurate, despite getting you into the stock after a large portion of the growth had already happened.

Ideally we would have like a MACD crossover above the zero line, but this was still a good signal considering the EMA crossover and the DMI line crossover. Notice how the DMI chart and the MACD chart both gave potentially false sell signals throughout November and December. These signals didnt follow through, though. The 10 day EMA staying above the 20 day EMA was an indication that the trend was still strong.

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Lets take a look at the downside of those same three lagging indicators on a chart of TriContinental (TY). By the time all three indicators were in agreement, the stock had nearly topped out at 16.00. Not only would you have missed the majority of your profit potential, youd be setting yourself up for a loss the stock pulled back to less than 13.00.

This is not to say that you have to wait for all three signals before taking action. But it is more comfortable to have a few indicators in agreement, rather than just one. There is one important note about DMI lines that we touched on briefly earlier in this workbook. The official DMI signal is a crossover of the DMI lines. However, we can see above that when the ADX line (dashed) and DMI- (thin line) started diverging in late July that it occurred at the beginning of the upturn. The ADX was still on the rise, but the DMIline was falling. While this is an unconventional use of the ADX line, here it would have been an effective one, if only to confirm the MACD crossover.

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As with all indicators, you have the choice of parameters you can use to fine tune your momentum indicators. Optimal settings for momentum indicators are as follows: Moving Averages: Short term Long term line 1: 10 day exponential moving average line 2: 20 day exponential moving average line 1: 50 day simple moving average line 2: 200 day simple moving average

ADX/DMI: DMI+: 14 bars DMI-: 14 bars ADX: 14 bars or 25 bars MACD: Fast MA: 12 bars Slow MA: 26 bars MACD MA: 9 bars (Remember, the fast and slow moving averages dont appear on the chart only the difference between the two appears on the chart. The MACD MA will be the slower moving average) Momentum: 10 or 20 bars. (10 for short term, 20 for intermediate term)

You should experiment with these settings, but if you find yourself micro-adjusting these parameters, then you may need to rethink how youre using the tools. They should be widely effective, but will not be 100% accurate. Thats ok. Frequent fine tuning may improve results for one stock or one timeframe, only to hamper results with other stocks and other timeframes. You want your indicators to be simple to use, so once youve found settings that work, you really shouldnt need to adjust them. Now that we understand the advantages and disadvantages of oscillators and trend indicators, we have one more piece of the puzzle to add. Fortunately, weve already explained the last part of the puzzle. Now its time to apply it. How does one effectively know whether to use oscillators, or momentum indicators, or both? After all, we know they dont always work in tandem. When do we favor one over the other? The answer lies in Bollinger bands, Acceleration Bands, moving average envelopes, and support and resistance lines.

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Reading The Market Lets revisit some concepts from section 3. We have seen that support and resistance lines are barriers to stock prices. While a stock may move back and forth between these lines, the most common occurrence is to reverse when prices hit those levels. But as we have seen, when a price breaks out of that range, it usually does so in a big way. Likewise, Bollinger bands usually contain the price of a stock inside them. But when you do start seeing prices outside of the Bollinger bands, its quite likely that shares will continue to move in that direction. This concept is true for all sorts of bands, envelopes, and support and resistance lines. The most critical moment for a stock or index is when it approaches these lines. It will either cross them, or it will touch them and reverse the other direction. Lets define these ideas in real terms. Crossing over bands or support/resistance lines can be considered a continuation of a trend. This continuation of a trend is a sign of momentum. This type of environment is called trending market. It is here you would want to use trend or momentum indicators. On the other hand, if a stock or index fails to cross these lines, and reverses instead, you may be in a reversal oriented market. This type of environment is called a range-trading market, because prices will only move between two levels. This is where oscillators are most effective. Once you are able to identify the type of market you are trading in, you will then know which indicators to place the most weight in, and which ones have less meaning at that time. This is no easy task. In fact, this may be the most challenging part about technical analysis. While we will explain it as a science, it truly is an art that can only be self-learned. But if you learn it, the use of the technical analysis tools will be easy. As before, lets explain the concepts of trending versus range trading with a few graphic examples. In the image below, we have a one year chart, showing both a trending and rangetrading market.

