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Click on a term below to see what it means.
Moving Average Convergence-Divergence
Chart Scale: Linear vs. Logarithmic
Bollinger Bands
Bollinger bands are lines displayed on a chart that define the upper and lower boundaries of a stock's normal price range. Unlike a moving average envelope, the width of the bands is determined by the volatility, measured by standard deviations, of the stock and not by a set percentage. As such, the bands are self-adjusting, widening during volatile market periods and contracting during calmer periods. The bands are constructed around a 20-period moving average. Each band is drawn at two standard deviations above and below the average.Bollinger bands are often used to identify a period of low volatility and to prepare for a move above or below a trading range. The theory is that low volatility leads to high volatility and vice versa, so the trader can identify candidates to buy and sell in advance of their actual breakouts. Unfortunately, the direction of the breakout is not indicated by the bands, so the trader must wait to see which way the stock actually starts to move before taking action.
Unlike other bands and envelopes, in a trending market a move outside the bands tends to lead to a continuation of the trend and not overbought or oversold conditions. In flat markets, moves above the bands can indicate overbought and below the bands can indicate oversold, similar to analysis of other types of bands.
Chart overlay
By overlaying an index on a price chart of an individual stock, you can see how the stock is performing compared to the index. Typically, the index chosen is a relevant benchmark for the stock in question.For example, Intel's (INTC, news, msgs) stock may be compared to the Dow Jones Industrial Average ($INDU), the S&P 500 Index ($INX) and the Nasdaq Composite Index ($COMPX), since it is an important member of all three. However, comparisons of a stock with a small market capitalization to the Dow may not be as relevant.
The chartist looks for the relative, not absolute, slopes of the two lines -- the stock and the index -- on the chart. If they are not moving in the same direction, then the one with the rising line is outperforming the one with the falling or flat line.
Money flow index
Money flow measures the rate at which money is flowing into or out of a stock. If volume traded on days when prices rise outweighs volume traded on days when prices fall, then we can say that money is flowing into the stock. Another way to put this is that investor demand for the stock is greater than supply.The money flow index typically rises and falls with stock price movements and therefore can be used as a confirming indicator. However, when the direction of the money flow index line diverges from the direction of the price chart over a period of time, then a trading signal is generated. Typically, stock price direction changes to follow the direction of money flow.
The money-flow index is plotted on a scale of 0 to 100. Values above 80 indicate a possible overbought situation and values below 20 indicates a possible oversold condition. This does not mean, however, that a market will immediately reverse once either of these levels is reached. It is more likely that the market will pause to consolidate, resulting in a more neutral money flow index value.
Moving averages
Moving averages are, as the name implies, an average of stock prices over a defined period of time. They "move" as each period's calculation is made fresh from the most recent data. Traders use moving averages to smooth out market volatility and identify changes in trend. A commonly used method is to buy stocks when they are above their moving average and sell them when prices cross below the averages.The direction of the moving average -- higher, lower or flat -- indicates the trend of the market. Its slope indicates the strength of the trend.
Longer moving averages are used to identify longer-term trends, and shorter averages are used to identify shorter-term trends. For example, the 200-day moving average is commonly used to identify a multimonth trend. The 50-day average is commonly used to identify a multiweek trend. A 10-day moving average identifies a multiday trend.
Moving average convergence-divergence (MACD)
These charts show how two moving averages move together and apart over time. They are used in similar fashion to other momentum indicators to help identify overbought and oversold conditions. The MACD is calculated by taking the difference of the two averages and plotting it as a line. This is called the MACD line. A moving average of that difference is also plotted and is called the signal line.A strong near-term rally will cause the difference between the two moving averages to increase until some extreme value is reached. This signals an overbought condition. Conversely, in a down market, the difference will become large but in the negative direction until an extreme is reached indicating an oversold condition.
In similar fashion to other momentum indicators, overbought and oversold levels give warning of impending changes in trend. Divergences in the direction of the MACD and signal lines and price action also warn that prices are going to change direction to that of the indicator.
Crossovers of the two MACD lines themselves also yield clues as to the health of the trend. As a rule, the market is bullish if the MACD line is rising and is above the signal line. It is bearish if the MACD line is falling and is below the signal line. Buy signals are given when the MACD crosses above the signal. Sell signals are given when the MACD crosses below the signal.
Moving-average envelope
An envelope is typically a range above and below a moving average and is used to help gauge overbought and oversold conditions. The calculation here uses a 20-period moving average with a 5% range above and below that average.When prices move above or below the envelope, then one of two things may be occurring: Either the stock has moved too far, too fast and will snap back to the average, or the movement outside the envelope signals that the overall trend is changing.
Chartists can apply other tools to help determine which is which, but even without them, knowing if the stock trend is at some sort of inflection point serves as a warning that something is about to happen.
On-balance volume
On-balance volume (OBV), sometimes known as cumulative volume, provides a running total of volume and shows whether it is flowing into or out of a given stock. The aim is to determine whether the stock is being accumulated (aggressively bought) or distributed (aggressively sold). OBV is calculated by adding a stock's trading volume for a day to a running total when the stock's price rises and by subtracting the volume when the price falls. If today's closing price is greater than yesterday's, then today's volume is added to the running total. If today's closing price is lower than yesterday's, then today's volume is subtracted from the running total.Over time, OBV and price should rise and fall in tandem. Most of the time, it does not yield clues as to market direction. However, when the directions of OBV and price action diverge, it does offer a good signal that price action is about to change.
