but OBVfalls or fails to set a new high, it suggests that the trend is running out ofsteam and a potential reversal is at hand. Notice on this chart that in September and October, Lehman’s OBV began to slope downward prior to thestock starting to decline.
MOVING AVERAGESMoving averages (MAs) are simply the average price of a stock over a specific number of days. For instance, for a nine-day average, the technicalanalyst would take the closing prices of the underlying asset for the pastnine days, compute the sum, and divide by nine. Of course, to create anongoing nine-day moving average, every day we would drop the ninth dayback and add today’s new closing prices. A moving average is a trend-following device. It helps you see when an old trend has reversed and a newtrend has begun. While it does not have any predictive properties, it cannevertheless provide excellent guidance. The technical analyst can useany time frame to create a moving average—a 9-day, 20-day, 50-day, or200-day MA—which can provide a wealth of information.Before using moving averages as a tool, an important factor to consider is the number of days used to compute the average. A 50-day MA, for
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example, will behave differently than a 200-day MA. The shorter the timeframe, the more sensitive the moving average will be to price changes inthe stock. Consider Figure B.2, which shows the stock price action ofCoventry Healthcare (CVH) along with both the 50-day MA (solid line) andthe 200-day (dotted line). Notice that the 50-day moving average fluctuatesmore than the 200-day. It captures a shorter time frame. Some traders willuse very short-term moving averages, like a 9-day MA. The general rule isto use a moving average that corresponds with the time frame of yourtrading strategy. For instance, in looking at a stock for a long-term strategy like a bull call LEAPS spread, a 9-day moving average will be simplytoo short a time frame.The first way to use a moving average is to consider its slope. For instance, if a moving average is upward sloping, it suggests that the trend ishealthy. It is a bullish sign for the stock. On the other hand, a downwardsloping moving average indicates weakness and is considered bearish. Notice on the chart of Coventry Health (see Figure B.2) that the 50-day MA willchange direction much faster than the longer-term (200-day) MA. In November 2004, the 50-day MA started and stayed on a downward slope and did notchange direction until late December 2004. When it eventually developed anupward slope, it was followed by a large price increase in the stock.A second way to study moving averages is to look for buy and sell
FIGURE B.2 OHLC Chart of Coventry Healthcare with 50-Day and 200-Day Moving Averages (Source: www.ProﬁtSource.com)
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signals by considering when the stock price crosses over the moving average. For instance, when the stock price of Coventry Health fell below the50-day MA in late November, the indicator gave a buy reading.Again, the fewer the number of days used to compute the moving averages, the greater the number of buy and sell signals. For that reason, abreak of a long-term (i.e., 200-day) MA holds more technical importancethan a break of a shorter-term MA (i.e., 50-day); it occurs less often. In theCVH example, the stock broke both moving averages, giving a very powerful buy signal.Moving averages can also serve as support and resistance zones. Forinstance, on the chart of Coventry Health, the stock rose along its 50-daymoving average in an orderly manner. In late April (on the very right of thechart) it bounced off of that MA several times. This is typical of a movingaverage. It can serve as support or a floor for falling prices. The oppositealso holds true—sometimes moving averages can create resistance.The final way of using moving averages is to look at the crossovers between two moving averages. When the short-term MA crosses up over thelonger MA, it triggers a buy signal. This occurred on the Coventry Healthcare chart in early January 2005 and the stock increased. Conversely,when the 50-day MA drops below the 200-day MA, a sell signal is triggered.On the Coventry Healthcare chart, this occurred in early December 2004and shortly before the stock started to drop. Moving averages work verywell in uptrends and downtrends and not as well in sideways markets.That’s because in sideways markets, you can get buy signals near tops andsell signals near the bottom. If you trade on those signals, you will surelyincur a loss.
