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In the realm of technical indicators, moving averages are extremely popular with market technicians and with good reason. Moving averages smooth the price action and make it easier to spot the underlying trends. Precise trend signals can be obtained from the interaction between a price and an average or between two or more averages themselves. Since the moving average is constructed by averaging several days’ closing prices, however, it tends to lag behind the price action. The shorter the average (meaning the fewer days used in its calculation), the more sensitive it is to price changes and the closer it trails the price action. A longer average (with more days included in its calculation) tracks the price action from a greater distance and is less responsive to trend changes. The moving average is easily quantified and lends itself especially well to historical testing. Mainly for those reasons, it is the mainstay of most mechanical trend-following systems. Popular Moving Averages In stock market analysis, the most popular moving average lengths are 50 and 200 days. [On weekly charts, those daily values are converted into 10 and 40-week averages.] During an uptrend, prices should stay above the 50-day average. Minor pullbacks often bounce off that average, which acts as a support level. A decisive close beneath the 50-day average is usually one of the first signs that a stock is entering a more severe correction. In many cases, the breaking of the 50-day average signals a further decline down to the 200-day average. If a market is in a normal bull market correction, it should find new support around its 200-day average. [For short-term trading purposes, traders will employ a 20-day average to spot short-term trend changes]. Bollinger Bands These are trading bands plotted two standard deviations above and below a 20-day moving average. When a market touches (or exceeds) one of the trading bands, the market is considered to be over-extended. Prices will often pull back to the moving average line. Moving Average Convergence Divergence (MACD) The MACD is a popular trading system. On your computer screen, you’ll see two weighted moving averages (weighted moving averages give greater weight to the more recent price action). Trading signals are given when the two lines cross. Oscillators are used to identify overbought and oversold market conditions. The oscillator is plotted on the bottom of the price chart and fluctuates within a horizontal band. When the oscillator line reaches the upper limit of the band, a market is said to be overbought and vulnerable to a short-term setback. When the line is at the bottom of the range, the market is oversold and probably due for a rally. The oscillator helps to measure market extremes and tells the chartist when a market advance or decline has become overextended. Relative Strength Index (RSI) This is one of the most popular oscillators used by technical traders. The RSI scale is plotted from 0 to 100 with horizontal lines drawn at the 70 and 30 levels. An RSI reading above 70 is considered to be overbought. An RSI reading below 30 is considered to be oversold. The most popular time periods for the RSI are 9 and 14 days (See Figure 13-1). Stochastics This oscillator is also plotted on a scale from 0 to 100. However, the upper and lower lines (marking the overbought and oversold levels) are at the 80 and 20 levels. In other words, readings above 80 are overbought, while readings below 20 are oversold. One added feature of stochastics is that there are two oscillator lines instead of one. (The slower line is usually a 3-day moving average of the faster line). Trading signals are given when the two lines cross. A buy signal is given when the faster line crosses above the slower line from below 20.A sell signal is given when the faster line crosses beneath the slower line from above 80.The time period used by most chart analysts is fourteen days (See Figure 13-2). Any Time Dimension As is the case with most technical indicators, these oscillators can be employed in any time dimension. That means they can be used on weekly, daily, and intraday charts. It’s a good idea to use the same time span in all time dimensions. When plotting the stochastics lines, for example, use 14 weeks on the weekly chart, 14 days on the daily chart, and 14 hours on an hourly chart, etc. Another reason for keeping the same numbers is that computers allow you to switch back and forth between weekly, daily, and intraday charts with a keystroke. Using the same time spans in all time dimensions makes your work a lot easier.
 

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