originally published in 1932 but available in a Noonday Press paperback). It’s a bit scary to think that the rise andfall of the Internet stocks, still an incomplete story, may qualify as anothergreat financial bubble.The contrarian is the investor who believes in doing the opposite of themajority of investors. Some of the qualities of contrarian investors are:• They are value investors.• They look for undervalued stocks or opportunities where prices are awayfrom value.• They are attracted to prices after a sustained run up or down.• Once they identify an opportunity, they use other technical tools fortiming; being undervalued does not mean the stock price will rise anytime soon.• After they buy, they wait patiently for prices to turn from down to up.To be successful, contrarians must not act in the same way as everyone else.
Bullish ConsensusOne of the tools for measuring public opinion is the Bullish Consensus byEarl Hadady. The Bullish Consensus assesses the impact of the opinions ofprofessional market analysts and brokerage houses by ranking the bullishness of their analyses and weighting the results by the circulation of eachone’s market letter:
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FIGURE 15.1
Interpretation of the BullishConsensus. (With permission from Figure 6.1,p. 69, R. Earl Hadady, Contrary Opinion, New York,John Wiley, 2000).
Bullish Consensus = sum of (each source × relative weight × bullish opinion)sum of (each source × relative weight × 100)Bullish Consensus values range from 0 to 100 percent. It is consideredneutral at 55 percent because of the bullish bias in the stock market that hasresulted in a 5 percent rise over the long term. In Figure 15.1, an imminentdowntrend is expected when the Bullish Consensus is greater than 90 percent, and an imminent uptrend when it is below 10 percent. Positions arenever entered without confirmation.The obvious problem with the Bullish Consensus is timeliness. First,the analysts must evaluate the individual stocks and write their reports; thereports are then published and distributed. They are usually sent by mail. The
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A SHORT COURSE IN TECHNICAL TRADING
elapsed time must be no less than two weeks. Then the reports must be rankedfor bullish content.
OSCILLATORS: OVERBOUGHT/OVERSOLD INDICATORSOscillators are the best tools for identifying contrary options without readingthrough all the available market letters—and a much more definitive andtimely solution. Some oscillators measure the current price relative to previous highs and lows, while others try to extract a more complex “quality” ofthe price. We’ll look carefully at the two most important of these indicators,the stochastic and the Relative Strength Index.
The StochasticNot to be confused with the stochastic random process, this stochastic wascreated by George Lane and is a widely used technical indicator for determining overbought and oversold conditions.The basic calculation, called the raw stochastic (also called %K), givesthe relative position of the closing price within the range of the previousN days.Raw stochastic = %K(today) = 100 ×
close(today) − lowest low of past N days(high − low) range of past N days
where range is the highest high of the past N days (not including today)minus the lowest low of the past N days (not including today). Dividing bythe range creates a value from 0 to 100. For example, if we are using thepast 10 days (called a 10-day stochastic), the raw stochastic has the value:• 100 if today’s close is higher than the high of the past 10 days.• 0 if today’s close is lower than the low of the past 10 days.• 0 < %K < 100 if today’s close is between the high and low of the past10 days.Calculating the 10-Day Stochastic for Nokia. Using an Excel spreadsheet, we can calculate a smoothed version of the raw stochastic called%K-slow (or %D), and an even smoother version called %D-slow. In Figure15.2, the historic prices for Nokia are imported into columns A to D. We arethen ready for the calculation of the raw stochastic:
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A
B
C
D
Date1/2/19961/3/19961/4/19961/5/19961/8/19961/9/19961/10/19961/11/19961/12/19961/15/19961/16/19961/17/19961/18/19961/19/19961/22/19961/23/19961/24/19961/25/19961/26/19961/29/19961/30/19961/31/19962/1/19962/2/19962/5/19962/6/19962/7/19962/8/1996
High2.502.552.392.302.232.202.202.272.262.212.252.302.302.332.372.372.372.402.352.362.412.382.452.452.452.482.442.39
Low2.452.412.292.192.192.142.072.152.182.102.122.182.232.252.272.312.342.302.262.302.372.302.352.382.392.452.312.31
Close2.502.442.342.212.192.192.162.272.192.122.252.202.292.302.372.342.372.302.352.352.372.342.432.412.452.452.362.34
EF10-day 10-dayHighLow
G10-dayRange
H10-dayStochastic %K
2.552.552.392.302.332.372.372.372.402.402.402.412.412.452.452.452.482.482.48
0.480.480.320.230.260.300.300.270.300.300.280.230.180.200.190.190.220.220.22
10.437.540.695.788.5100.090.0100.066.783.382.182.661.190.078.9100.086.445.536.4
2.072.072.072.072.072.072.072.102.102.102.122.182.232.252.262.262.262.262.26
I
J
%K-slow %D-
29.557.974.994.792.896.785.683.377.482.775.377.976.789.688.477.356.1
54.175.887.594.791.788.582.181.178.578.676.681.484.985.173.9
FIGURE 15.2
Excel example of 10-day stochastic. The stochastic has three variations,the raw calculation, %K, a three-day smoothing of %K, called %K-slow or %D, and a three-daysmoothing of that called %D-slow. The raw values, %K, fluctuate faster between 0 and 100percent, while the slowest, %D-slow, fluctuate the least.
