# Technical Indicators Explained

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1 Chapter I. Technical Indicators Explained In This Chapter The information in this chapter is provided to help you learn how to use the technical indicators that are available for charting on the AIQ TradingExpert Pro charts. There is a brief explanation of how each indicator is derived and how it is used. 1. Reproducing charts shown in this manual 2 2. Changing indicator constants 3 3. Explanation of technical indicators 5 Price Plot indicators 5 Separate indicators 19 Charting tools Candlesticks, Point and Figure 93 Chapter I: Technical Indicators Explained 1

2 1. Reproducing charts shown in this manual When reproducing a chart from this manual, in order to obtain values for the Expert Ratings and indicators that agree with the manual, you should do the following: 1. Change the market date to the date of the chart you are reproducing. The market date is the most current date on the chart (date at far right). 2. Be sure that your data base contains historical data for at least 200 trading days (or 200 weeks for weekly plots) prior to the date you are examining. This allows TradingExpert Pro to compute the indicators for the knowledge base. Note Data sources can also cause indicator variations. When you reproduce a chart from this documentation, indicator values could possibly vary because of different data sources. Variations in indicator values explained Differences in the values of some indicators may occur depending on the position of a particular date relative to the market date of the displayed chart. Indicators such as the Accumulation/Distribution and On-Balance Volume are computed as summations. When a particular date is at the far right on the chart, these summations contain over 200 periods of data. However, as this date is shifted to the left, the summation contains fewer periods of data. Therefore, as the date is moved backwards in time summations contain proportionately less data. This can result in the value of a summation for a particular date changing depending on the position of the date on the chart. Since exponentially smoothed averages are computed as summations, the value of indicators which are computed using the exponentially smoothed average formula can also change depending on the position of the date on the chart. However, with an exponentially smoothed average, the differences are noticeable only when the data being smoothed fluctuates widely from day to day. The actual value of these summation indicators is, however, of little importance. Important are the shapes of their graphs, showing trends and trend breaks, and nonconformations and divergences with price action of the ticker you are examining. 2 Technical Indicators Reference Manual

3 2. Changing indicator constants TradingExpert provides users with the ability to control the computation of each of the indicators that can be displayed. This is accomplished through the constants used in the computation of the indicators. Factors such as time periods and smoothing constants may be varied for most of the indicators. Note In this chapter, the default indicator values together with permissible ranges are noted at the end of the explanation for each indicator. Default settings The indicator constants set by AIQ and delivered with TradingExpert (defaults) are those derived from extensive historical research and have been deemed to be the best for AIQ usage. When an indicator is first displayed, the values used by the system to compute the indicator are the default settings. Changing indicator constants is an optional feature, and has been included for advanced users of TradingExpert. For example, technical indicator constants can be adjusted for longer-term or shorter-term trading styles. Less experienced users, if they wish to experiment, will find this feature an excellent tool for determining, by trial-and-error, their own best or optimum values. Default settings are easily restored. The default values are always listed in the dialog box used for changing the indicator constants. How to change indicator constants å Follow these basic steps: 1. Access the dialog box for changing indicator constants in one of two ways when you are working within Charts: With a chart displayed, double click the indicator on the Control Panel of the chart. With a chart displayed, click Chart on the menu bar, select Settings, and then select Indicator Constants. The Change Indicator Constants dialog box will appear on your screen. (continued next page) Chapter I: Technical Indicators Explained 3

4 Dialog box for Change Indicator Constants 2. In the Change Indicator Constants dialog box, use the up/down arrows on the Indicators scroll box to select the indicator you want to change. 3. Constants that can be changed are displayed in the Constants text box. Also displayed are the default values for each indicator and permissible ranges for changing the values. If an indicator has no constants to be changed, the dialog box will indicate no constants. 4. Use the up/down arrows in the Value text box to select new values. 5. When you have made your selection, choose OK. 6. The values entered are stored and will become the new default constants for that indicator when you again call up a chart. AIQ assumes that the new constants are the ones that you prefer, and therefore they are saved for future analysis. Important AIQ emphasizes that changing the indicator constants does not alter the expert system knowledge base or the rules. Changing the constants only affects the indicators displayed on the charts. Tip You will find a Colors command button in the Change Indicator Constants dialog box. Click the name of an indicator, then click the Colors command button. You then can change the colors of that one indicator. 4 Technical Indicators Reference Manual