MACDThe moving average convergence-divergence (MACD) indicator can beamong the most useful tools to the technical analyst. It can effectivelyprovide trading signals on long-term or short-term charts (i.e., daily,weekly, and monthly graphs). The MACD is considered a trend-followingindicator. Therefore, it can help determine if a trend in a stock is healthyand likely to continue, or is set for a reversal instead.The MACD is viewed on a stock chart either as lines or as a histogram.The MACD shows the relationship between two moving averages. It canbe plotted using two lines: a fast line and a slow line. The fast line is computed as the difference between two exponential moving averages (EMA)with different time periods. One moving average will be the average over arelatively short period of time—for example, 12 days. The second moving
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average is the average price change in a stock over a longer period oftime, such as 26 days. Therefore, after computing the 12-day and 26-dayEMAs, the 26-day EMA is subtracted from the 12-day EMA to create thefast line. The slow line (sometimes called the “signal” line), on the otherhand, is the 9-day EMA of the fast line.Because MACD is a trend-following indicator, it is not a reliable indicator in sideways-moving markets. During periods when a stock or indexis rising, the shorter-term MA (fast line) will rise more rapidly than theslow line. During times when one line changes faster than the other, thedifference between the two lines will increase. This is known as the divergence. In a downward-trending market, the fast line will drop below theslow line. The fast line reacts faster to the most recent price changes andmoves quicker than the slow line. Technical analysts look for crossoversbetween the two lines to generate trading signals. For example, if the fastline is above the slow line, then moves lower and crosses the slow line, asell signal is triggered. Conversely, when the fast line is below the slowline and then rises above it, a buy signal is triggered. The daily chart inFigure B.3 shows some examples using Google Incorporated. In the middle of the chart, in mid-October, the fast line (shown here as the dashedline) is below the slow line. Then it rises above the slow line and gives abuy signal.
FIGURE B.3 OHLC Chart of Google Incorporated Using MACD (Source: www.ProﬁtSource.com)
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MACD is often plotted as a histogram. When using a technical analysispackage, the MACD histogram is typically depicted graphically on the bottom of a stock or index chart along a zero line. When the fast line is abovethe slow line, MACD-histogram will be positive and sit above the zero line.If the fast line is below the slow line, the histogram will be below the zeroline and negative. Therefore, MACD-histogram shows the difference between the long-term and short-term moving averages, and is either positive or negative.MACD-histogram is generally used as a confirmation tool. For instance, when the fast line is moving up at a faster pace than the slow line,MACD-histogram rises into positive territory and confirms the movehigher in the stock or index. If the stock or index is rallying and MACDhistogram is not moving higher, the rally is not confirmed and is likely toprove short-lived. The same analysis is used during market declines.Therefore, MACD-histogram is primarily used to measure the strength ofthe trend in a stock or index; if it is moving in the same direction, thestock’s trend is considered strong.The most powerful trading signals from MACD-histogram occur whenthe histogram fails to confirm the rise or fall in the stock. For example, onthe Google chart, in late November the stock rose to new highs, butMACD-histogram did not. That, in turn, signaled what is known as a bearish divergence or bearish nonconfirmation, which was a sign that therally in Google was running out of steam. MACD can also provide a bullishsignal when price trends lower, but the indicator fails to make new lows.In other words, MACD will make a higher low. This is known as a bullishdivergence.MACD can also be applied to weekly and monthly charts. On amonthly chart, the moving averages would represent not days or weeks,but months. In general, the most important trading signals occur on thelonger-term chart. As a rule, when MACD gives conflicting signals on thedaily, weekly, and monthly charts, the analyst defers to the longer-term(monthly) chart’s trading signal.