1. In column E find the 10-day high, not including today, using the function
@Max.2. In column F find the 10-day low, not including today, using the function
@Min.3. Calculate the high-low range by subtracting column F from column E
and putting it in column G in the same row.4. The raw stochastic %K, in column H, is = (close − 10-day low) × 100 / range.5. In column I, the %K-slow is the three-day average of K.6. In column J, %D-slow is the three-day average of column I.
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If we look at the raw stochastic in column H of the spreadsheet, we seethat values reach 100 percent three times. This means that prices are at thehighest level, or higher than prices during the past 10 days. For the firstoccurrence of 100 percent on January 22, 1996 the closing price of $2.37 wasthe high of that day and higher than the highs of the past 10 days. On January24, 1996 the same high of 2.37 was equal to the high of the past 10 days. Whencalculating the stochastic, today’s close is compared to the range of the previous 10 days; the range does not include today’s values.The smoother values in columns I and J will reach 0 or 100 percent lessoften but will also lag because of the smoothing.Charting the Stochastic. The stochastic is an interpretation of the pricechart that removes the trend and scales the prices between 0 and 100. InFigure 15.3, the price of AOL appears on the top and the raw and smoothedstochastic values appear on the bottom. You should first notice that the stochastic peaks and valleys fall at about the same place as prices, but thestochastic values run sideways while AOL prices first go up and then down.
FIGURE 15.3
Charting the stochastic. The 20-day raw stochastic %K is the thicker grayline along the bottom. The 3-day average %K-slow is the thinner dark line that appears smoother.
Overbought/Oversold Indicators and Double Smoothing
219
Two horizontal lines have been drawn at 20 percent and 80 percent toindicate an oversold and overbought levels. Whenever prices approach thelows of the past 20 days, the stochastic falls below the 20 percent line. Whenit nears the highs, it moves above the 80 percent line. Most analysts use thetwo slower stochastic values and avoid the raw stochastic because the rawvalue tends to jump around. On the other hand, because it is not smoothed,you can react quickly to current market action, rather than waiting a day ortwo for a lagged confirmation.Trading the Stochastic. The smoothed stochastic trading signal is similarto the signal line used with the MACD. If you look back to Chapter 14, youwill see that the MACD smoothed signal line was created in order to get a buyor sell signal. As with the MACD, the best signals follow after the stochasticreaches an extreme:1. After the smoothed stochastic %K-slow has moved above the 80 percent
line, sell when the %K-slow line crosses the %D-slow line moving down.2. After the smoothed stochastic %K-slow has moved below the 20 percent
line, buy when the %K-slow line crosses the %D-slow line moving up.In Figure 15.4 we see an example of the slow (%D, the heavier line) andslower (%D-slow, the thinner line) stochastics applied to the S&P from thebeginning of 2002. At the beginning of 2002 the S&P was mostly sideways,and the stochastic shows swings from below 20 to over 80. During this periodthe peaks are easier to trade than the valleys because the stochastic movesabove the 80% line and turns down quickly. Stochastic peaks correspond toprice peaks.The oversold points are a problem. As prices decline, the stochastic tendsto stay below 20 percent, occasionally moving higher but rarely reaching 50percent. This is the typical pattern of the stochastic during a downtrend. Asprices make new lows, the stochastic value must near zero. Because thesetwo stochastic lines are smoothed, they don’t touch zero as often as the rawstochastic.Clearing Up the Confusing Signals. The stochastic works best in a sideways market, where prices are not reaching new highs or new lows. Duringa upward-trending market the stochastic will usually remain above 50 andduring a downtrend below 50. Traders will use the stochastic with a trendline(a moving average or breakout) to decide which stochastic signals are good.
