Indicators
An indicator is a mathematical calculation that can
be applied to a security's price and/or volume fields. The result is a
value that is used to anticipate future changes in prices.
A moving average fits this definition of an
indicator: it is a calculation that can be performed on a security's
price to yield a value that can be used to anticipate future changes in
prices.
The following chapters (see page ) contain numerous
examples of indicators. I'll briefly review one simple indicator here,
the Moving Average Convergence Divergence (MACD).
MACD
The MACD is calculated by subtracting a 26-day
moving average of a security's price from a 12-day moving average of
its price. The result is an indicator that oscillates above and below
zero.
When the MACD is above zero, it means the 12-day
moving average is higher than the 26-day moving average. This is
bullish as it shows that current expectations (i.e., the 12-day moving
average) are more bullish than previous expectations (i.e., the 26-day
average). This implies a bullish, or upward, shift in the supply/demand
lines. When the MACD falls below zero, it means that the 12-day moving
average is less than the 26-day moving average, implying a bearish
shift in the supply/demand lines.
Figure 28 shows Autozone and its MACD. I labeled
the chart as "Bullish" when the MACD was above zero and "Bearish" when
it was below zero. I also displayed the 12- and 26-day moving averages
on the price chart.
Figure 28
A 9-day moving average of the MACD (not of the
security's price) is usually plotted on top of the MACD indicator. This
line is referred to as the "signal" line. The signal line anticipates
the convergence of the two moving averages (i.e., the movement of the
MACD toward the zero line).
The chart in Figure 29 shows the MACD (the solid
line) and its signal line (the dotted line). "Buy" arrows were drawn
when the MACD rose above its signal line; "sell" arrows were drawn when
the MACD fell below its signal line.
Figure 29
Let's consider the rational behind this technique.
The MACD is the difference between two moving averages of price. When
the shorter-term moving average rises above the longer-term moving
average (i.e., the MACD rises above zero), it means that investor
expectations are becoming more bullish (i.e., there has been an upward
shift in the supply/demand lines). By plotting a 9-day moving average
of the MACD, we can see the changing of expectations (i.e., the
shifting of the supply/demand lines) as they occur.
Leading versus lagging indicators
Moving averages and the MACD are examples of trend
following, or "lagging," indicators. [See Figure 30.] These indicators
are superb when prices move in relatively long trends. They don't warn
you of upcoming changes in prices, they simply tell you what prices are
doing (i.e., rising or falling) so that you can invest accordingly.
Trend following indicators have you buy and sell late and, in exchange
for missing the early opportunities, they greatly reduce your risk by
keeping you on the right side of the market.
Figure 30
As shown in Figure 31, trend following indicators do not work well in sideways markets.
Figure 31
Another class of indicators are "leading"
indicators. These indicators help you profit by predicting what prices
will do next. Leading indicators provide greater rewards at the expense
of increased risk. They perform best in sideways, "trading" markets.
Leading indicators typically work by measuring how
"overbought" or "oversold" a security is. This is done with the
assumption that a security that is "oversold" will bounce back. [See
Figure 32.]
Figure 32
What type of indicators you use, leading or
lagging, is a matter of personal preference. It has been my experience
that most investors (including me) are better at following trends than
predicting them. Thus, I personally prefer trend following indicators.
However, I have met many successful investors who prefer leading
indicators.
Trending prices versus trading prices
There have been several trading systems and
indicators developed that determine if prices are trending or trading.
The approach is that you should use lagging indicators during trending
markets and leading indicators during trading markets. While it is
relatively easy to determine if prices are trending or trading, it is
extremely difficult to know if prices will trend or trade in the
future. [See Figure 33.]
Figure 33
Divergences
A divergence occurs when the trend of a security's
price doesn't agree with the trend of an indicator. Many of the
examples in subsequent chapters demonstrate divergences.
The chart in Figure 34 shows a divergence between
Whirlpool and its 14-day CCI (Commodity Channel Index). [See page .]
Whirlpool's prices were making new highs while the CCI was failing to
make new highs. When divergences occur, prices usually change direction
to confirm the trend of the indicator as shown in Figure 34. This
occurs because indicators are better at gauging price trends than the
prices themselves.
Figure 34
