Back to Chapter List

Chapter 2 Leading Indicators

1) Relative Strength Index

RSI is a popular momentum oscillator that is computed on the basis of the speed and direction of a stock’s price movement. It helps spot overbought and oversold areas on the price chart.

Computing RSI

RSI = 100-100/(1+RS)

RS = Average up point for period (14 days)/Average down point for period (14 days)

Nine and 14 days are the most commonly used time periods to calculate RSI; however, this can be customized as per the trader’s need and choice. Shorter durations of five or seven days are also used to increase the volatility of the RSI line, while on the other hand, some take a time frame of either 21 or 28 days to smoothen it out.

Overbought and oversold zones

The RSI oscillates between 0 and 100. It is considered to be in the overbought zone when it moves above 70 and in the oversold zone when it slips below 30. Buy signals are generated when RSI crosses the oversold zone and sell signals are generated when it crosses the overbought zone. However, these standard levels can be adjusted, if required, to better fit the security.

For e.g., as can be seen in the following chart of Jet Airways, the down arrow indicates the overbought zone, where the RSI has also crossed the signal line from top to bottom. This indicates the beginning of short-term price erosion. On the other hand, the up arrow indicates the oversold zone, followed by a crossover of the RSI and the signal line from down to up, to indicate a short-term up move. Some investors also pay attention to the centerline crossover, i.e. the scenario when the RSI line crosses the 50-line mark. Here, if the RSI crosses from above, it is considered as bearish, whereas if it crosses from below, then it is considered as bullish.

RSI: Technical Analysis Chart

Divergence:

Divergence between the RSI and the price line is very crucial. The RSI should be closely observed when it is above 70 or below 30, or when the market makes a new high but the RSI does not.

DIVERGENCE PRICE RSI SIGNAL
Regular Bullish Divergence Lower Low Higher Low Buy
Regular Bearish Divergence Higher High Lower High Sell
Hidden Bullish Divergence Higher Low Lower Low Buy
Hidden Bearish Divergence Lower High Higher High Sell

Regular Bullish Divergence:

Regular bullish divergence can be observed when the stock is making a lower low (LL) and the RSI is making a higher low (HL). This indicates the strength in the underlying assets, where bears are exhausted, and hints of a possible trend reversal from down to up.

Regular Bearish Divergence:

Regular bearish divergence can be seen when the stock is making a higher high (HH) and the RSI is making a lower high (LH). It indicates weakness in the underlying assets, where bulls are exhausted, and warns of a possible reversal in the trend from up to down.

Hidden Bullish Divergence:

Hidden bullish divergence occurs when the price is making a higher low (HL) and the RSI is making a lower low (LL). This indicates good strength in the underlying assets. It occurs during the retracement in an uptrend. In this scenario, one can consider “buy on dips” strategy.

Hidden Bearish Divergence:

Hidden bearish divergence occurs when the price is making a lower high (LH) and the RSI is making a higher high (HH). This indicates weakness in the underlying assets and is found during the retracement in a downtrend. “Sell on rise” should be the ideal strategy one can use in this situation.

RSI may remain in the overbought and oversold zone for extended periods when the prevailing trend is strong. RSI cannot be used solely to identify market trends as sudden large price movements can create false buy or sell signals in the RSI. It is, therefore, best used with refinements to its application or in conjunction with other confirming technical indicators.

For Advanced Traders

RSI also forms chart patterns, such as support or resistance, trend lines, and double top and bottoms, that may not be seen on a price chart. Like many other momentum oscillators, RSI works best when prices move sideways within a range.

2.) Stochastic Oscillator

Stochastic oscillator follows the speed or the momentum of a stock’s price as momentum changes direction before price. Thus, bullish and bearish divergences in the stochastic oscillator can be used to foreshadow reversals. As the stochastic oscillator is range-bound, it is also useful for identifying overbought and oversold levels.

