DANGEROUS OPINIONS AND INDICATORS: A WORD ABOUT MACD AND STOCHASTICS

When I began trading, my indicators indeed gave me signals that prices or
trends may change, but they did very little to help me consistently time
those changes accurately enough to make money. Instead, these indicators
caused me to form counterproductive opinions.


Three examples that show how opinions and indicators can be
dangerous:
1. Opinion—MACD Example:
Let’s say you have bullish divergence in a moving average convergence/
divergence (MACD) oscillator, and you now have an opinion in
your mind that prices should change from the current downtrend to an
uptrend.

So, you look for a reason to go long, an entry signal. One comes
along and you take it. You think to yourself that you would not have
normally taken that signal if you did not see bullish divergence, but
with bullish divergence you feel you should. Prices then continue
downward even lower and the bullish divergence remains bullish so
you stay with your long position.

“. . . Can’t go much lower . . .” you say to yourself. It does go lower
and now you’re worried but you do not want to sell and take the large
loss, so you hold on. After all, the MACD divergence is still bullish, but
not as much as before.

Soon the divergence turns into no divergence and instead the trend
down becomes apparent, and you now must sell out. You feel depressed,
frustrated, and betrayed by your MACD oscillator! If the oscillator
had not been there, you would never have taken the trade to
begin with.

2. Opinion—Stochastic Example:
You get a trading signal to go long, but this time your stochastic
oscillator indicates that prices are overbought already, so you do not
take the long position. The so-called overbought stochastic oscillator
formed an opinion in your mind not to take the trade. Now you sit
there and watch a great uptrend developing right before your eyes and
the stochastic oscillator remains overbought during the entire 10-point
uptrend. Had you never looked at the stochastic oscillator, you would
not have had an opinion, and would have gone long.

3. Opinion—MACD Example:
You see bearish divergence on the MACD oscillator, so you form
an opinion that the uptrend is ending and now you look to get out of
your long position right away. You then use a trailing stop and exit
the market—only to find prices reverse and go higher and the MACD
oscillator turn bullish. You are left scratching your head.

Examples of how opinions distort reality could go on and on, but you
get the idea. And the idea is that oscillators form opinions, and opinions are
not in the best interest of the successful trader. Instead, with ART, you will

learn to listen to what the market is actually saying through price action
and volume.

Strive to create an environment without opinions. That means avoid
reading financial newspapers, watching financial TV, or listening to financial
news in any form while trading.

News programs form opinions, trading oscillators form opinions, and
market analysts form opinions. We do not know how the markets will react
to news and financial recommendations. If we think we do, then we are
forming an opinion about the news.

How many times have companies come out with great earnings and
sold off right after the announcement. And when the market does sell off,
the news commentator comes out and says “. . . the stock had run up already
in expectation of the good numbers and then sold off. . . .” If instead
the stock continued upward, the news commentator would say, “. . . good
earnings drove the market upward. . . .” News commentators operate on
20/20 hindsight. We do not have this luxury.


OVERBOUGHT AND OVERSOLD CONDITIONS


The Market Itself Is Never Overbought or Oversold—Think about It
Markets work to bring price in line with supply and demand. Markets are
perfectly efficient. If supply always equals demand, then how can a market
be overbought or oversold? It may be expensive, but expensive can be a
relative term.

For example, suppose you purchased a painting by a currently unknown
artist/painter for $1,000. The next week your artist/painter gets reviewed
in a famous magazine and his work is now nationally recognized,
so your painting increases in value to $1,500. Some say that your painting
is too expensive or that prices are now overbought because it went up in
value too quickly in just one week.

What if the next week a famous collector buys a similar painting by the
same artist/painter for $4,000, and now the value of your painting increases
to $3,000!

All the indicators said that it was overbought at $1,500 because the
price went up too high in a short period of time. The reality is that because
of supply and demand, prices are exactly where they should be—regardless
of the reasons! There is no such thing in an efficient market as overbought
and oversold. Prices are where they are because that is where they are
supposed to be!


INEFFICIENT MARKETS VERSUS EFFICIENT MARKETS
There’s a great debate between academics regarding the issue of efficient
markets versus inefficient markets. There are traders who believe that just
because they make money in the markets, the markets are therefore inefficient.
Their belief is that they exploit the inefficiencies of the market in
order to make money.

But, aren’t they just adding to the efficiency and liquidity of the market
with each and every trade they make? For every one of those traders who
made money in the market, there is another trader on the other side of the
trade who lost money. Now, that is efficient. The bottom line is the markets
are efficient no matter how you look at it.

