thinkMoney - Fall 2018

They say too many cooks spoil the broth. You can think of indicators the same way. Too many on a chart, and you won’t be able to make any sense of potential price direction. So which indicators should you consider adding to your charts?

Option contracts have a limited lifespan. So the challenge is to figure out which options will move within the lifespan of the options contract.

Options traders generally focus on volatility (vol) and trend. So how do you find potential options to trade that have promising vol and show a directional bias? This is where indicators may help.

NOT JUST FOR CHAR T GEEKS

No one indicator has all the answers. But throw a few together on a chart, and they may “indicate” if a stock is trending, which direction it’s trending, and with how much momentum.

Fire up your thinkorswim® platform from TD Ameritrade, select the Charts tab, pull up any chart, choose the Studies option, then Add Study, and finally All Studies. You’ll see a long list. But you don’t need to know all about every single indicator. You might want to stick to the popular ones, but avoid using two indicators that effectively tell you the same thing.

Where to start? Keeping vol and directional bias in mind, let’s divide the indicators into categories.

TREND-FOLLOWING INDICATORS
Moving averages. When you think
“trend-following,” the first indicator
that usually comes to mind is the
moving average. It’s the line that goes
through prices to show the general price
movement. And there are different types:
simple, exponential, weighted. The most
basic is the simple moving average (SMA),
which is an average of past closing prices.
So, if you use a 50-day SMA, you’re looking
at the average of the past 50 days. If you
use a 20-week SMA, you’re
seeing the average of the
last 20 weeks.

The SMA’s main objec-
tive is to identify if price is
in a possible trend and the
trend’s direction. A quick
glance at a chart can help
answer those questions. In
Figure 1, it’s clear when a trend is going up
or down. Remember, a trend can reverse at
any time without notice.

Moving average convergence/divergence (MACD). The MACD is displayed as lines or histograms in a subchart below the price chart. We’ll focus on the line display, which is made up of two lines—the MACD line and signal line (see Figure 1). These two lines oscillate around the zero line. The MACD line, by default, is the difference between the 12- and 26-period exponential moving average (EMA) of the close. The signal line, by default, is the 9-period EMA of the MACD. You can change these parameters.

The MACD provides three signals—a trend signal, divergence signal, and timing signal.

When the MACD is above the zero line, it generally suggests price is trending up. When it’s below the zero line, it suggests a downtrend. Crossovers can also be used to indicate uptrends and downtrends. When the MACD crosses above its signal line, prices are in an uptrend. The opposite is true for downtrends.

There’s another way you might use MACD—for divergence signals. That’s when price moves in one direction, but MACD moves in the opposite direction. A divergence could signal a potential trend change.

But when will that change happen, and will it be a correction or a reversal? You may never get a perfect answer. But to get a possible idea, use the SMA and MACD together.

In Figure 1, notice how price reacts to
the SMA after the MACD divergence. Price
broke through the SMA, after which a
bearish trend started. Usually, you won’t see
a divergence early in an uptrend. Instead,
price, SMA, and MACD will probably move
up. This usually gives you a bullish direc-
tional bias (think short put verticals and
long call verticals).

Once a trend starts, watch it, as it may continue or change. Where are prices in the trend? How much steam does the trend have left? This is where momentum indicators come in.

MOMENTUM INDICATORS

To measure price momentum, you
can examine where a stock’s price
closed relative to previous closes
or price ranges. Two common momentum
indicators are stochastics and the Relative
Strength Index (RSI).

Stochastics. This is an oscillator that moves from zero to 100 and goes up and down with price. It’s derived from the closing price relative to the price range. If price rises and pushes the stochastic above 80, which is the “overbought” level, it suggests the trend may be losing steam, and prices could fall.

In the same way, when price falls and the stochastic goes below 20, which is the oversold level, it suggests that selling may have dried up and price may rise.

Relative Strength Index (RSI). RSI looks at the strength of price relative to its closing price. It measures a security’s speed and the change in its price movements. A

10-period RSI will look at the prevailing closing price relative to the closing price of the prior 10 days. Like stochastics, RSI has overbought/oversold threshold levels—70 and 30, by default.

FIGURE 1: SMA and MACD. On your chart, try inserting the SimpleMovingAvg and MACDTwoLines studies. Here, the MACD divergence indicates a trend reversal may be coming. Source: thinkorswim® from TD Ameritrade. For illustrative purposes only.