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FIGURE 15.4 Sell signals using the stochastic. The stochastic generates good signalsduring a sideways market, but will stay at low values during a downtrend and high values duringan uptrend. To trade the stochastic successfully, you’ll need to use a trend to find the directionof prices and then use the stochastic to time your entry.
If the price is trending down, as the S&P in Figure 15.4, you want to sellwhen the stochastic moves below 80 after being higher, or when the fasterstochastic line crosses the slower line heading lower the first time after thefaster line has been above 80.During March 2002 the S&P stochastic reached about 90 and both stochastic lines crossed twice above 80. The proactive trader will take the firstcrossing as a sell signal. The more conservative trader will wait until thefaster or slower stochastic crosses below 80. If you take the first signal, thenyou have the advantage of selling while prices are rising—you get a goodprice—-but with greater risk. If you wait for a confirmation, you are safer butprices are already heading down and your entry could be much lower. You’llneed to try both ways and decide for yourself.Comparing the 20-Day Stochastic with a 20-Day Momentum. Whenyou plot the faster stochastics (%K and %D) along with momentum, the peaksand valleys occur at the same points (see Figure 15.5). Neither the stochasticnor the momentum indicators have a lag; that is, neither is the result of
Overbought/Oversold Indicators and Double Smoothing
221
smoothing or averaging. They tend to peak where prices peak and are therefore more responsive to price change than averages.The main difference between the stochastic and momentum is that thestochastic is be scaled between 0 and 100. Even though the AOL rally inNovember 2001 was much smaller than the previous one in May, the stochastic values reached the same levels near 100 percent. This makes it easierto say the prices are overbought.When you look at the way momentum shows the same two rallies, theone in November peaks at about 7 percent and the May rally touches above15 percent. Because momentum is more variable, it is not a good candidatefor an overbought/oversold indicator.A Brief Review of the Stochastic. The stochastic will be an important toolfor timing, but it has three different calculations and some confusing names,used differently throughout the industry:1. The raw stochastic is the fastest. It is called %K, %FastK, and %K-fast.
It is the only stochastic called fast.
FIGURE 15.5
Comparing the 20-day stochastic with a 20-day momentum. The peaksand valleys of both indicators fall at about the same point, but the stochastic is scaled between0 and 100; therefore, it has the ability to show when it is overbought and oversold using simple80–20 lines.
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FIGURE 15.6
Fast and slow stochastics. The center panel shows the raw (%K) and slowstochastic (%D). The bottom panel shows the slow (%D) and slowest (%D-slow) stochastics.
2. The next slower stochastic is %SlowK, which is simply a three-day aver-
age of %K. It is also called %D and %K-slow.3. The slowest stochastic is called %SlowD or %D-slow. It is a three-day
average of %D and it is used as the signal line.Figure 15.6 shows the faster stochastics in the middle panel and the slowerones along the bottom.When trading, use the stochastics as follows:1. Sell in a downtrend when the stochastic crosses the signal line above 80
percent, or when the stochastic moves back below 80 after being higher.2. Buy in an uptrend when the stochastic crosses the signal line below 20
percent, or when the stochastic moves back above 20 percent after beinglower.3. In a sideways market use both buy and sell signals.
An Example of Stochastic Timing. Although the AOL charts showed periods where the stochastic indicator was confusing, the stochastic has gained
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Overbought/Oversold Indicators and Double Smoothing
popularity because it also can have extended periods where the signals arevery clear. These tend to be sideways patterns, and prices often go sideways.In Figure 15.7 we see AOL in the last part of 2000, where prices had onlya slight downward bias. We trade by combining the trendline and the fasteststochastic line (the thinner of the two). During the sideways period fromJune into October we sell when the stochastic falls below 80 after beinghigher and buy when it moves above 20 after being lower. When the downtrend becomes clear in mid-October, the stochastic is used only to entershorts. When the stochastic falls below 20, the trade is closed out.Stochastic Divergence. We used divergence with the MACD when wefound that there were too many signals and they were not always reliable.Divergence selects those patterns that are likely to forecast a turn in prices.Divergence is associated with a broadening pattern, or a rounded top or bottom. It shows when prices are rising but at a slower rate.Divergence works well with the stochastic. The fastest stochastic line isbest because it has less lag. The raw stochastic line (the thinner one at the
DowntrendNewsell
Sideways marketReverse to short
Reverseto short?