STOCHASTICSStochastic values are functions of momentum, but from a more sophisticated point of view compared with other oscillators. Stochastics usethe daily high, daily low, and closing price. The concept of stochasticsis based on the premise that as prices move higher, the daily close tendsto be closer to the high of the daily range. The reverse is true in downtrends: As prices decrease, the daily close tends to move closer to the
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daily range. This concept holds true for daily, weekly, and monthlycharts.Stochastics give an indication of the relationship between a stock’scurrent price and its recent trading range. In a bullish market, when astock is moving higher, the stock has a tendency to close near the highpoints of the day. When the rise is running out of steam, however, thestock will have a tendency to close away from the highs of the day. Thebulls, who were previously driving the stock higher, are running out ofbuying power. At that point, investors are hesitant to continue driving thestock higher and they begin taking profits. As the buyers run out of gas,the stock price starts to close below the highs of the day. In the oppositesituation, during a bearish market, a stock will close near the lows of theday. Near the end of the downtrend, however, sellers have exhausted theirsupply and the stock begins closing above the day’s lows.There are a number of different ways to use stochastics as a tradingtool. In general, the indicator is best used for stocks that are movingwithin a trading range rather than trending dramatically higher or lower.For example, Figure B.4 shows the stock price action of Chicago Mercantile Exchange (CME) over the course of six months along with stochastics. Notice that the indicator consists of two lines—a fast and slow line.On the far right-hand side of the chart, the fast line is above the slow line.
FIGURE B.4 OHLC of the Chicago Mercantile Exchange Using Stochastics(Source: www.ProﬁtSource.com)
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Typically, stochastics are used to gauge overbought and oversold conditions. If a stock is overbought, it has risen very rapidly and is likely tomake a move lower. An oversold stock, by contrast, has fallen dramatically and is due for a short-term rally. Using stochastics, when both thefast and slow lines rise above 80 percent (top horizontal line), the stock isconsidered overbought. Conversely, when the indicator falls below 20 percent (lower horizontal line), the stock is oversold. Notice on this CMEchart that the stock became overbought in late September, but oversoldby the middle of October.Stochastic lines may diverge with price to warn of a potential top orbottom. In fact, according to the indicator’s developer, George Lane, themost powerful signals occur when stochastics show divergences from thestock price. For instance, if a stock price rises to a new high, but stochastics makes a lower high, the indicator triggers a sell signal. When stochastics (or any other indicator) fail to confirm new highs in a stock, it isknown as a bearish divergence. Conversely, if a stock price sets a newlow, but stochastics begins a move higher, it is considered a bullish divergence and a buy signal. An example of a bullish divergence occurred withshares of the CME in late August 2005. As depicted in Figure B.4, the stockwas approaching new lows, but the stochastics indicator was movinghigher.
RELATIVE STRENGTH INDEXThe relative strength indicator (RSI) is another type of oscillator. Developed by Welles Wilder, RSI is common on almost all computer tradingsoftware programs available today and, therefore, does not require manual computation. Instead, the RSI is generally viewed on a stock chart underneath the price chart. For instance, the chart in Figure B.5 includes therecent price action of Apple Computer, along with its RSI. The RSI canwarn you when a market is near a top or bottom. It all depends onwhether it is in the overbought or oversold section of the chart andwhether you have a bullish or bearish divergence.There are basically three ways to use the RSI. The first is to identifyoverbought and oversold conditions. The RSI will fluctuate between 0 and100. On the Apple Computer chart (Figure B.5), RSI had been betweenroughly 40 and 80 percent, which is the normal range. When the indicatordropped below 40 percent in mid-April, it was a sign of a relatively oversold condition and hinted at a snapback. And indeed Apple did snap back.The second way to use oscillators is as a confirmation tool. Whenlooking at trends, RSI should be setting new highs or new lows along with
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FIGURE B.5 OHLC of Apple Computer Using the Relative Strength Index(Source: www.ProﬁtSource.com)
the index. For instance, when Apple Computer set a new high in late September, the RSI did not. In fact, the indicator had taken on a downwardslope. That delivered a sell signal, which is known as a bearish divergenceor nonconfirmation. It hinted that a reversal might be on the way.Finally, when looking at the RSI, the technical analyst wants to consider the slope of the indicator. An upward-sloping RSI is the sign of ahealthy advance and a downward-sloping RSI is evidence of a strong decline. Most oscillators are used in the same fashion as RSI, but each isunique in its own way and must be considered individually.
