Computerized Technical Analysis

To be a successful trader, you have to analyse and understand the markets better than your competitors do and a computer can help in doing so. 

Computerised Technical Analysis is a more objective method of trading by which we can identify charts and patterns, and trade on the information provided by the computer. A computer can help us in a better in-depth analysis because it can process more information than us. 

A trader without a computer is like a man travelling on a bicycle. His progress is very slow. 

There are three steps to a computerised technical analysis:

A) Choose a software – There are three kinds of programs that a trader can choose from, toolboxes, which are for serious traders, black boxes, which are for people who believe in “Santa Claus”, grey boxes, for people who believe in both.

B) Choose a computer – The author suggests buying the best computer with the best features so that it provides the best platform to work on, and isn't required to be upgraded for some years.

C) Choose the data you want to analyse – Each trader needs to start with a historical database and update it daily. The author suggests that to track 6 or fewer markets in the beginning and keep adding as he gains experience in the markets.

For starters, the author suggested buying 3 to 5 years of historical weekly data and one year of daily data.

There are three major indicators which can help us identify trends and their turning points:

• Trend-following Indicators-  It includes moving averages, MACD (moving average convergence-divergence), MACD-Histogram, the Directional System, On-Balance Volume, Accumulation/Distribution. Trend-following indicators are coincident or lagging indicators. 
• Oscillators - Oscillators help identify turning points. Examples include Rate of Change, the Relative Strength Index, Elder-Ray, the Force Index, etc. They can be leading or coincident indicators.
• Miscellaneous Indicators - These indicators can be both leading or coincident. They provide insights into the intensity of bullish or bearish market opinion. Examples include Put – Call Ratio, Bullish Consensus, etc.

Moving Averages:

A moving average (MA) shows the average value of a data in a selected time window. For example, a 5-day moving average shows the average price of the past 5 days. The primary advantage of a moving average is that they are easy to calculate.

The value of a moving average depends on two factors:

• The values which are being averaged.
• The width of the MA time window.

The most important thing about a moving average is the direction of its slope. When the direction of the slope of a moving average rises, it shows that the crowd has become more optimistic, i.e., bullish and vice – versa.

There are three main types of moving averages:

1.Simple Moving Average (MA) - Simple MA’s move twice as much the piece of data they respond to. Simple averages reflect the changes in prices, the problem is that a simple average changes again when an old price is dropped off at the end of a MA window. The 2nd change has nothing to do with the market.

2.Exponential Moving Average (EMA) – EMAs are better tools for identifying trends than simple MAs. Its weight distributions are better and responses are faster than Simple MAs. The problem with EMA is that they respond to changes in latest data only. It does not respond to old sets of data.

A short EMA is more sensitive to changes in price changes and helps in catching trends sooner.

3.Weighted Moving Average – A weighted moving average assigns any weight to any day which is selected. Weighted averages are complicated, and the author suggested using EMAs only.

Trading rules for moving averages:

1.When an EMA rises, trade only longs. Buy when prices fall near or slightly below the moving averages.
2. When an EMA falls, only short trades. Sell when prices rise near or slightly or above an EMA.
3.When an EMA goes flat, do not trade in that market.

Moving averages can also be used as support or resistance levels.

Moving Average Convergence and Divergence (MACD):

A MACD indicator consists of three exponential moving averages.

A long moving average line shows long term consensus, a short moving average line shows short term consensus.

Trading rules for MACD:

1.When a fast MACD line crosses a slow signal line from below, it means that we should go long and place a protective stop below the latest low.
2.When a fast line crosses a slow line from above, we should go short and place a protective stop above the latest high.

MACD Histogram:

A MACD histogram shows the difference between the MACD line and the signal line. It is one of the best available tools to a trader.

Trading rules for MACD Histograms:

1.When a MACD – Histogram stops falling and ticks up, it gives a buy signal. Go long and place a protective stop below the latest low.
2.When a MACD – Histogram stops rising and ticks down, go short and place a protective stop above the latest high.
3.Short sell when a MACD – Histogram ticks down from its second, lower top, while the prices reach a new high. Also place a protective stop above the latest high.
4.Buy when a MACD – Histogram ticks up from its second bottom, while prices are at a new low. Place a protective stop below the latest low.