The stochastic oscillator operates in a range of 0 to 100 to identify possible entry and exit points in a trade. The two stochastic oscillator lines are identified as %K and %D. The oscillator gives a bullish sign when the %K line crosses over the %D line. On the flipside, when the %K line moves below the %D line, you have a bearish sign. If at least one of the lines dips below 20 and comes back up, it is considered as a buy signal, and when at least one of the lines rises above 80 before dropping again, it is a sell signal.

Computing a stochastic oscillator

%K = (Current Close - Lowest Low)/(Highest High - Lowest Low) * 100

%D = 3-day SMA of %K

Lowest Low = Lowest low for the selected period

Highest High = Highest high for the selected period

%K is multiplied by 100 to move the decimal point by two places.

Traders generally make use of 14-day stochastic oscillators, which is also the default setting. A 14-day %K would use the most recent close, the highest high over the last 14 periods, and the lowest low over the last 14 periods. %D is a three-day simple moving average of %K. This line is plotted along with %K to act as a signal or trigger line.

Interpretation

The stochastic oscillator measures the level of the close relative to the high-low range over the selected time period. For e.g., assume that 190 was the security’s highest high in the selected time period, the lowest low was 170, and the current price is 185.

The high-low range here is 20, which is the denominator in the %K formula. Subtracting the close from the lowest low gives us 15, which is the numerator. Thus, 15 divided by 20 equals 0.75. We multiply this number by 100 to find %K.

Overbought and oversold zones

The stochastic is a bounded oscillator like RSI, which makes it easy to identify overbought and oversold levels. It ranges from zero to 100. Conventional settings use 80 as the overbought zone and 20 as the oversold. However, these levels can be adjusted based on the market of trade as well as the security’s characteristics. Readings above 80 for the 14-day stochastic oscillator would indicate that the underlying security was trading near the top of its 14-day high-low range. Readings below 20 occur when a security is trading at the low end of its high-low range.

It is important to note that overbought readings are not necessarily bearish. Securities can become overbought and remain overbought during a strong uptrend. Closing levels that are consistently near the top of the range indicate sustained buying pressure.

Similarly, oversold readings are not necessarily bullish. Securities can become oversold and remain oversold during a strong downtrend as well. Closing levels consistently near the bottom of the range indicate sustained selling pressure.

It is, therefore, important to identify the bigger trend and trade in that direction. Look for occasional oversold readings in an uptrend and ignore frequent overbought readings. Similarly, look for occasional overbought readings in a strong downtrend and ignore frequent oversold readings.

In the above example of ACC, the up arrow indicates the oversold zone, followed by a crossover of the stochastic and the signal line from down to up indicating a short-term up move in the price of the stock. On the other hand, the down arrow indicates the overbought zone, where the stochastic has also crossed the signal line from top to bottom. This indicates that there could be a correction in the price of the security in the short term. The indicator is both overbought and strong when above 80. A subsequent move below 80 is needed to signal some sort of reversal. Conversely, the oscillator is both oversold and weak when below 20. A move above 20 is needed to show an actual upturn.

Divergence

Divergence is witnessed when a new high or low in price is not confirmed by the stochastic oscillator. A bullish divergence is formed when the price records a lower low but the stochastic oscillator forms a higher low. This shows less downside momentum that could warn of a bullish reversal. Likewise, a bearish divergence forms when the price records a higher high, but the stochastic oscillator forms a lower high. This shows less upside momentum, which could foreshadow a bearish reversal. Once a divergence takes hold, chartists should look for a confirmation to signal an actual reversal.

A bearish divergence can be confirmed with a support break on the price chart or a stochastic oscillator break below 50, i.e. the centerline. A bullish divergence can be confirmed with a resistance break on the price chart or a stochastic oscillator break above the centerline.

In the above example of Tech Mahindra, we observe that the stock continued to form a lower top-lower bottom chart structure on the price chart between March 20, 2017 and July 28, 2017.