BOLLINGER BANDSJohn Bollinger is credited with the development of Bollinger bands, whichappear as three lines overlaid on the main price chart. The center line is asimple moving average. Above and below it are bands plotting two standard deviations away from the simple moving average. The indicator iscomputed as the standard deviation of the moving average. Standard deviation is a measure of how far from the average the data is distributed. Onestandard deviation will include about 68 percent of all data, while two
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standard deviations will include 95 percent of the data. Three standard deviations include 99 percent of the data. For the less mathematically inclined, stocks with wildly swinging price movements will have a greaterstandard deviation than a stock with a relatively stable price. Importantly,according to statistical probabilities, regardless of whether a stock has ahigh or low standard deviation, its price tends to remain within two standard deviations of its moving average 95 percent of the time. Therefore,stocks should stay within the ranges defined by Bollinger bands 95 percent of the time.Bollinger bands indicate the volatility of the market. A volatile markethas much more dramatic price movements, and in order to incorporate 95percent of all price data, the Bollinger bands have to move further awayfrom the moving average. In a less volatile market, the stock price doesn’tmove as much, and the Bollinger bands will be much narrower.Bollinger bands can be used in two ways. The first is as an overboughtor oversold indicator. Using Bollinger bands is this manner is based on theassumption that once a stock price diverges meaningfully from its averagevalue, it has a tendency to move back toward its moving average. This isbased on the phenomenon of reversion to the mean. In the case ofBollinger bands, if a stock moves above two standard deviations of itsnormal range, it will rise above the upper Bollinger band and is likely tofall back toward its moving average. Conversely, if a stock falls below thelower band, it is likely to respond by moving higher. Therefore, a stock isconsidered overbought when it rises above the top Bollinger band (ormore than two standard deviations above its moving average) and oversold below the lower Bollinger band (or more than two standard deviations below its moving average).Figure B.6 provides some specific examples of an index penetratinga Bollinger Band and signaling overbought or oversold conditions. Thechart looks at the NASDAQ Index Trust (QQQQ). In September 2005,the chart breaks above its upper Bollinger band and then makes a significant move lower. It was overbought. In October, however, the stockfalls below its lower band and signals oversold conditions. Notice thesharp rally during the next few days. Used in this manner, Bollingerbands can be applied to daily, weekly, or monthly charts. The longer thetime frame on the chart, the more important the overbought and oversold readings.The second way to use Bollinger bands is as a tool for measuringthe volatility of a stock. Stocks with high standard deviations tend toswing more wildly and move a greater distance from their moving averages. In that case, the bands are wide and reflect the higher standarddeviation and greater volatility. Stocks that trade in a narrow rangehave lower standard deviations around the mean. In that case, the
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FIGURE B.6 OHLC of the NASDAQ 100 Index Trust Using Bollinger Bands(Source: www.ProﬁtSource.com)
bands will contract and become narrow, typically followed by a sharp increase in volatility. Again, reversion to the mean affects both stock pricesand volatility.
AVERAGE TRUE RANGEThe average true range (ATR) is derived from past prices and is anothertool for measuring historical volatility. Developed by Welles Wilder, ATR isused to gauge an asset’s daily price swings. As a result, the ATR does notprovide an indication of price direction or duration, but simply the degreeof price movement or volatility. Most other measures of historical volatility, such as statistical volatility, consider only closing prices for a stock orindex and do not consider the open, high, and low prices of the day. TheATR, by contrast, considers the close, high, and low prices. The averagetrue range is the average of the true ranges (TR) over a period of days—usually 14. As each day of new data is added, the last is dropped. The truerange is computed as the greatest of:• The distance between the current day’s high and low.• The distance from the previous day’s high to the current day’s low.• The distance from the previous day’s high to the current day’s high.