5 Explanation of technical indicators Note Should you require more detailed information about any technical indicator, consult References, Appendix 2. You will find the mathematical formulae for the indicators in Appendix 1. The technical indicators that can be plotted on the AIQ charts are divided into three groups: Price Plot indicators: These indicators are designed to be shown in conjunction with price and are, therefore, displayed within the Price Plot section of a chart. Included in this group are price averages and trading bands. Separate indicators: The majority of the technical indicators fall in this group. These indicators are displayed separately below the Price Plot. Charting tools: These are not conventional indicators but are special charting methods. Included in this group are Candlestick charts and Point and Figure charts. Price Plot indicators Note To select indicators for charting and for printing, see Using the Indicator Library, Chapter IV in the Reference Manual. This section provides explanations of the technical indicators that are available for charting on the Price Plot of a chart. Upper/Lower AIQ Upper/Lower BB Upper/Lower ESA Upper/Lower MA ESA (ST, IT, & LT) MA (ST, IT, & LT) AIQ Trading Bands Bollinger Bands ESA Trading Bands Moving Average Trading Bands Exponentially Smoothed Averages (Short, Intermediate, & Long Term) Moving Averages (Short, Intermediate, & Long Term) 21 d High Maximum price during prior 21 days (days adjustable) 21 d Low Minimum price during prior 21 days (days adjustable) ParaSAR ZigZag Trailing price stops Filtered Waves Chapter I: Technical Indicators Explained 5

6 AIQ Trading Bands (Upper/Lower AIQ) These bands are designed simply to encompass 90% of price activity. The AIQ Trading Bands indicate overextended prices. A price above the upper trading band is possibly a selling opportunity. A price below the lower trading band is perhaps a buying opportunity. AIQ Trading Bands Values shown in Control Panel The values shown are the prices corresponding to the Upper and Lower Trading Bands for the date specified. Note In the explanations of technical indicators in this chapter, the terms day and period are used interchangeably to refer to time periods. When the indicators are calculated from weekly data, the terms day and period should be replaced by week. There are no constants to be changed for the AIQ Trading Bands. 6 Technical Indicators Reference Manual

7 Bollinger Bands (Upper/Lower BB) Bollinger Bands, developed and introduced by John Bollinger, are trading bands based on the volatility of prices around a simple moving average The result of using volatility to compute the spacing of the bands above and below the average is that the spacing varies with volatility. Volatility in this case is measured as the statistical standard deviation computed on the same set of data as the moving average. To compute his bands, Bollinger recommends using a 20-Day Moving Average, which is the arithmetic average of the previous 20 days of data. Volatility for the same period, the same 20 days, is the variation of the data around the average for the last 20 days. This variation is measured by the standard deviation of the data from the average. The actual trading band is plotted some number of standard deviations above and below the average. Aside from the computational differences, Bollinger Bands are used in the same way as other trading bands. In addition, Bollinger has developed several rules for these Bands that can be used to look for indications of possible price moves. The Bollinger rules are: 1. Sharp moves in price tend to occur after the Bands tighten, and the closer to the average the better. Since reduced volatility denotes a period of consolidation, the first increase in volatility after a consolidation tends to mark the start of the next move. 2. Moving outside the Bands signals a continuation of the move until the prices drop below or inside of the Bands. 3. Moves starting at one Band tend to go to the opposite Band. The charts of Microdyne Corp. (MCDY) and AFLAC Inc. (AFL) shown on the next page contain examples of Bollinger s first rule. Tip You can expand the Price Plot to fill the entire chart window. Position your mouse cursor on the Price Plot, and press the Z key. Pressing the Z key again restores the plot to its original size. Chapter I: Technical Indicators Explained 7

