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eSignal’s Basic Studies (Part 2)
Part 1 | Part 2 | Part 3
This month is the second of our 3-part series on the basic studies in eSignal. Previously, we reviewed price studies, which are indicators that appear within the main price chart; however, this time, we’ll be heading into new territory by looking at indicators that reside in their own separate sub-chart. These are sometimes referred to as pane studies. Because eSignal has many pane studies, we will be dividing the list in half and taking a look at seven of them this month.
Accumulation/Distribution
The first study we’ll look at is an interesting example of a pane study. The Accumulation/Distribution (A/D) indicator is built on the premise that volume confirms price action. It has no parameters of its own the way all the price studies had. Instead, the A/D has only one fixed calculation applied across the chart. It employs both price and volume in its calculation and attempts to measure the amount of money pouring into the stock against the money coming out of the stock.
This is accomplished by an algorithm that looks at where the close is, in comparison to the high and low range, and, then, either adds or subtracts volume from the cumulative total of each day. If the close is greater than the mid-point of the bar, a value is added to the total. The inverse is true as well: If the close is less than the mid-point, a value is subtracted. If the close is equal to the mid-point, no adjustment is made for that bar’s period. The amount added or subtracted depends on how close the close is to the high or low for that bar.
Accumulation/Distribution is often used as a confirming indicator to determine if a trend’s momentum is valid or whether the price action is expected to reverse soon. This is accomplished by looking at the general price trend and the trend of the A/D line. If they are in agreement, the trend is expected to continue; however, if they are in disagreement, a correction is imminent. This is referred to as a divergence.
Average True Range
The Average True Range study, or ATR, was originally built to measure the volatility of the futures market, which, at the time, was typically much more volatile than the stock market back then. With today’s markets, this study can be used on practically any issue from high-volume stocks to pink sheets to foreign currency pairs.
The indicator’s designer, Welles Wilder, wanted to create a way to measure the lock limit situations that can arise in futures markets, as well as the typical swing moves that happen under normal conditions. He came up with the concept of True Range, which uses the highest of three calculations:
- Current bar’s high minus the current bar’s low
- Distance from previous bar’s close to the current bar’s high
- Distance from previous bar’s close to the current bar’s low
The ATR then takes the average of these values over time to derive its value. This creates a single line showing how wildly the symbol is trading.
If traders are panicking over recent news of a major downgrade, or if the public is excited about the prospects of a new product release, these periods will often see the ATR rise as volatility increases. As indecision and consolidation occur, these often form the valleys in the Average True Range study.
The ATR is used in many different ways in today’s markets. Some traders use this as a way to filter out entry signals from more sensitive indicators. For instance, one might not enter a trade until the symbol has moved a specific percentage of the Average True Range to confirm the move.
Others may use it as a stop to protect their position to the downside. One example of this is to take the entry price, subtract the current Average True Range, and then apply that value as the stop for that position.
Lastly, one could simply draw trend lines along the highs or lows of the indicator, as seen in the image shown previously, to mark key significant turning points in the current market trend.
Choppiness
The Choppiness Indicator (CI) is a relative newcomer to the technical analysis world; it was developed based on computerized fractal geometry. Certainly, the methods used in its calculation go beyond the scope of this article. Generally speaking, a high choppiness value above the black 61.8 line is indicative of a market that was dramatically swinging back and forth across its overall trend. A low choppiness value that is below the 38.2 line indicates a market that is closely following a trend.
One common method of using the choppiness indicator is as an exit indicator. One of the more difficult (and often emotional) periods of the trade lifecycle is deciding when to get out of a trade. This is where the choppiness study can assist. When a market is in an up or down trend, watch closely for the CI line to drop below the 38.2 line, and then come back up above that line. When this occurs, it is a confirmation of the end of a trend.
As with all technical analysis, this shouldn’t be the only indicator you use to determine when to take an exit trade. It should be used in conjunction with other indicators.
Commodity Channel Index
The Commodity Channel Index, or CCI as it is more commonly known, is another indicator that was originally designed for the futures market but is very significant in today’s hyper-active equity and currency markets. The CCI is an oscillator whose goal is to define directional deviations from normal market behavior as defined by the Typical Price (H + L + C / 3) and a moving average. There is more to calculation involving a mean deviation algorithm, but, again, that would be heading into a topic beyond the scope of this article.
Although the CCI was first developed to highlight overbought and oversold conditions, a myriad of additional trading methods have arisen since that time. We’ll look at two of the more popular methods.