DowntrendUptrend
New shortNew short
Buyback
New buy
Reverseto long
Close outshort
FIGURE 15.7
Close outshort
Close out short
Combining the stochastic and a trendline. The stochastic is a very goodindicator for timing but needs a trendline to select which signals are best. During the sidewaysperiod both buys and sells are used. When the downtrend becomes clear in mid-October, onlythe sell signals are taken.
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Bearishdivergence#1
Bearishdivergence#2
Bullishdivergence#1Bullishdivergence#2
Bullishdivergence#3
Is this a validstochasticdivergence?
FIGURE 15.8 Stochastic divergence with AOL. A bearish divergence occurs when pricesare rising and the stochastic is falling. In this chart there are two bearish and three bullishdivergences, all profitable trading signals.
bottom of Figure 15.8) must always be in the extreme zone before there canbe a divergence.A sell signal (a bearish divergence) occurs when there are two decliningstochastic peaks at the same time that prices are rising. In August and October 2000, the raw stochastic indicator first peaked near 100 and then peakedagain at about 80. When you connect the two peaks with a straight line, theline clearly angles down.If you look above the two stochastic peaks, you see prices rising. Pricespeak at about the same place as the stochastic peaks (because the raw stochastic doesn’t lag) and if you connect those peaks, you see that prices arerising. The combination of rising prices and a falling stochastic creates adivergence. The sell signal occurs when the raw stochastic line crosses theslower stochastic line after the second peak. In this example prices are fallingquickly at the same time as the sell signal, but there is still room for profit. InFigure 15.8 there are two bearish divergences (sell) signals and three bullishdivergence (buy) signals. All of them are profitable.
Overbought/Oversold Indicators and Double Smoothing
225
Stronger and Weaker Divergence Signals. A bearish divergence is strongerwhen the angle between the rising prices and the falling stochastic is greater,that is, when prices are rising faster and/or the stochastic is falling faster.Divergence only works when the prices and the stochastic are moving inopposite directions. It is not enough to have a strong relative difference,where prices are declining slightly and the stochastic is declining sharply.One must be going up and the other down.Bearish Divergence Rules. There are specific rules for recognizing a divergence signal (this describes a bearish signal, but the bullish signal is just thereverse):1. The first stochastic peak must be greater than 80.2. The second stochastic peak should be at least a 15 percent lower (but no
less than 5 percent lower). For example, if the first peak is at 90, the second should be at 70 or 75.3. The price peaks that occur at the same time as the stochastic peaks must
be clearly rising.Using Faster and Slower Stochastics for Divergence. Do we get betterdivergence signals when we use a faster or slower calculation period for thestochastic? In Figure 15.9 a 10-day and a 20-day fast stochastic are shownalong the bottom, the 10-day above the 20-day. Because the 10-day calculation causes the stochastic to change faster, it creates clear and frequentpeaks and valleys on the chart. The angles are clearer. In May 2001, the20-day stochastic has a rounded formation with a very small dip in value,while the 10-day stochastic shows a drop to 60 in between two peaks of 90.In this case the faster stochastic works better and is likely to give us moretrading opportunities.
Relative Strength IndexCreated by Wells Wilder in 1978, the Relative Strength Indicator (RSI) isused more often than the stochastic. It is most often used the same way asthe stochastic, but has some extra features. The RSI is a ratio of the upwardprice movements to the total price movement over 14 days. It has a slightsmoothing feature, and is a little more difficult to calculate. The way to calculate the RSI is:
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Bearishdivergence#1
Bearishdivergence#2
Bullishdivergence#1
Bullishdivergence#2
Bullishdivergence#3
Is this a validstochasticdivergence?
FIGURE 15.9
Comparing the divergence signals for a 10-day and a 20-day stochastic.A faster 10-day stochastic is more sensitive and gives a clearer picture. The bullish divergence inDecember 2000 can be seen and the one in May 2001 is now clear.