8 Bollinger Bands, Microdyne Corp. In the Microdyne chart, the Bands narrowed in August and September of 1994 as reduced volatility produced a period of consolidation. This is followed by a sharp move up in the price of the stock. The Bands narrowed again in December, followed by another move up in the Microdyne stock. Bollinger Bands, AFLAC Inc. 8 Technical Indicators Reference Manual

9 The chart of AFLAC (AFL) shows a tightening of the Bollinger Bands during December 1994 and January 1995, followed by a sharp move up in the price of the stock. Values shown in Control Panel The values shown are the prices corresponding to the Upper and Lower Bollinger Bands for the date specified. The Bollinger Bands constants that can be changed are the number of periods in the moving average and the number of standard deviations that defines the distance of the Bands from the average. The longer the moving average period, the more stable the average becomes. Also, standard deviations beyond three tend to reduce the value of the Bands. The default values, which are those recommended by the developer, are a 20-period moving average and 2 standard deviations of variability around the average. Permissible ranges are periods and 1-5 standard deviations (Sigma Factor). Chapter I: Technical Indicators Explained 9

10 Exponentially Smoothed Average Trading Bands (Upper/Lower ESA) These bands are placed above and below the exponentially smoothed price average by an amount equal to a constant percentage of the average. The ESA Trading Bands indicate overextended prices. A price above the upper trading band is possibly a selling opportunity. A price below the lower trading band is perhaps a buying opportunity. Values shown in Control Panel The values shown are the prices corresponding to the Upper and Lower ESA Trading Bands for the date specified The constants that can be changed are the number of periods that the exponentially smoothed average represents and the percentage of that average that is used to compute the distance of the bands from the average. The default values and permissible ranges for these constants are as follows: Default Range Periods % of ESA Technical Indicators Reference Manual

11 Moving Average Trading Bands (Upper/ Lower MA) These bands are placed above and below a moving average of price by an amount equal to a constant percentage of that average. The Moving Average Trading Bands indicate overextended prices. A price above the upper trading band is possibly a selling opportunity. A price below the lower trading band is perhaps a buying opportunity. Tip If you are displaying multiple charts, you can maximize one of the charts to fill the entire chart window. First make the chart active by clicking your mouse on its title bar, then click the maximize button in the upper right corner of the active chart. To restore the chart to its previous size, click the restore button (two arrows). Values shown in Control Panel The values shown are the prices corresponding to the Upper and Lower Moving Average Trading Bands for the date specified The constants that can be changed are the number of periods that the moving average encompasses and the percentage of the average price that is used to compute the distance of the bands from the average. The default values and permissible ranges for these constants are as follows: Default Range Periods % of MA Chapter I: Technical Indicators Explained 11

12 Exponentially Smoothed Averages (ESA), Short, Intermediate, & Long Term The ESA, Exponentially Smoothed Average, is a price average that smooths the random price fluctuations that normally occur in a series of daily price data. Similar to the simple moving average, it is used to depict the underlying trend of the data. The Exponentially Smoothed Average tends to offer support and resistance support in an up-trending market and resistance in a down-trending market. Historically, support and resistance will prevail until a breakout occurs. A price which breaks through an ESA line can be a signal that a trend reversal is taking place. Depending on the value of the smoothing constant used in the exponential smoothing formula, the ESA can represent a short-term, intermediate-term, or long-term trend. The longer the time period used to calculate the smoothing constant, the longer the term of the trend depicted by the average. All data values in the time series are included in the ESA computation. However, the values are weighted so that only the more recent values are actually reflected in the average. The exponential smoothing formula assigns maximum weight to the most recent data value and successively smaller weights to each prior value in the series. Because these weights decline exponentially with time, older data (data older than the term of the average) does not significantly affect the value of the average. ESA, Bank America Corp. 12 Technical Indicators Reference Manual

13 The Bank America (BAC) chart shows a good example of the Exponentially Smoothed Average (ESA) providing resistance during end-of-year weakness and support during the 1995 rally. Values shown in Control Panel The values shown are the prices corresponding to the Short-, Intermediate-, and Long-Term ESA for the date specified The smoothing constants that are used to compute the exponential averages are a function of the number of days that the average represents. These constants, expressed in terms of the number of days represented by the average, may be changed. Default values and permissible ranges for these constants are as follows: Default Range ST ESA IT ESA LT ESA Chapter I: Technical Indicators Explained 13