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FIGURE B.7 OHLC of the S&P 100 Using the Average True Range (Source:www.ProﬁtSource.com)
Like most indicators, ATR is generally viewed graphically rather thannumerically. Figure B.7 shows the ATR for the S&P 100 Index ($OEX). TheATR is generally not used to predict future price movements in a stock orindex. Rather, it gauges the price swings or activity level of a stock or index. Low levels occur during periods of narrow and quiet trading. Highlevels occur during sharp moves and violent swings. Either case—extremely high or low levels of volatility—is usually short-lived and notlikely to be sustained for long periods of time. Notice on the chart of theOEX that the ATR spiked higher after the September-through-October selloff in 2005, but then began a move lower. Again, it is reversion to the meanat work.
RATE OF CHANGE INDICATORThe rate of change (ROC) indicator is a type of momentum indicator thatattempts to measure the speed of price changes and is normally used todetermine whether the stock or index is overbought or oversold and possibly due for a correction. The ROC is considered to be a leading indicatorand works best in nontrending or range-bound markets.The ROC is calculated by dividing the latest price by the price from nperiods ago. This gives the percentage change in price over the given
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period. Typically the default parameter on many charting packages is 10.Figure B.8 shows the ROC in action with the S&P 500 index ($SPX), whichdepicts a distinct overbought condition in September 2005.
AVERAGE DIRECTIONAL INDEX INDICATORThe average directional index (ADX) is an indicator that can help thetechnician time profitable exit points when holding a particular stock orindex position. Traders who use ADX follow a very simple rule: A climb bythe ADX line above 40 followed by a downturn indicates an imminent endto the current trend. Based on this rule, when the ADX line moves above40 and then turns down, a trader should consider taking a profit. It doesnot matter if the primary trend is up or down. Once the ADX line turnsdown, it’s a signal to exit and take a profit. While the ADX can indicate theend of an existing trend, a reversal in the trend line is not always the nextstep. Instead, prices may enter a consolidation phase and move sidewaysfor a period of time.The ADX is not helpful during sideways markets. During an extendedconsolidation period, an ADX line can fall below 20 and even approach
FIGURE B.8 OHLC of the S&P 500 Using the Rate of Change Indicator (Source:www.ProﬁtSource.com)
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FIGURE B.9 OHLC of the DJIA Using the Average Directional Index (Source:www.ProﬁtSource.com)
10 on the scale. When the ADX approaches 10, a major move is usuallyabout to take place. However, the ADX will not indicate which directionthe move will go. You have to rely on other indicators for the probable direction of the next move. The ADX combines the dashed lines positive directional indicator (+DI) with negative directional indicator (–DI) andthen smoothes the data with a moving average. The positive directional indicator (+DI) indicates the strength of upward price pressure, and thenegative directional indicator (–DI) indicates the strength of downwardprice pressure. On Figure B.9, we can see one dashed line moving higherduring uptrends and one moving lower during downtrends. These are +DIand –DI, respectively.
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Option StrategyReviews
Long StockStrategy: Buy shares of stock.Market Opportunity: Look for a bullish market where a rise in the price of the stock is anticipated.Maximum Risk: Limited to the price of thestock as it approaches zero.Maximum Proﬁt: Unlimited as the stock pricerises above the initial entry price.
FIGURE C.1 LongStock
Breakeven: Price of the stock at initiation.
Short StockStrategy: Sell shares of stock.Market Opportunity: Look for a bearish market where a fall in the price of the stock is anticipated.Maximum Risk: Unlimited as the stock pricerises.Maximum Proﬁt: Limited to the full price ofthe stock shares as they fall to zero.
FIGURE C.2 ShortStock
Breakeven: Price of the stock at initiation.Margin: Required—usually 150 percent of the total cost of the shares.
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Long CallStrategy: Buy a call option.Market Opportunity: Look for a bullish market where a rise above the breakeven is anticipated.Maximum Risk: Limited to the amount paidfor the call.Maximum Proﬁt: Unlimited as the price ofthe underlying instrument rises above thebreakeven.