The first is a counter-trend trade entry method. This involves looking at divergences above the +100 line or below the -100 line, and then triggering a trade entry when the CCI crosses back against that same line. Some great examples are marked as “A” in the preceding image. Counter-trend trades are higher risk but tend to reap more rewards.
If you prefer to trade with the trend, this next CCI strategy may be more up your alley. Look for broad up / down trend patterns using a moving average or MACD, and then watch for a CCI rejection near the zero “line”. In the previous examples marked with a “B”, there are three longs we could have taken. All three were coming off small downside retracements of a larger up trend, and the CCI helped us identify these reentry points.
Directional Movement
So far in this article, all of our indicators have had only one line to look at. The Directional Movement indicator has three! Does this mean it is more or less complex than the others, though? At first glance, it may seem so, but once you get the basics down on this indicator, it actually becomes quite straight-forward.
The first two lines are the +DI and -DI lines, seen as thin, blue and red lines respectively. The calculations for these lines are quite complex, so we’ll skip right over that part of the discussion. What a trader needs to know is that, when the +DI line is trending upward, an uptrend is growing stronger, and, likewise, when it is heading down, the uptrend is becoming weaker. The inverse is true for the -DI line.
The Average Directional Index, or ADX, is the third line plotted on this chart (the bolder pink line). It is derived from the +DI and -DI lines based on the difference of the two lines divided by the sum of the two lines and then smoothed out using an exponential moving average model.
In its simplest form, the Directional Movement indicator defines…well, the direction of the chart. If the blue +DI line is on top, the symbol is heading up, and if the red -DI line is on top, the symbol is heading down. The downside of using only that to define when to be long or short is that, in choppy markets, your profits will get eaten up in the “whipsaws”, or back and forth action, of the DI lines.
The ADX line can assist in filtering out these sideways markets. When the ADX is heading up, the overall strength of the trend is increasing, and this can be used as confirmation of a DI line crossover. In early 2008, Google had this exact pattern occur on its daily chart, and the stock has tumbled approximately 200+ points since that time.
MACD
The Moving Average Convergence/Divergence, or MACD, is a lagging indicator designed to keep you on the right side of a trade and help you profit from long-term trends. This is accomplished by the use of various calculations on two moving averages.
By default, the blue MACD Line in eSignal is the difference between a 12- and 26-period exponential moving average. This blue line, all by itself, is similar to the Price Oscillator study, which we’ll cover in the next part of this series. The MACD study takes it two steps further with the addition of a red Signal Line and a magenta Histogram.
The Signal Line is a simple moving average of the MACD values. In other words, it’s a moving average of the difference between two moving averages. The Histogram is displayed as vertical lines, and is the difference between the MACD Line and the Signal Line.
The MACD can be used in two general ways. The simplest is just using the blue MACD line. If this line crosses from below zero to above zero, a long position is taken. Likewise, if the line crosses from above zero to below zero, the long position is closed and a short position is taken. In the previous graph, these are denoted as the blue arrows.
The second method involves looking at the crossovers of the red and blue lines, or simply using the histogram as your guide. If the histogram is above zero, the trader should be in a long position, and if it’s below zero, the trader should be in a short position. Entry points using this strategy are marked with magenta arrows.
Just as with the ADX and other lagging indicators, profits are minimal at best in sideways markets. More often than not, losses will occur during these times. The MACD strategy alone is typically not advisable; it is best used in conjunction with other indicators to filter out choppy markets.
Momentum
The momentum indicator displays the speed of price movement during a specified time period. In eSignal, the default period for this study is 10, which means that, to calculate a symbol's momentum, one just needs to take the current close and subtract the close from 10 bars ago. For example, in the following chart, the current price of IBM is 114.06 and the momentum indicator is 7.9. If you subtract the value of the momentum indicator from the price, you’ll have exactly the close of the IBM from 10 days ago, or 106.16.
As with the MACD, when the momentum indicator is above zero, the symbol is considered to be in an uptrend, and when it’s below zero, it will be in a downtrend. Also of note is the fact that the extreme peaks and valleys of this study often correlate with the ends of trends.
As with most indicators, the momentum indicator can be used in a variety of ways. You could draw trend lines on this indicator and make trends on the line break. You could use it as a general overbought or oversold oscillator, or even, as with the MACD, in an always-in style of trading, buying on the crossing of the zero line.
My personal preference is to use this study in a way similar to what we did with the Accumulation/Distribution study (for instance, looking for divergences between the price and the momentum of the stock). When these occur, they tend to spot an end to a long- or medium-term trend and are helpful as a warning indicator to exit a trade when trading with the trend.
Next month, we’ll finish up the remainder of the basic studies in eSignal.