14 Moving Averages (MA), Short, Intermediate, & Long Term Moving Average is perhaps the oldest and most widely used statistical method applied to stock price data. Primarily, it is used to smooth out short-term fluctuations and depict the underlying trend; the longer the time period used in the calculation, the longer the term of the trend depicted by the average. Long-Term Moving Average, Merck & Co. Mathematically, the Moving Average is a simple arithmetic mean, giving equal weight to all data values. Although many different time periods are commonly used, 21 days is considered appropriate for short-term trading and 50 days for intermediate-term trading. For long-term trend analysis, most analysts prefer a 200-day average. The Moving Average, like the Exponentially Smoothed Average, tends to offer support and resistance support in an up-trending market and resistance in a down-trending market. Historically, support and resistance will prevail until a breakout occurs. A price which breaks through a Moving Average line can be a signal that a trend reversal is taking place. 14 Technical Indicators Reference Manual

15 A 100-week Moving Average is plotted on the weekly chart of Merck (MRK), providing a long-term picture of the stock s trend. When price is below the Moving Average, the long-term trend is down. When price moves above the Moving Average, as it did in September 1994, the long-term trend changes to up, a bullish signal. Values shown in Control Panel The values shown are the prices corresponding to the Short-, Intermediate-, and Long-Term Moving Average for the date specified. The time period used to compute the average may be changed. Default values and ranges are as follows: Default Range ST MA IT MA LT MA Chapter I: Technical Indicators Explained 15

16 ParaSAR (parabolic stop-and-reversal) Welles Wilder's Parabolic Time/Price System, usually referred to as "SAR" (stop-and-reversal), is used to set trailing stops. Each day a new SAR stop level is computed based on that day's closing price. Note that stop values are valid only for the day on which they are computed. According to the system, the trader should remain long when the SAR is below the current price and short when it is above the price. With these values plotted on the price chart, the relationship between price and the SAR stop level is readily apparent. When you are long, an exit point is signalled when the SAR switches from below to above the price. The reverse is true when you are short. In other words, you should close long positions when price falls below the SAR and close short positions when price rises above the SAR. ParaSAR, Cisco Systems On the Chart for Cisco Systems, ParaSAR stop levels are shown by a series of short horizontal dashes above and below the price plot. Notice how the SAR trailing stop is always rising when it is below price and falling when it is above. A number of good short-term buying and selling opportunities are signalled by SAR reversals on this chart. 16 Technical Indicators Reference Manual

17 Value shown in Control Panel The value shown is the SAR stop value for the date specified. Two values used in the computation of the SAR trailing stop may be changed. Default values and ranges are as follows (values are expressed in 1/1000): Default Range Acceleration Limit Day High (21-d High) and 21-Day Low (21-d Low) The 21-Day High indicator is a plot of the highest price during the previous 21 days. The 21-Day Low indicator is a plot of the lowest price during the previous 21 days. The number of days can be adjusted by the user. These indicators are designed to identify support and resistance levels. Values shown in Control Panel The values shown are the price values of the High and Low indicators for the date specified The time period may be changed. Default is 21 days and permissible range is 1 to 125 days. Chapter I: Technical Indicators Explained 17

18 ZigZag (Filtered Waves) ZigZag is not as much an indicator as it is a generalization of price action wherein the significant price movements are shown while the day-to-day randomness is removed (Reference No. 34). ZigZag reduces price action to a series of straight lines connecting successive highs and lows in closing prices. ZigZag, International Paper Co. Note The last point on the ZigZag chart is always the current price. Since this last point usually does not coincide with the last major trend, a short final trendline will normally appear at the far right. This final trendline gives an indication of the direction and strength of recent price action. On the International Paper Co. (IP) chart, ZigZag shows price as a series of successive highs and lows which are at least 5 percent apart. The concept of wave action in prices is easily seen price appears as a series of crests and troughs generated by the sequence of high and low prices. The fact that ZigZag removes the random aspect of stock prices allows the user to concentrate on the major moves and their duration within a wave. Value shown in Control Panel The value shown is the price value of the ZigZag indicator for the date specified The percentage difference between successive highs and lows may be changed. The default value is 5, and permissible range is 1 to Technical Indicators Reference Manual