Simultaneously, the stochastic witnessed a bullish divergence forming a higher top-higher bottom structure and indicated a reversal in the price trend. This was confirmed after the stock finally managed to give a breakout above the declining trend line.

3.) Commodity Channel Index

Commodity Channel Index (CCI) is a versatile indicator that can be used to identify a new trend or warn of extreme conditions. Although this indicator was originally developed for commodities, it is used to signal cyclical turns in stocks.

The CCI gives entry signals when it is above +100 and exit signals when it is below -100. A potentially bullish signal occurs when the indicator moves from the negative range into the positive range and vice versa when it falls from the positive into the negative. Since there is no upper or lower range limit with this indicator, identifying overbought tops and oversold bottoms with CCI is difficult.

Computing CCI

CCI = (Typical Price - 20-day SMA of TP) / (0.015*Mean Deviation), where typical price (TP) is (High+Low+Close)/3, and constant = 0.015.

To find the mean deviation, we need to apply the following steps:

  • Subtract the most recent 20-day average of the typical price from each period's typical price
  • Take the absolute values of these numbers
  • Sum the absolute values
  • Divide by the total number of periods (20)

Identifying a new emerging trend

As noted above, a majority of the CCI movement occurs between -100 and +100. A move that exceeds this range shows unusual strength or weakness that can foreshadow an extended move. Think of these levels as bullish or bearish filters. Technically, CCI favors the bulls when positive and the bears when negative. However, using a simple zero line crossover can result in many whipsaws. Although entry points will lag more, requiring a move above +100 for a bullish signal and a move below -100 for a bearish signal reduces whipsaws.

The chart above shows Adani Enterprises’ 20-day CCI. The stock bottomed on December 4, 2017, and witnessed a reversal in price. CCI moved above +100 on December 18, 2017 (10 trading days later) to signal the start of an extended move. Similarly, the stock topped on February 8, 2018, and the CCI moved below -100 on March 6 (13 trading days later) to signal the start of an extended decline. CCI does not catch the exact top or bottom, but it can help filter out insignificant moves and focus on the larger trend in the security.

4.) Williams %R

The Williams %R is a momentum based leading indicator that helps identify when a stock is overbought or oversold. Unlike other leading indicators, Williams %R uses a negative trading range to predict stock movement. The indicator oscillates between a low of -100 to a high of 0. A stock is considered to be overbought when the indicator reaches -20 and oversold when the reading is below -80. Analysts also make use of the centerline (-50), to generate buy and sell signals.

The CCI gives entry signals when it is above +100 and exit signals when it is below -100. A potentially bullish signal occurs when the indicator moves from the negative range into the positive range and vice versa when it falls from the positive into the negative. Since there is no upper or lower range limit with this indicator, identifying overbought tops and oversold bottoms with CCI is difficult.

Computing Williams %R

%R = (Highest High-Close)/(Highest High-Lowest Low) * -100

Lowest Low = Lowest low for the selected period

Highest High = Highest high for the selected period

%R is multiplied by -100

Analysts generally use a default period of 14 days to calculate William’s %R.

Interpretation

Similar to the stochastic indicator, Williams %R reflects the level of the close relative to the high-low range over a given period of time. Consider that a stock hits a high of 210 in the selected time period, a low of 200, and manages to give a close at 208. Then, according to the Williams %R formula, the numerator is calculated as highest high less the close, i.e. 210-208 = 2, while denominator equals the range between the high and the low, i.e. 210-200 = 10. The numerator is then divided by the denominator, which yields a value of 0.2. This value is then multiplied by -100 to give us the final value of -20 for % R.

A Williams %R cross above -50 signals that prices are trading in the upper half of their high-low range for the selected period. Conversely, a cross below -50 means prices are trading in the bottom half of selected period.

Low readings (below -80) indicate that price is near its low for the given time period. High readings (above -20) indicate that price is near its high for the given time period.

