A trend directional system, shown in the middle window of Figure 5.9
, may also be incorporated into the volume indicator. The lower window shows just the percentage plot of the volume indicator without the trend indicator. When the trend is weak, the color histogram of the volume plot is red, and it is blue when the trend is strong. A tall red histogram generally at the halfway point of the decline would indicate bearishness in the market, and a tall blue histogram would indicate bullishness.
FIGURE 5.9
The difference in the plots of a volume indicator. The lower window shows the normal plot of a percentage volume indicator and the middle window shows addition of a trend system to the volume indicator.
The formula for computing an indicator combining volume and trend in TradeStation format is as follows:
{Parameters Input}
Input: VolLength1(2), VolLength2(10), Percent(200), ShowTrendMarker(True);
{Input of variables}
Vars:BarColor(0), SMA(0), WMA(0);
{Input volume indicator criteria here}
If CurrentBar>1 then begin
Value10=XAverage(Volume,VolLength1);
Value20=Average(Volume,VolLength2);
If Value20<>0 then Value30=100*(Value10/Value20)
else Value30=0;
end;
{Input your system conditions here}
If CurrentBar>1 then begin SMA=T3(Close, 5);
WMA=T3(TypicalPrice,9);
If SMA > WMA then BarColor=Blue else If SMA <= WMA then BarColor=Red else BarColor=DarkGreen;
End;
{Input plots here: true/false}
If ShowTrendMarker then begin Plot1(Value30,"Volume",BarColor);
Plot2(100,"100 Percent");
Plot3(Percent,"Volume Limit");
End;
Note: T3 moving average was developed by Tim Tillson. It is a smoothing technique that is intended to produce better signals. The function in an EasyLanguage version of the formula is described in the January 1998 issue of Technical Analysis of Stocks & Commodities magazine.
CONCLUSION
The aim of this chapter is to show traders the importance of understanding volume in technical analysis and how volume can be used to identify the change in trend. When volume is used in conjunction with other supporting indicators, the probability of picking a winning trade is increased. Price represents the consensus value in a transaction between the buyer and seller, and volume represents the financial commitment. In short, volume is the liquidity of the market, without which the market is stagnant. And so, volume is deemed to be the driving force of price movements. Generally, a rising price trend has to be supported by a positive volume trend. When volume fails to support the continuing rising price, it signals a weakening of the rising price trend. On the other hand, when the price is declining with increasing volume, it confirms the continuity of the bearish outlook. A market is healthy when the trends of both volume and prices are moving in tandem. But when the movement of price starts to diverge with the volume trend, the continuation of the prevailing market trend is in doubt. For example, when a price, trading in a narrow range, fails to continue its rising trend despite heavy volume, traders should take note as the price may have reached a strong resistance level. And in reverse, traders should also exercise caution when heavy volume cannot push the price any lower and price continues to hold its trading in narrow ranges; it may indicate the price has reached a strong support level. When price spikes up with unconvincing volume, the price spike is usually short-lived. But when the price spikes up on heavy volume, traders should pay attention to a probable change in trend, and look for confirmation from other indicators. In summary, the importance of volume should not be overlooked as it often presages price direction.
CHAPTER 6
Key Indicators
Price is the only key that leads the direction of trend. There is nothing on a chart that matters more than price.
Data of daily transactions of prices are generally reported with information of the price range consisting of open-high-low-close, volume, and turnover of shares. The information is then used as the basis for calculating indicators.
All indicators in technical analysis are mathematical attempts to predict the future trend of stock prices based on historical data. Indicators are used as added value to the analysis of price movements to form buying and selling decisions. Indicators are not indubitable and should only be used as handy tools. In calculating indicators, it is important to ensure that price data are adjusted accordingly if there are changes to the company’s equities as a result of schemes of arrangements, rights issues, or bonus issues. It is also necessary to make adjustments to the data when trading in the shares is suspended. Such suspension may last from one day to several months. If the price data are not adjusted, especially when trading in the shares is suspended for a long period, it is not advisable to do any wave count or any reading of the indicators or patterns following the resumption of trading.
Figures 6.1 and 6.2
show two charts of a stock whose shares have been suspended for trading. Note the differences in the patterns of price and indicators before and after adjustments of the price data due to the suspension of trading.
FIGURE 6.1
Trading in the shares was suspended for 28 days, represented by a flat dotted line. The red line represents the 50-day moving average. The lower windows are the 14-day RSI and volume.
The drawing of a trend line is meaningless, as it has been distorted by the suspension period.
Compare this chart to Figure 6.2
.
FIGURE 6.2
Data and indicators adjusted for the suspension on trading in the shares. Patterns of price, indicators, and volume are showing the true trend, and the drawing of the trend line is reliable now.
A good chart layout should facilitate meaningful reading of price movements. The layout should not be crowded with too many indicators. It should have informative indicators that tell the different aspects of the market, such as a trend indicator to show the probable direction of the trend, a momentum indicator to measure the speed at which price is changing, and a volume indicator to measure the stock activities. On no account should the layout have similar types of indicators, whose functions are of the same nature and parameters.
Oscillators are indicators that are constructed so that the results are plotted between positive and negative levels, in which case the centerline is 0. If a plot fluctuates within a range of 0 to 100, the centerline is 50.
Oscillators are useful in identifying overbought and oversold conditions of the market, and in divulging divergence of directional movements between oscillators and prices. When the oscillator is above the centerline, the interpretation is positive, and when it is below the centerline, it is negative. When the oscillator is positive and shows readings in the upper positive range, it suggests that the market is overbought and is due for a correction. On the
other hand, when the oscillator is negative and shows readings at the bottom of the negative range, it suggests an oversold market that is due for a rebound.
An alert to sell is triggered when the market is overbought, and when the market is oversold, traders should be prepared to buy. This does not mean that one should rush to buy when the market shows the first sign of being in an oversold condition, or to sell when the market is overbought. The reason is simple. When a market enters initially into either overbought or oversold conditions, it may continue to remain in such conditions for some time. The market can even become more overbought or more oversold before making a definitive reversal.
Therefore, it is necessary to keep an eye on the weakening of price when in overbought condition, and the strengthening of price when in oversold condition. When the oscillator breaks out from its overbought or oversold levels, it is important to ensure that the breakout of the oscillator corresponds with the directional movement of the price. This will help traders avoid getting caught in a false breakout of the oscillator. Sometimes, the oscillator attempts to break out early from its overbought or oversold levels, only to reverse immediately to its former levels.
When using more than one oscillator, it is important to make sure that the parameters of each oscillator are different. A common error is to unknowingly plot various oscillators on the same chart with the same parameters, particularly the use of closing price for all oscillators.
This is tantamount to multiple counting of the same information. As a result, the readings generated by each of the oscillators tend to be similar. A better way is to choose different types of oscillators to complement the trading systems, and use different approaches to analyze the directional movement of the market. It will not serve any useful purpose if the oscillators are repeating the same criteria.