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As you can tell from the previous graphic, the QQQs bounced around inside support and resistance In July and again in early 2003. When they werent oscillating between support and resistance, they were moving either up or down with very little variance. Obviously the gift of hindsight is valuable, but we were able to discern the trending environments and the tradingrange markets while they were happening. Lets take a look at similar scenarios with other technical analysis tools. Remember we had mentioned that Bollinger bands have characteristics of momentum indicators as well as oscillators? In fact they can be used as support and resistance levels, with the key exception being that they are not straight lines. Rather, they adjust for volatility. All the same, as the price approaches a Bollinger band, the stock either crosses above it (indicating momentum) or it touches it and reverses (indicating a reversal). Take a look in the example below. Here we can see how Bollinger bands actually gave more accurate indications of support and resistance levels than our actual support and resistance lines.

Compaq moved back and forth between 25 and 29 between April and June. It was contained within support and resistance lines, but held even tighter within the Bollinger bands. The breakout from resistance and the upper Bollinger band were nearly simultaneous. At that point, oscillators became less effective and momentum indicators became important. Bollinger bands served as both types of indicators.

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Lets take a look at the same scenario in detail, this time applying a stochastics oscillator as well. Compaq was touching the upper Bollinger band right as Stochastics was saying overbought/sold. These both proved to be great indicators during the entire time that CPQ was trading in that range. However, stochastics gave a few errant signals in late July, just as Compaq shares were rallying. At that point the oscillators became ineffective. However, the Bollinger band was still an effective tool as spotting the switch from range-trading price movement to bullish momentum in August.

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How would a momentum indicator look for the same situation? Lets see. We actually got the bullish MACD crossover before the breakout. However, we also got errant MACD crossovers many times prior to that (since there really wasnt any momentum). Although the actual breakout from resistance and the upper Bollinger band came well after the MACD signal, that doesnt make that momentum signal any less valid; it supported the other data you were seeing. Besides, wed rather see the MACD lines above the zero line to confirm the strength of the momentum. This is a fine example of using all three types of indicators. The oscillator worked for a while, and when it failed, the momentum indicator was effectively applied. The third indicator (the Bollinger band) was able to act as both an oscillator as well as a momentum indicator. That versatility is why Bollinger bands are so popular.

The lesson to be learned here is being adaptive. An indicators failure is not bad it just means that something significant is happening with the stock, and you should be aware of it. The potential frustration that many traders experience is the insistence on using range-trading techniques even after you get trending indications (or vice versa). Once price actions creates an errant signal, at least reassess your techniques. Change them only if you need to. Obviously this is not easy, but it will become easier with experience. Lets continue on with other examples.

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In September and October of 2002, Dow Chemical (DOW) was establishing a strong, downward sloping, resistance line. It was approaching this line every few days and bouncing off of it to move lower than it was previously. While it was in this back and forth pattern, an oscillator was an effective tool. Here we plotted the relative strength index (RSI), which did indeed signal a short term bottom in early October the stock shot back up to 28 from 25 shortly after the signal. However, our DMI indicator would have failed to give that signal. The DMI lines didnt create a bullish crossover until the stock had already hit the resistance line.

In late November DOW finally broke through its resistance line, breaking out of its range. The break above the resistance line was a bullish signal, and was confirmed by a bullish DMI cross. Although DMI+ (thicker line) crossed over DMI- (thin line) prior to the breakout, the signal is still a valid indication of momentum. The rising ADX (dashed) is even further evidence of a strong trend in development. It is at this point that the RSI oscillator becomes ineffective, as it gave an erroneous sell signal in early December, and an erroneous buy signal throughout February.

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Lets take a look at the parabolic SAR oscillator and the momentum indicator called momentum. In late 1999 and early 2000 we can see that Pfizer was bouncing around between 31 and 37. The parabolic SAR marker accurately identified two tops as well as two minor bottoms, giving the signal right at the time of reversal (which was right at the time PFE met support or resistance). Had you been following the momentum indicator, you would have gone long right as the stock turned down. The parabolic SAR was better suited to spot the trading range.

Conversely, in April when Pfizer shares broke out of resistance, we already had a buy signal from the momentum indicator. Remember, a full buy from the momentum line comes when the line is rising and above zero. You also had a bullish parabolic SAR indication the day before the breakout, but once shares got out of the trading range, the momentum was obvious. In this case the parabolic SAR and the momentum line agreed with each other for most of the uptrend. However, the parabolic SAR would have given you a couple of sell signals during that upturn that would have best been ignored. The momentum line was still well above zero and rising just like the stock. This is why its important to understand what kind of market youre in. Ignoring the wrong kind of signal is as much of a skill as acting on the right signal.