Overbought/oversold
Overbought is simply another way to say prices have advanced too far, too fast. Conversely, oversold means that the prices have fallen too far, too fast. For the former, prices would be prone to a correction. For the latter, prices would be prone to a bounce.In both scenarios, we would need more information to determine if the countertrend moves were temporary or the start of a new trend in the opposite direction.
Price channel
This chart plots two bands over price action; the upper band being the highest closing value of the stock over the past 20 periods and the lower band being the lowest closing value over the past 20 periods. Theoretically, when prices move above or below this set of bands, it warns of a pending change.Theoretically, a stock making a fresh closing high is bullish as strength begets strength in the market. In a flat market, a close above the bands, one that forces the level of the band to be redrawn higher that day, is a buy signal under most conditions. In a rapidly rising market or rapidly falling market, other indicators are needed to confirm whether a trend is likely to continue or reverse course.
Price limit lines
Price limit lines are simply horizontal lines to help identify support and resistance levels at which price action paused or changed direction in the past.They are set by the chart user.
Relative strength index
The relative-strength index (RSI) is a widely used indicator of price momentum. Many traders use it to determine if a stock is overbought or oversold, which is another way of saying that a stock has moved too far, too fast and is prone to a correction in the opposite direction of the prevailing trend.Typically, stock traders use a 14-day RSI, which focuses on how fast prices have been moving over a 14-day period. Futures traders tend to use shorter periods, such five days. Longer-term investors may choose to use longer periods, such as 20 days.
The RSI value itself ranges from 0 to 100. Values above 75 indicate a possible overbought situation and values below 25 indicates a possible oversold condition. This does not mean, however, that a market will immediately reverse once either of these levels is reached. It is more likely that the market will pause to consolidate, resulting in a more neutral RSI value.
Relatively high RSIs (60-75) normally accompany a rising price trend and relatively low RSIs (25-40) normally accompany a declining price trend.
Chartists also look for divergences between price action and the RSI plot. If prices are rising and making higher highs while the RSI plot is making lower highs, a divergence is established that can be an early warning for a change in trend. The converse is also true for a declining trend.
Stochastic oscillator
The stochastic oscillator, or simply stochastics, is an indicator that measures price momentum. Specifically, it measures the placement of a current price within a recent trading range on a scale from 0 to 100. Values above 75 or below 25 are potential market signals.The theory is that as prices rise, closing stock prices tend to be closer to the high end of a stock's recent range. When prices trend higher or are flat, and closes begin to sag within the range, it signals internal market weakness.
There are two lines plotted, called the "%K" and "%D." The former is also called the "raw stochastic" and the latter is simply a smoothed version. What makes this study more valuable is that not only can it measure potential overbought and oversold conditions, but crossovers between these two lines (when overbought or oversold) can help determine when it is time to take action.
Chartists also look for divergences between price action and the stochastic lines. If prices are rising and making higher highs while stochastics is making lower highs, a divergence is established that can be an early warning for a change in trend. The converse is also true for a declining trend.
Volume
Volume is simply the number of shares changing hands. The theory is that rising markets should be accompanied by rising volume, as the desire to own stocks propagates from the early buyers to the rest of the public. Exhausted markets are usually accompanied by falling volume or unusually high volume spikes that indicate a final buying frenzy.When prices are falling, the converse is not exactly true. Volume can be falling or steady. Typically, market participants are less active in bear markets. If volume begins to increase, it does not signal an immediate reversal, but usually one is near.
Volume can confirm or deny a reversal or breakout condition. If the market changes trend on high volume, it is likely that the change is real. Similarly, when the market breaks out of a chart pattern on a correction with high volume, the breakout becomes more valid.
Chart Styles:
- HLC and OHLC
Traditional bar charts can be drawn in two formats, either with a stock's opening price indicated (an open-high-low-close bar -- OHLC) or without it (a high-low-close bar -- HLC). Each bar in either format summarizes the period's trading action, with the top of the bar representing the high price, the bottom of the bar representing the low price and the tick market on the right of the bar representing the close price. OHLC bars also represent the open price with a tick mark on the left of the bar.
Over time, bars form trends and patterns that are analyzed with the many tools available to chartists. They allow investors to visually assess where the market is and, more importantly, how it got there.
- Candlesticks
Candlesticks are so named because they resemble candles. The wide part is called the "real body," and it represents the range between a stock's opening and closing price. When the real body is black (filled in), it means the close was lower than the open. If the real body is white (empty), the close was higher than the open.
The wicks of the candle are called "shadows" and represent the high and the low. The shorter the upper shadow on a black body, the closer the open was to the high. A short upper shadow on a white body means that the close was near the high.
- Line
Line charts connect each period's closing price to the next with a continuous line. While information contained in open, high and low prices is lost, clutter is reduced so that trends and patterns may be seen more easily.
This is especially true for charts that cover long periods of time and have many data points, such as a 10-year chart, as the loss of resolution has minimal impact.
Chart scale: linear vs. logarithmic
Most charts are scaled with a linear (arithmetic) price axis and show equal distances between price increments. An increase from $10 to $15 has the same weight on the chart as increase from $100 to $105. But the change at the lower price is clearly more significant than the change at the higher price, so for charts covering large price changes, a logarithmically (log) scaled chart can be more helpful.Log-scaled charts can be thought of as showing percentage changes, so an increase from $10 to $15 -- a 50% increase -- would have much more significance on the chart than the $100 to $105 increase -- a mere 5%.
These charts are typically used when a stock moves over a wide range of prices during the time period covered. For stocks with very large price moves (40% or more) over a short period of time or for those that gain slowly over a long period of time, log charts are ideal to keep all the action in perspective.
By Michael Kahn
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