CHART CHAT
Take it to Extremes
In this edition of Chart Chat, we will discuss another trading and investing strategy for new and/or inexperienced individuals. In Chapter 2 of our publication When to Buy and When to Sell; Combining Easy Indicators, Charts, and Financial Astrology (available on Amazon), we introduced common chart patterns that are regularly used for technical analysis.
For beginning investors, it normally takes a while to learn to read these patterns in their truest form. These patterns are not always obvious, and need to be combined with other factors, such as market sentiment, depth and length of the pattern, fundamentals, and indicators, to provide the highest probability of a successful trade.
As we tend to focus on the easiest indicators for newbies, we stress the importance of the Fear & Greed Index, which we provide a blog for every week. This gauge is broad-based, and it used mainly as an indicator for reversals, at extremes, on indexes and sector ETFs.
Diving deeper into individual stock charts, there are technically no Fear & Greed gauges. There are, however, many additional indicators (also discussed in our publication) that can assist in essentially coming to the same conclusion. These include Average True Range (ATR), Relative Strength (RS), Bollinger Bands, Keltner Channels, and the Average Directional Index (ADX), which can be found on all trading platforms and research sites. ALL these indicators can be used to determine extreme price moves, that are likely to reverse in the short-term. Let us review them separately…
Average True Range – The range of a stock is simply the total price, from high to low, that an equity moves over the course of a trading period (usually measured in 1 trading day). The ATR is the “average” range over a specified time frame. Most platforms set the default time frame as 14 periods/days, but this number can be adjusted based on the investor/trader’s preference. For example, if an ATR (14) for an equity is noted on the platform as 3.50 on a daily chart, that infers that the average price move, over 14 days, is $3.50. This is very helpful, especially for traders, as any move outside of that range can be considered “extended or extreme.” The further outside the “lines” that an equity moves, the more “extreme” conditions are outside the norm, suggesting a near-term reversal, similar to the Fear & Greed Index. Day, or short-term swing, traders often choose to lower the time-period to 10, or even lower, to represent a more accurate immediate condition. Some also look for a 1.5 or 2x move beyond the line in either direction, to find extreme extended conditions, to close or reverse their trade.
Relative Strength – The relative strength of an equity refers to the strength of its current price movement vs that of the sector or index. This indicator is utilized as a lower study, below the stock price chart. Most traders use the 30 (for low) and 70 (for high) as a sign of “oversold” (30 or below) or “overbought” (over 70). There are many false moves in this lagging indicator, however, and we like to use 20 and 80, for more extreme conditions, and higher probability of reversal. Platforms generally use the RSI 14-period setting, however Day-traders will also move the RSI down to the 2-period for more recent readings.
Bollinger Bandwith – Bollinger Bands are also very popular among traders and investors, as they attempt to identify trading “channels.” Bollinger Bandwith, however, is an indicator that can be added underneath a chart to display how extreme price action is at any given time. As the price extends beyond the developed channel, the riskier the short-term trade becomes. As this gauge moves higher and higher, the momentum is more likely to stall or pull back.
Keltner Channels – Keltner Channels are very similar to Bollinger Bands, though they are a bit less flexible. The “bands” in the Bollinger fluctuate more with the most recent price, like an elastic, while the Keltner is a basic average of the set time-period. The same rules apply for both, however, as the further out of the lines the price moves, the more likely to reverse, at least for the short-term.
Average Directional Index - The ADX is another lower study that is useful for determining the strength of a price move. When a stock move has positive momentum, this indicator will track upward. The line will move downward when negative sentiment is strong, not necessarily when there is only a slowing in buying. Basically, it reflects the strength of the move in either direction. A reading between 20-40, with an upward trajectory is ideal, as the trade tends to become extended, or in extreme territory, the higher it goes.
Whichever indicator or gauge meets your investment or trading strategy, those that show extreme conditions can be more reliable than those that do not. Remember to have a risk management plan, and learn your emotional boundaries.
***As always, this information is not intended to be financial advice, or any specific buy or sell recommendation, but rather a guide to assist the reader in some further understanding of current economic conditions/movements in the sky, and how they can affect moods, behaviors, world events, and financial markets.