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110 Checkpoint 5 Final Exam

You should have reviewed all of the book material and passed the previous checkpoint tests before continuing on to the final exam Putting It All Together. If not, it is recommended that you go back and do that first. On the following pages you will be presented with three charts, each of which will have a different set of technical indicators and chart patterns. Although there are only a few questions, this IS a difficult test. You will be asked to write your opinions of indicators in the three scenarios. There are no multiple-choice questions, and there are no fill-in-the-blank questions. You will then compare your answers with our analysis of the same scenario. There are no specific right or wrong answers, but your analysis should closely match ours.

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Scenario 1. In the chart of IBM below, we have plotted 10 and 20 day EMA, an RSI chart, trade volume, and MACD. With an explanation of your rationale for each indicator, what is your assessment of this chart? Would you buy, sell, or do nothing?

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Scenario 2. In the chart of Pepsico below, we have plotted a 10 day EMA, the VIX (with Bollinger bands), a relative strength chart (comparing PEP to the S&P 500) and stochastics. With an explanation of your rationale for each indicator, what is your assessment of this chart? Would you buy, sell, or do nothing?

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Scenario 3. In the chart of Coca-Cola below, we have plotted Bollinger bands around the price chart, as well as a 10 day EMA. We also have plotted stochastics and a DMI chart. With an explanation of your rationale for each indicator, what is your assessment of this chart? Would you buy, sell, or do nothing?

Stop! You have completed section 5. You may check your answers with the answer key. This is the end of this workbook.

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Scenario 1. Based on the chart, IBM would have been a good purchase. It had made a trading range between 66 and 73 after from June through August. In August it broke past its upper resistance line, which would have been an important buy signal. RSI actually did give a buy signal when it hit the oversold threshold in June. As you can see, it did start rising after it hit the oversold line. That in itself would not have been enough of a signal to actually merit making a purchase, but it did confirm what other indicators eventually said. MACD was similar to RSI in that it gave a buy signal very early. Bullish MACD crossovers that occur beneath the zero line arent really the strongest buy signals. But when those MACD lines stayed bullish AND crossed over the zero line, that proved to be a great buy signal. The fact that this occurred at the same time as the break through the resistance line is even that much more bullish. Volume wasnt very helpful in this particular chart.

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Scenario 2. Based on this chart, we would have avoided taking any position, long or short. When the share price fell under the 10 day exponential moving average, that was a sell signal. But at the same time, the VIX was rising, and starting to form a peak. This would have been a sign that a market rally was soon approaching, and that could potentially lift shares of PEP back out of their slump. The relative strength analysis was making a sell signal when shares of Pepsico started underperforming compared to the rest of the market (signaled by the cross under), but stochastics had indicated that shares were already oversold and could reverse soon. While stochastics was bullish in the sense that shares were oversold, it was also a bearish indication. The stochastic lines had not crossed back above the oversold threshold yet, and as we have seen, stocks can decline greatly while the stochastic lines stay in oversold territory. Considering the mixed data and volatility, this trade would have been best left alone.

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Scenario 3. This was a pretty straightforward sell signal. The upper Bollinger band had acted as resistance, and when shares fell under the 10 day EMA, that was enough of a signal to sell or short Coca-Cola. That opinion was supported by stochastics, when slowK crossed under slowD and then the both fell back under the overbought line. ADX/DMI further confirmed the sell when the DMIminus line crossed over the DMIplus line, and ADX started rising.

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This is the end of the BigTrends technical analysis guide. We hope it proves beneficial to you and your trading. While we have given you a thorough understanding of the primary indicators and chart patterns, nothing teaches like experience. For that reason, we encourage you to paper-trade for a while, to get a good feel for how these indicators work, including their shortcomings, before committing any money to them. Its also important to note that while these techniques are effective, there are always exceptions. It is the net result you are interested, and not necessarily every trade. There will also be conflicting signals given at any point in time. Thats the interesting part about technical trading. It is not a science its an art. The best way to learn an art is to simply do it. Dont try and use all of the indicators and signals at the same time. You will never see all of them in agreement, and you will get far more information than you can process. Instead, find the ones that work best for you and your strategic style, and become a master of them. In our experience, the best trading systems are the simplest ones.

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Inquiries about this workbook and other BigTrends services can be made through our website BigTrends.com, or by calling 1-800-BIGTRENDS/1-800-244-8736.

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