SUPPLY = DEMAND
When supply equals demand, both the seller and the buyer disagree on
value, but agree on price. This is important . . .
When this happens, it is a truth in the marketplace. The amount of
supply and demand occurring in the market is called volume. That also is
a truth. Both price and volume are absolute and are truths of the market
because they are not distorted. (Indicators used in technical analysis often
distort price and volume.)
Read More: DANGEROUS OPINIONS AND INDICATORS: A WORD ABOUT MACD AND STOCHASTICS

Bonds As A Leading Indicator Of Stocks

The purpose of this article is twofold. One is to demonstrate a strong positive relationship between bonds and stocks. In other words, the price action and technical readings in the two markets should confirm each other. As long as they are moving in the same direction, analysts can say that the two markets are confirming each other and their trends are likely to continue. It's when the two markets begin to trend in opposite directions that analysts should begin to worry.

The second point is that the bond market usually turns first. Near market tops, the bond market will usually turn down first. At market bottoms, the bond market will usually turn up first. Therefore, the technical action of the bond market becomes a leading technical indicator for the stock market.

The young bull market in bonds and stocks continued into early 1983. In May of 1983, however, the bond market suffered a bearish monthly reversal, setting up a potential double top on the bond chart. At the same time, the stochastics oscillator gave a sell signal. Data shows, stocks began to roll over toward the end of 1983 and flashed a stochastics sell signal as the year ended. The setback in stocks wasn't nearly as severe as that in bonds. However, the weakness in bonds warned that it was time to take some profits prior to the 15 percent stock market decline.

In mid-1984 both markets flashed new stochastics buy signals at about the same time. (Bonds actually began to rally a month before stocks.) The beginning of the second bull leg in the bond market had a lot to do with resumption of the bull market in stocks. Both markets rallied together for another two years. It wasn't until early 1987, when the two markets began to move in opposite directions, that another negative divergence was given.

hi April 1987 bonds began to drop (flashing a stochastics sell signal), which set the stage for the 1987 stock market crash in October of that year. Once again the bond market had proven its worth as a leading indicator of stocks. The bullish monthly reversal in bonds in October 1987 also set the stage for the stock market recovery from the 1987 bottom. A stochastics buy signal in bonds at the end of 1987 preceded a similar buy signal in stocks by almost a year. During the entire decade of the 1980s, every significant turn in the stock market was either accompanied by or preceded by a similar turn in the bond market.

Overlay charts will show comparison of the relative action of bonds and stocks over shorter time periods. On the monthly charts used in preceding paragraphs, price breakouts and stochastics buy and sell signals were emphasized. In the overlay charts, attention will shift to relative price action. Price divergences are easier to spot on overlay charts, and the leads and lags between the two markets are more obvious.

Data compares the two markets from 1982 through the third quarter of 1989. The similar trend characteristics of the two markets are more easily seen. The most prominent points of interest on this chart are the simultaneous rallies in 1982; the breakdown in bonds in 1983 leading to a stock market correction; the simultaneous upturn in both markets in 1984; the top in bonds in early 1987, preceding the stock market crash of 1987; and both markets rallying together into 1989. To the upper right it can be seen that the breakout by stocks above their 1987 pre-crash highs has not been confirmed by a similar bullish breakout in bonds.

Data show break the period from 1982 to 1989 into shorter time intervals to provide closer visual comparisons. I'll take a closer look at the events immediately preceding and following the October 1987 stock market crash and will also examine the market events of 1989 in more detail. Data shows the relative action of bonds and stocks at the 1982 major bottom. Notice that as the Dow Industrials hit succeeding lows in March, June, and August of 1982, the bond market was forming rising troughs in the same three months. In August, although both markets rallied together, bonds were the clear leader on the upside.

In May of 1983, bonds formed a prominent double top and began to drop. That bearish divergence led to an intermediate stock market peak at the end of the year, which led to a 15 percent downward correction in the equity market. The downward correction in both markets continued into the summer of 1984. A close inspection of Figure 4.5 will show that the mid-1984 upturn in bonds preceded stocks by almost a month. Both entities then rallied together through the end of 1985. Notice, however, that short-term tops in bonds in the first quarter and summer of 1985 preceded downward corrections in the stock market.

Data compares the two markets during 1986 and 1987. After rising for almost four years, both markets spent 1986 in a consolidation phase. However, at the beginning of 1987, stocks resumed their bull trend. As the chart shows, bonds did not confirm the bullish breakout in stocks. What was even more alarming was the bearish breakdown in bonds in April of 1987 (influenced by a sharp drop in the U.S. dollar and a bullish breakout in the commodity markets). Stocks dipped briefly during the bond selloff. During June the bond market bounced a bit, and stocks resumed the uptrend. However, bonds broke down again in July and August as stocks rallied. You'll notice that bonds broke support at the May lows in August, thereby flashing another bear signal. This bear signal in bonds during August 1987 coincided with the 1987 peak in stocks the same month.