19 Separate indicators This section provides explanations of the technical indicators that are available for charting separately below the Price Plot. Accumulation/Distribution (AcmDis) Note In the explanations of technical indicators in this chapter, the terms day and period are used interchangeably to refer to time periods. When the indicators are calculated from weekly data, the terms day and period should be replaced by week. Note To select indicators for charting and for printing, see Using the Indicator Library, Chapter IV in the Reference Manual. Accumulation/Distribution is a single value indicator that weighs buyer dominated volume (accumulation) against seller dominated volume (distribution). It is computed as a running total of weighted volume. A weighting factor derived from price action is applied to the day s volume and the result is added to the accumulated total. The weighting factor, which ranges in value between +1 and -1, is a measure of accumulation and distribution pressures. The volume weighting factor is determined from the closing price in relationship to the intraday high and intraday low. (For weekly charts, the intraweek high and low are used.) If the closing price is midway between the high and the low, then accumulation and distribution pressures are balanced, and the factor is zero. If the closing price is equal to the day s highest price, then the accumulation factor is 1.0. If the day s closing price is equal to the intraday low, then the accumulation factor is -1.0, which indicates distribution. Since this is a summation indicator, the actual indicator values that you see on the Control Panel will depend upon how many total days of data are available for summation. If the date you are examining is on the far right of the chart, then TradingExpert uses over 200 periods of data to arrive at the figure. If that same date is in the middle of the chart, then there are fewer periods of data for the summation, and the value will be somewhat different. However, the actual value of the Accumulation/Distribution line is not important. What is important are the trends and trend breaks, and nonconformations and divergences with the price action of the ticker. Chapter I: Technical Indicators Explained 19

20 Accumulation/Distribution, Clear Channel Comm. When charting the Accumulation/Distribution indicator, look for divergences and nonconformations. Divergences occur when the trend of price action and the trend of the indicator are in opposite directions. A nonconformation occurs when price action achieves a new high or new low that is not matched by an equivalent high or low by the indicator. On the Clear Channel Comm. (CCU) chart, there is a classical divergence. While prices decline during the month of June 1994, the trend of the Accumulation/Distribution is positive. This divergence signals the rise in the stock price which took place later that summer. Tip You can expand an indicator plot to fill the entire chart window. Position your mouse cursor on the indicator plot, and press the Z key. Pressing the Z key again restores the indicator plot to its original size. Value shown in Control Panel The value shown is the value of the Accumulation/Distribution indicator for the date specified There are no constants to be changed for the Accumulation/ Distribution indicator. 20 Technical Indicators Reference Manual

22 The smoothing constant that is used to compute the exponential average of the Advance/Decline Indicator is a function of the number of days that the average represents. This constant, expressed in terms of the number of days represented by the average, may be changed. The default value is 27 days and the permissible range is days. Advance/Decline Line (AD Line) Note The Advance/Decline Line can be displayed only on charts of market type tickers. This classic indicator is the difference between the day s advances and the day s declines summed to the previous day s total. The Advance/Decline Line is a very good indicator of the overall strength of the total market. It tracks the entire market, and tends to lead the indices in market direction. A break in the A/D Line tends to indicate a future break in average prices. Advance/Decline Line, AIQ Market Timing Chart On the AIQ Market Timing Chart for 11/28/94, you can see that the Dow is flat from September to November of 1994, while the Advance/ Decline Line is falling. This divergence signaled the November 1994 weakness of the market. 22 Technical Indicators Reference Manual