Differences between MACD Histogram and prices occur only a few times a year, but they give us some of the most powerful messages in Technical Analysis. They help in identifying major turning points and a divergence between the two indicates a major breakout might happen in the near future.

The Directional System:

The Directional System is a method which follows trends. The directional system measures the capacity of bulls and bears in moving a stock’s price out of a previous day’s range. 

If today’s high is above yesterday’s high, it shows that the market is more bearish, and vice- versa.

Trading rules for The Directional System:

1.When the Average Directional Indicator (ADX) declines, it is better to not use a trend following method because it shows that the market has become less directional.
2.When ADX falls below both the directional lines, it identifies a flat and quiet market. Major bullish trends may emerge.
3.When ADX falls below both the directional lines and the longer that it stays there, the better can be your next move.
4.When ADX rises above both the directional lines, it signifies an overheated market.

Oscillators:

Oscillators provide us with the best trading signals when they diverge from the price of a stock.

Types of Oscillators:

1)Momentum Oscillator and Rate of Change (ROC) Oscillators - These oscillators measure a trend’s acceleration, its gain or loss of speed. They also compare today's closing price to the previously chosen closing price. When momentum or ROC rises to a new peak, it shows that optimism is growing in the market crowd and vice-versa.

When a momentum or Roc rises to a new peak, it shows that optimism is high in a market, and the prices are likely to rise and vice – versa.

Trading rules:

• In an uptrend, buy whenever Roc declines below its centerline and ticks up and vice – versa.
• If prices start to decline and you hold a long position, check whether a Roc has recorded a peak or not.
• A break in the trendline of momentum or Roc means that a break in the price trend of that stock is going to take place.

2)Williams % R – Williams% R measures the placement of each closing price in relation to the recent high-low range. This oscillator measures the capacity of bulls and bears to close prices each day. This oscillator is closely related to the Stochastic Oscillator.  The highest range of price shows the maximum power of bulls, and vice-versa. W%R shows which groups are capable of closing the prices in their favour.

Trading rules:

• Divergences rarely occur, but provide the best trading opportunities. When you identify a bullish divergence, go long and place a protective stop below a recent low and vice –versa.
• Failure swings occur when the Wm%R fails to rise above its upper reference or stops falling in the middle of a decline and turns up without reaching its lower reference line. When W%R stops rising in the middle of a rally and goes down, it signifies a sell signal and vice- versa.
• W%R becomes oversold when prices close near the upper edge of their range. When Wm%R rises above its upper reference line, it signifies a sell signal and vice –versa.

3)Stochastic Oscillator - This is a widely used oscillator, and is used for tracking the relationship between each closing price to a recent high – low range. If bulls can push the prices near the high but the prices do not close near the high, it indicates a sell signal and vice-versa.

Trading rules:

• A bullish divergence occurs when prices reach a new low but the Stochastic oscillator shows a higher bottom than during the previous decline and vice-versa.
• When we can identify an uptrend in a weekly chart, we should wait for the daily Stochastic lines to decline below the reference line and place a buy order and vice –versa.

Don’t buy when stochastic is overbought and don’t sell when stochastic is oversold.

4)Relative Strength Index (RSI) -  RSI measures the strength of a trading strategy by monitoring the changes in its closing prices. It is a leading indicator and is included in most software packages.

Trading rules:

• When prices fall to a new low but the RSI makes a shallower bottom during its previous decline, it shows bullish divergence and vice-versa.
• We can place a buy order above price trendline when RSI breaks its down trendline to catch an upside breakout.
• We can buy when RSI declines below its reference line and goes above it and reverse our decisions when the opposite occurs.

5)Smoothed Rate of Change Oscillator - This oscillator avoids a major flaw of Roc, it responds to each price data only once rather than twice. The quality of changes provided by this oscillator is better than Roc. S-Roc can track major upturns or downturns of a market crowd.

Trading rules:

• Buy when S-Roc turns up from below its centerline.
• If S-Roc reaches a lower peak than the previous one but the market reaches a new high, then this shows that the crowd is less enthusiastic than it previously was.