FIGURE C.3 Long Call
Breakeven: Call strike + call premium.
Short CallStrategy: Sell a call option.Market Opportunity: Look for a bearish orstable market where you anticipate a fall in theprice of the underlying below the breakeven.Maximum Risk: Unlimited as the stock pricerises above the breakeven.Maximum Proﬁt: Limited to the credit receivedfrom the call option premium.Breakeven: Call strike + call premium.
FIGURE C.4 Short Call
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Long PutStrategy: Buy a put option.Market Opportunity: Look for a bearish market where you anticipate a fall in the price ofthe underlying below the breakeven.Maximum Risk: Limited to the price paid forthe put premium.Maximum Proﬁt: Limited as the stock pricefalls below the breakeven to zero.
FIGURE C.5 Long Put
Breakeven: Put strike – put premium.
Short PutStrategy: Sell a put option.Market Opportunity: Look for a bullish orstable market where a rise above thebreakeven is anticipated.Maximum Risk: Limited as the stock pricefalls below the breakeven until reaching aprice of zero.Maximum Proﬁt: Limited to the credit received from the put premium.Breakeven: Put strike – put premium.
FIGURE C.6 Short Put
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Bull Call SpreadStrategy: Buy a lower-strike call and sell ahigher-strike call with the same expirationdates.Market Opportunity: Look for a bullishmarket where you anticipate a modest increase in the price of the underlying abovethe price of the short call option.Maximum Risk: Limited to the net debitpaid: (lower-strike premium – higher-strikepremium) × 100.
FIGURE C.7 Bull CallSpread
Maximum Proﬁt: Limited to (difference in strikes – net debit) × 100.Breakeven: Lower strike + net debit.
Bull Put SpreadStrategy: Buy a lower-strike put and sell ahigher-strike put with the same expiration date.Market Opportunity: Look for a bullish market where you anticipate an increase in theprice of the underlying asset above the strikeprice of the short put option.Maximum Risk: Limited to (difference instrikes – net credit) × 100.
FIGURE C.8 Bull PutSpread
Maximum Proﬁt: Limited to the net credit received: (Higher strike premium – lower strike premium) × 100.Breakeven: Higher strike – net credit.
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Option Strategy Reviews
Bear Put SpreadStrategy: Buy a higher-strike put and sell alower-strike put with the same expiration date.Market Opportunity: Look for a bearishmarket where you anticipate a modest decrease in the price of the underlying asset below the strike price of the short put option.Maximum Risk: Limited to the net debit paid:(higher-strike premium – lower-strike premium) × 100.
FIGURE C.9 Bear PutSpread
Maximum Proﬁt: Limited to (difference in strikes – net debit) × 100.Breakeven: Higher strike – net debit.
Bear Call SpreadStrategy: Buy a higher-strike call and sell alower-strike call with the same expiration date.Market Opportunity: Look for a bearishmarket where you anticipate a decrease in theprice of the underlying asset below the strikeprice of the short call option.Maximum Risk: Limited to (difference instrikes – net credit) × 100.
FIGURE C.10 BearCall Spread
Maximum Proﬁt: Limited to the net credit:(lower-strike premium – higher-strike premium) × 100.Breakeven: Lower strike + net credit.
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Long StraddleStrategy: Purchase an ATM call and an ATMput with the same strike price and the sameexpiration.Market Opportunity: Look for a market withlow implied volatility options where a sharpvolatility increase is anticipated.Maximum Risk: Limited to the net debit: (callpremium + put premium) × 100.
FIGURE C.11 LongStraddle
Maximum Proﬁt: Unlimited to the upside andlimited to the downside (as the underlying can only fall to zero). Proﬁt requires sufﬁcient magnitude of market movement, but does not depend onmarket direction.Upside Breakeven: ATM strike price + net debit.Downside Breakeven: ATM strike price – net debit.