23 As with other summation indicators, the actual values in the Control Panel will depend upon how many total periods of data are available for summation. If the date you are examining is on the far right of the chart, TradingExpert can use over 200 periods of data to arrive at the figure. If that same date were in the middle of the chart, then there are fewer periods of data for summation, and thus there will be a different value. The actual value is not important. Important is the shape of the chart, which can show trends and trend breaks, and nonconformations and divergences with the price action of the market. Value shown in Control Panel The value shown is the value of the Advance/Decline Line for the date specified. The Advance/Decline Line has no changeable constants. Chapter I: Technical Indicators Explained 23

24 Advance/Decline Oscillator (AD Osc) Note The Advance/Decline Oscillator can be displayed only on charts of market type tickers. An oscillator is the difference, in percentage terms, between two different exponentially smoothed averages. The Advance/Decline Oscillator was developed from the McClellan Oscillator (Reference No. 32). It is the difference between a long-term and a short-term advance/decline moving average. The difference is computed by subtracting the day s declines from the day s advances and that number is averaged on a short-term basis and a long-term basis. This oscillator is the difference between the two averages. Advance/Decline Oscillator, AIQ Market Timing Chart Look for nonconformations with price action ( highs or lows do not agree) when charting the Advance/Decline Oscillator. Examining the AIQ Market Timing Chart for 11/01/94, you can see that on that date the Advance/Decline Oscillator moved into negative territory. The action of this indicator contributed to the 100 sell signal (ER Down: 100) issued by the AIQ expert system. The market fell sharply during the month of November. Value shown in Control Panel The figure shown is the numeric difference between the two advance/ decline averages for the date specified. 24 Technical Indicators Reference Manual

25 Note The default averages (19 and 39 days) were used by the McClellans in their research and so far there has been no research to support using any other values. Changing these defaults may be of no benefit. The smoothing constants that are used to compute the exponential averages are a function of the number of days that the averages represent. These constants, expressed in terms of the number of days represented by the average, may be changed. Default values and permissible ranges for the constants are as follows: Default Range Short Term Long Term Tip If you are displaying multiple charts, you can maximize one of the charts to fill the entire chart window. Make the chart active by clicking your mouse on its title bar, then click the maximize button in the upper right corner of the active chart. To restore the chart to its original size, click the restore button (two arrows). Chapter I: Technical Indicators Explained 25

28 ADX Rate ADX Rate is a trend indicator which measures the rate of change of ADX using least squares methodology. The indicator is calculated as the slope of the line that most closely approximates the data over the period of time specified. ADX Rate is used to determine short-term changes in trend strength. The indicator cycles above and below the zero line as the trend increases and decreases in strength. When the indicator is above the zero line and rising, a trend is developing. When the indicator is falling, the trend is weakening. A high positive level indicates a strong trend and a low negative level indicates that price is nontrending (i.e., no trend in either direction). ADX Rate, Computer Associates In the example, ADX Rate shows a strong up trend at the start of the charted period followed by several months when the trend is relatively flat. In June, the trend was briefly down but strengthened again to the upside in August. The only constant involved in the calculation of ADX Rate is the time period over which the slope is calculated. The default value is 14 days and the permissible range is 1 to 50 days. 28 Technical Indicators Reference Manual

29 Commodity Channel Index (CCI) Commodity Channel Index (CCI) is a price momentum indicator developed by Donald R. Lambert. Despite its name, the indicator is equally applicable to stocks as well as commodities. CCI creates an index similar to a statistical standard score that measures price excursions from the mean price as a statistical variation. According to the developer, normal random fluctuations of the CCI fall within a channel between +100% and -100%. Movements above or below this channel are called nonrandom and are defined as trading opportunities. The CCI trading strategy is to buy when the index rises above 100% and sell when it falls back below 100%. On the short side, sell short when CCI falls below -100% and cover shorts when CCI rises above - 100%. Commodity Channel Index, Computer Associates In the example chart, CCI indicates two good buying opportunities for the nimble short-term trader. However, the stock recovered so quickly after the July sell signal that a short-side trade would not have been profitable. The only constant involved in the calculation of the CCI is the moving average time period. The default value is 90 days and the permissible range is 1 to 100 days. Chapter I: Technical Indicators Explained 29

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