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 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
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.
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.
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.