SumU = sum of price changes for all those days closing higher (positive numbers)SumD = sum of price changes for all those days closing lower (positive numbers)ThenRS =
SumU(the ratio of up changes to down changes)SumD
andRSI (first calculation) = 100 −
1001RSR× 100 ×1 + RS1 + RS
Once the first calculation has been made, the following values of SumUand SumD use the average off method, requiring only the previous values ofSumU and SumD, and the current price change:SumU(today) = SumU(previous) −
SumU(previous)+ today’s upward change14
SumD(today) = SumD(previous) −
SumD(previous)+ today’s downward change14
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Overbought/Oversold Indicators and Double Smoothing
Date1/2/19961/3/19961/4/19961/5/19961/8/19961/9/19961/10/19961/11/19961/12/19961/15/19961/16/19961/17/19961/18/19961/19/19961/22/19961/23/19961/24/19961/25/1996
Close2.502.442.342.212.192.192.162.272.192.122.252.202.292.302.372.342.372.30
FIGURE 15.10
Changes−0.06−0.10−0.13−0.020.00−0.030.11−0.08−0.070.13−0.050.090.010.07−0.030.03−0.07
10-daySumU0.0000.0000.0000.0000.0000.0000.0000.1100.1100.1100.2400.2160.2840.2660.3090.2780.2810.253
10-daySumD0.0000.0600.1600.2900.3100.3100.3400.3400.4200.4900.4900.4910.4420.3980.3580.3520.3170.355
RS
RSI
0.490.440.640.670.860.790.890.71
32.930.639.240.146.444.247.041.6
InitialIterativeIterativeIterativeIterativeIterativeIterativeIterative
RSI spreadsheet example.
If the current change is up then SumD is reduced by 1⁄14. If the current changeis down then SumU is reduced by 1⁄14.The RSI calculation seems like a lot of numbers, but it is easily done ona spreadsheet. Figure 15.10 gives an example that you can test yourself. Theformulas that go into the key cells are (for 10-day calculation period):Iterative SumU = IF($C14>0,D13 − (D13/10) + $C14, D13 − D13/10)Iterative SumD = IF($C14<0,E13 − (E13/10) − $C14, E13 − E13/10)Any number of days can be used instead of 14, but 14 is standard.Comparing the RSI with the Stochastic. Which is better, the RSI or thestochastic? We can find the answer by comparing some charts showing boththe RSI and the stochastic one above the other. In Figure 15.11, a 20-day RSIcan be seen in the center panel and a 14-day stochastic in the bottom panel.You will find that while the patterns of the two indicators often match, thecalculation periods will be different.In Figure 15.11 many of the peaks and valleys for the 20-day RSI and20-day stochastic are similar. The stochastic moves more freely between0 and 100; however, the most important extremes are in the same place.
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Bearishdivergence#1
Bullishdivergence#1
Bearishdivergence#2
Bullishdivergence#2
Bullishdivergence#3
Is this a validstochasticdivergence?
FIGURE 15.11 Divergence signals for the 20-day RSI and the 20-day stochastic. TheRSI has only one bullish divergence signal and no bearish signals, while the stochastic has threebullish signals and two bearish signals.
As a trader, you’ll see that the stochastic produced five divergence signals,while the RSI only had one. That’s an important difference if you’re tryingto make money.Speeding Up the RSI Calculation. We said earlier that we could make thetwo indicators similar by changing the speeds. In Figure 15.12 the RSI calculation period is reduced from 20 days to 10 days, while the stochastic is leftat 20 days. The patterns are much closer in appearance.Do these new RSI peaks and valleys produce more divergence signals?Look for yourself. It doesn’t seem to help. The stochastic seems to be the better indicator for finding divergence signals.
Anticipating Divergence: a ReminderDivergence signals are usually entered when, for example, the faster stochastic %K-slow crosses the slower %D-slow; however, they can be anticipated for greater profit with an occasional, relatively small loss:
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Overbought/Oversold Indicators and Double Smoothing
Bearishdivergence#1
Bullishdivergence#1
Bearishdivergence#2
Bullishdivergence#2
Bullishdivergence#3
Is this a validstochasticdivergence?
FIGURE 15.12 Comparing a 10-day RSI with a 20-day stochastic. The peaks and valleysof the RSI are now very similar to the stochastic but the stochastic is still better at showingdivergence signals.
1. When prices make a new swing high (a high greater than the previous
high peak), look at the position of the faster stochastic.2. If the faster stochastic is well below the level of its value at the time of
the previous price peak, then there is a potential divergence.3. Sell while the stochastic is still rising.4. Close out the trade with a loss if the current stochastic value becomes
greater or equal to its value at the previous price peak. This will happenif prices start to move higher at a faster rate.
DOUBLE-SMOOTHED MOMENTUMOriginally, we saw that momentum was unbounded and erratic. It is similarto most other trends but not quite as smooth. There is a technique calleddouble smoothing that will turn a questionable indicator into a very valuable one.
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The success of double smoothing is that it creates