Bonds not only led stocks on the downside in the fall of 1987, they also led stocks on the upside. Figure 4.7 shows the precipitous slide in bond prices which preceded the stock market crash in October 1987. The bearish breakdown in bonds was too serious to be ignored by stock market technicians. However, as the actual stock market crash began, the bond market soared in a flight to quality. Funds pulled out of the stock market in panic were quickly funneled into the relative safety of Treasury bills and Treasury bonds. There was another important factor that helps explain the sharp rally in interest rate futures in October 1987.

In the ensuing panic during the stock market crash, the Federal Reserve flooded the financial system with liquidity in an attempt to calm the markets and cushion the stock market fall. At the time the consensus view was that a serious recession was at hand. As a result the sudden monetary easing pushed interest rates sharply lower. The lowering of interest rate yields pushed up the prices of interest rate futures.

At such times the normal positive relationship of bonds and stocks is temporarily disturbed. Until the markets stabilized, an inverse relationship between the two sectors was evident. However, as Figure 4.7 shows, that inverse relationship was shortlived. In fact, it's remarkable how quickly the positive relationship was resumed. Within a matter of days, the peaks and troughs in bonds and stocks begin to move in the same direction. However, the sharp rally in bonds into the first quarter of 1988 reflected continued concerns about an impending recession (or depression) and the desire on the part of the Federal Reserve Board to lower interest rates to prevent such an eventuality.

By the middle of 1988, things seemed pretty much back to normal. However, through it all, on the downside first and then on the upside, important directional clues about stock market direction during the summer and fall of 1987 could be discovered by monitoring the bond market.

Data gives us a view of 1988 and the first three quarters of 1989. It can be seen that from the spring of 1988 to the fall of 1989, the peaks and troughs in both sectors were closely correlated and that both markets rallied together. However, in this instance the stock market proved to be the stronger of the two. Although both markets moved in the same direction, it wasn't until May of 1989 that bonds finally broke out to the upside to confirm the stock market advance.

Data gives a closer look at 1989. This chart shows the close visual correlation of both markets. The timing of the peaks and troughs is extremely close together. To the upper right, however, the bond market is beginning to show some signs of weakness in what could be the beginning of a negative divergence between the two markets. Read More : Bonds As A Leading Indicator Of Stocks

Leading and Lagging Indicators

The term leading indicator is somewhat of a misnomer in that
there is no tool that can predict what will happen in the future.

Previous and current price behaviors are generally the only
determinants in technical analysis. For the sake of analysis,
however, technical indicators can be divided into two types:
leading indicators and lagging indicators. A leading indicator
gives us an indication or signal before an actual price reversal;
a lagging indicator gives us an indication or signal after a new
trend has started.

The first thing one needs to understand about
this concept is that trades that are based on a leading indicator
probably are going to have a higher losing percentage because
the indicator is anticipating price behavior. In contrast, with a
lagging indicator we wait for behavior that indicates that a
reversal has occurred, and that new trend is already under way
before we commit to a trade. Most leading indicators measure
momentum, or the degree of the slope of a current price movement—
i.e., the speed of the trend—and are called momentum
oscillators. Momentum in markets ebbs and flows, and an indicator
that lets us know whether the speed of the market is accelerating
or slowing is a handy tool to have because larger price
changes usually are accompanied by higher price momentum.

A market can be making lower lows and lower highs and be in
an obvious downtrend, but if the rate of its descent is slowing
and we have a position that is going with the trend, we may
want to pay closer attention to price. We would take additional
confirmation from individual candle behavior and support
lines. Similarly, if the rate of acceleration is increasing in our
favor, we would be more inclined to maintain our position.


Direction constitutes important information, but measuring
momentum, particularly as a market approaches support
or resistance, has predictive value. Leading indicators include
stochastics, the Relative Strength Index (RSI), and the Commodity
Channel Index (CCI). Most trend-following indicators,
or “overlays,” such as moving averages and moving average
crosses, are considered lagging indicators as they are giving us
the price’s previous and current direction. Indicators based on
previous price action cannot alert us to a change of direction
until after the market has experienced it. An advantage of this
is that we are inclined to stay with positions longer. It is thought
by many experienced traders that the most important skill a
trader can have and the one that is the hardest to achieve is the
ability to “let a profit run,” or stay in a position longer and maximize
profits. Two of the main reasons for this are emotions,
generally nervousness, and leading indicators. Trend traders
need to be comfortable with lagging indicators. Lagging indicators
other then moving averages include moving average
convergence/divergence (MACD) and Bollinger bands.
Source: Mastering the Currency Market: Forex Strategies for High and Low Volatility Markets

Leading Indicators

For leading indicators one looks to the markets themselves:
The S&P 500. This stock index consists of 500 of the
top U.S. corporations. It provides a forward look on
the health of some of the largest companies in the
world and is thus a good gauge of the economy
overall.