Overbought and oversold zones

As a bounded oscillator, Williams %R makes it easy to identify overbought and oversold levels. The oscillator ranges from 0 to -100. No matter how quickly a security advances or declines, Williams %R will always fluctuate within this range. Traditional settings use -20 as the overbought threshold and -80 as the oversold threshold. These levels may be adjusted according to the nature of the market and the type of security. Readings above -20 for the 14-day Williams %R would indicate that the underlying security was trading near the top of its 14-day high-low range. Readings below -80 occur when a security is trading at the low end of its high-low range.

It is important to note that a security may remain in an overbought or an oversold zone for a considerable period of time during strong trending markets. Closing levels that are consistently near the top of the range indicate sustained buying pressure, while closing levels consistently near the bottom of the range indicate sustained selling pressure.

In the above example of Arvind, the up arrow indicates a bullish crossover from the oversold zone on the William %R which occurred on February 6, 2018. The stock also formed a bullish piercing candlestick pattern on the daily chart and provided a confirmation signal for traders to initiate a bullish trade the next day.

Similarly, on March 1, 2018, the stock witnessed a bearish crossover from the oversold levels indicated by the down arrow, with the stock price forming a bearish candlestick, giving a confirmatory sell signal the next day.

5.) On-Balance Volume

On-balance volume (OBV) measures buying and selling pressure as a cumulative indicator that adds volume on days the stock moves up and subtracts volume on days it witnesses a correction in price.

It was one of the first indicators to measure positive and negative volume flow. Analysts make use of the indicator to identify the divergence between OBV and the price or to confirm price trends.

Computing OBV

OBV is simply a running total of volume. A period's volume is taken as positive when the close is above the prior period’s close, while its volume is taken as negative when the close is below the prior close.

If the closing price is above the prior close price, then:

OBV = Previous OBV + Today’s Volume

If the closing price is below the prior close price, then:

OBV = Previous OBV – Today’s Volume

If the closing prices equals the prior close price, then:

OBV = Previous OBV (no change)

Interpretation

Technical analysts use volume as a secondary indicator as it is considered to precede price. OBV rises when the volume on up days outpaces the volume on down days and falls when the volume on down days is higher.

OBV can provide insight because it is dependent on the quantity of trade volume, and not just the price direction. For e.g., a down day with 20,00,000 volume is not as significant if the price surges with 70,00,000 volume the next day. Here, volume indicates that buyers are more bullish compared to earlier, and hence, OBV will move higher over the two-day period even though it moved in different directions in the duration.

The absolute value of OBV isn’t important, since the number can be huge for low-priced stocks, and near zero for illiquid stocks. What matters is how OBV is acting and its trend.

A rising OBV reflects positive volume pressure that can lead to surging prices. Conversely, a falling OBV reflects negative volume pressure that can foreshadow lower prices. A key point to take note of is that OBV is based on the closing prices, and hence, the closing price in the security is considered when identifying divergence or trend confirmation.

A confirmatory tool

OBV is primarily used as a confirmation tool for trends. OBV should rise when the price is rising and vice versa. It helps confirm the direction in which the price is likely to continue. Trend lines are used to indicate the current direction of both the price and the OBV.

In the above example of Ashok Leyland, OBV has been constantly rising from February 2018, in-line with the price surge, confirming the bullish trend in the stock, thus providing additional confidence to the trader to maintain his long position.

Divergence

OBV can also be used to anticipate trend reversals by observing the divergence signals it generates. A bullish divergence is observed when OBV moves higher or forms a higher low even as prices move lower or form a lower low. A bearish divergence forms when OBV moves lower or forms a lower low even as prices move higher or form a higher high. The divergence between OBV and price should alert chartists that a price reversal could soon be witnessed.

The chart for Lupin shows a bullish divergence forming in December 2017. On the price chart, Lupin moved below its December low with a lower low in March 2018. OBV, on the other hand, held above its December 2017-low to form a bullish divergence. The stock has currently witnessed a breakout on the price chart. We expect this positive momentum to continue in the coming days.

1 2 3