U.S. Treasury bonds and notes. These influential financial
instruments provide a direct look at current and future
interest rates as well as gauging demand for
government securities.

U.S. dollar index. This currency index shows how the U.S.
currency is faring relative to its trading partners’
economies.
As an analyst or trader you need to do the following:
• Keep an economic calendar marked with the key release
dates.
• Be aware of the major economic releases and the impact
they can have.
• Stay abreast of major international developments and
news as they affect the value of currency prices.
• Know that the currency markets of the major
industrialized nations tend to be self-correcting price
mechanisms. The very things that make a country’s
currency strong, such as a growing business environment
and firming interest rates, in time will have the opposite
effect as that demand will allow those countries’ trading
partners with cheaper currencies and lower interest rates
to undercut their prices, leading to slower growth and
lower interest rates in that country.
• If you are new to trading and economics, do not base
trades solely on fundamentals at this point in your trading
experience. The results are too unpredictable, and the risk
too high. In general, however, fundamental analysis is
most useful for long-term positions.

As you can see from the many examples just reviewed, there
are times when the current trend in the market takes precedence
over the fundamental news, just as there are times when
a news release overrides the current trend. There are no constants
in economic developments and releases because the
economy and the many moving parts that constitute it constitute
a very dynamic process. As traders, many of us devise a
more accessible framework for determining the direction from
which to trade a market not by studying the causes of price
movement—the fundamentals—but by going along with the
effects of price movement. You will never read the phrase fundamentals
versus technicals in this book, as we know and understand
the complementary value of both schools of thought.
Source: Leading Indicators

Volume – The Key to the Truth

Volume is the major indicator for the professional trader.
You have to ask yourself why the members of the self regulated Exchanges around the world like to keep true volume information away from you as far a possible. The reason is because they know how important it is in analysing a market!

The significance and importance of volume appears little understood by most non-professional traders. Perhaps this is because there is very little information and limited teaching available on this vital part of technical analysis. To use a chart without volume is similar to buying an automobile without a gasoline tank.

Where volume is dealt with in other forms of technical analysis, it is often viewed in isolation, or averaged in some way across an extended time period. Analysing volume, or price for that matter, is something that cannot be broken down into a simple mathematical formula. This is one of the reasons why there are so many technical indicators out there – some formulas work best for cyclic markets, some formulas are better for volatile situations, whilst others are better when prices are trending.

Some technical indicators attempt to combine volume and price movements together. This is a better way, but rest assured that this approach has its limitations too, because at times the market will go up on high volume, but can do exactly the same thing on low volume. Prices can suddenly go sideways, or even fall off, on exactly the same volume! So, there are obviously other factors at work.

Price and volume are intimately linked, and the interrelationship is a complex one, which is the reason Trade Guider was developed in the first place. The system is capable of analysing the markets in real-time (or at the end of the day), and displaying any one of 400 indicators on the screen to show imbalances of supply and demand.

Urban Myths You Should Ignore!
There are frequent quotes on supply and demand seen in magazines and newspapers, many of which are unintentionally misleading. Two common ones run along these lines.
• "For every buyer there has to be a seller"
• "All that is needed to make a market is two traders willing to trade at the correct price"
These statements sound so logical and straight forward that you might read them and accept them immediately at face value, without ever thinking about the logical implications! You are left with the impression that the market is a very straight forward affair, like a genuine open auction at Sotheby's perhaps. But these are in fact very misleading statements.

Yes, you may be buying today and somebody may be willing to sell to you. However, you might be buying only a small part of large blocks of sell orders that may have been on the market-makers' books, sitting there, well before you arrived The market will be supported until these sell orders are exercised, which once sold will weaken the market, or even turn it into a bear market.


So, at important points in the market the truth may be that for every share you buy, there may be ten thousand shares to sell at or near the current price level, waiting to be distributed. The market does not work like a balanced weighing scale, where adding a little to one scale tips the other side up and taking some away lets the other side fall. It is not nearly so simple and straight forward.

You frequently hear of large blocks of stock being traded between professionals, by-passing what appears to be the usual routes. My broker, who is supposedly "in the know", once told me to ignore the very high volume seen in the market that day, because most of the volume was only market-makers trading amongst themselves. These professionals trade to make money and while there may be many reasons for these transactions, whatever is going on, you can be assured one thing: it is not designed for your benefit. You should certainly never ignore any abnormal volume in the market.

In fact, you should also watch closely for volume surges in other markets that are related to that which you are trading. For example, there may be sudden high volume in the options market, or the futures market. Volume is activity! You have to ask yourself, why is the ‘smart money’ active right now?
Read More : Volume – The Key to the Truth