Greetings, fellow Pro-fundity team members -
5-7-99 Page

1. In previous Guideposts we have studied moving averages as a way to time our entry and exit points into the market. That is, when to buy and when to sell. We learned these were “trend-following” indicators, telling us what the current action has been. The information “lags” the action. It does not tell us what will happen, only what has happened. Moving averages (MA's) do not warn us of pending price changes or changes in the direction of a trend. The result is by nature a conservative indicator because we will buy and sell late. Although we may miss “early” opportunities, we are protected from false signals, greatly reducing our risk.
2. Moving averages perform well in long-term trending markets. However, in side-ways markets they have less value. Side-ways markets are those we enjoy with rolling stocks. We need “leading” indicators to help us predict what prices will do next. Sound too go good to be true? We will examine this class of indicators here, understanding that we assume more risk with the greater reward.
3. Leading indicators measure how “overbought” or how “oversold” a stock is. When a stock is “overbought” it has moved up to the point where the money available has already been poured into the stock. Traders will pause and take profits causing the price to slow and to correct downward before resuming its up-trend.
4. On the other side of this cycle, buyers will appear for bargains when the stock price falls too far. When this occurs the now attractive stock is termed oversold. Stock prices will cycle between these two extremes. For our money, it is usually better to buy a stock when it is oversold and to sell when it’s overbought.
5. Because of the cyclical nature of this market phenomenon, particularly those trading in a side-ways pattern, these indicators are called Oscillators, continually cycling between a top and a bottom. Momentum is the principle upon which oscillators are based. While the price chart tells us if the price are rising or falling, an oscillator chart tells us about the momentum, or the rate of change, of the stock price. This indicator tells us whether the trend is gaining or losing momentum. As an up-trend starts to play out, the rate of change will usually slow. That is, the price increase will slowly level out as it nears the top, not move straight up and some angle then turn to move down at a constant rate. Similar action will take place at the bottom of the cycle.
6. The slowing momentum can be measured by comparing the rate of increase today with the rate of increase a week or two ago. This is often not obvious on the price chart. That is why the oscillator can predict forthcoming price changes, before they happen. Thus, oscillators are called “leading” indicators.
7. The concept is very basic. One indicator compares the most recent closing price to some price in the past. The “Rate of Change (ROC) oscillator divides the latest price by the price 10 days ago. If today's closing price is higher than 10 days ago, the ratio will be greater than one:

Closing price today  Closing price ten days ago        ROC
  11.26		           9.13		        11.26/9.13  =  1.23
  8.37	             12.63	                8.37/12.63  =  0.66

This ratio will vary above and below 1. If the ratio is larger than one, the price is increasing and vice versa. The size of this ratio is a measure of the rate of change. The larger the ratio, the faster the price is changing. The 10 day period is a choice for short term trades, but can be extended as desired for longer cycles. This indicator is available on most charting software, but lacks a reference point. That is, when the line crosses the middle point, where the two prices are equal, it signals an imminent change. However, it does not tell us how over bought or how oversold the price is. A better oscillator for that purpose is also available.

8. Wilder's Relative Strength Index (RSI) was introduced over 20 years ago and has become very popular for both long and short term traders. It does the same thing as the ROC but with a stronger basis. See the sidebar at the end for an explanation of how it is calculated. The major difference between these two oscillators is the RSI provides upper and lower boundaries to measure just how overbought and/or oversold a price is. The RSI indicator varies between 0 and 100, with readings over 70 considered overbought and under 30 as oversold. This boundary condition makes it easy to identify good “buy” and good “sell” candidates.
9. Let’s begin our study of this indicator by looking at the price chart of one of our recent picks. This was chosen because of its low price and its rolling pattern. However, this first chart demonstrates the tentative condition of most rolling patterns.

Take-Two Interactive Software (TTWO)





10. In the following chart, we choose only part of the price pattern of the previous chart and expand the scale to see more clearly what we like as a rolling pattern.





11. To demonstrate the value of the RSI, look at the next chart where we have imposed two moving average lines as a review of previous Guideposts. Remember, last week we explained the two options for a moving average; a simple or a weighted moving average. On this chart we have shown the same 15 day moving average but the Blue line is a weighted (exponential) MA and the Red is a simple MA. The Blue line places more value on recent prices in the 15 day sample which makes it react a little faster. Look carefully how the Blue line is a little faster, sooner on the price chart, than the Red. Although the difference in this example is slight, we prefer the Blue example and will use the exponential MA in all of our examples.

Take-Two Interactive Software (TTWO) with Moving Averages
Lagging Indicators





12. This next chart has the RSI plotted on the price chart for illustration. The two pairs of lines near the one-third levels represent the 30 and 70 overbought and oversold levels for the RSI. Compare the points where the RSI line moves above and below these levels as buy and sell triggers.

Take-Two Interactive Software (TTWO) with RSI
Leading Indicator






13. The Stochastic is another “leading” indicator with the same price chart below including this indicator for comparison. The Stochastics indicator is covered in the Technical Analysis tutorial on the Pro-fundity Page.

Take-Two Interactive Software (TTWO) with Stochastics
Leading Indicator






14. The importance of the “leading” indicators covered in this Guidepost lie in their ability to forecast changes in trends. They work better where trends are changing, that is, in sideways markets. They work less well during sustained up or down-trends. We might characterize the two conditions as trending (sustained trends) and as trading (sideways movements). Leading indicators work better in trading markets, while lagging indicators work best during trends. While it is fairly easy to determine if prices are trending or trading, it is difficult to know how long the condition will exist.
15. Our most formidable task as traders is to know when to utilize each of the types of indicators. During strong trending periods, moving averages perform best. When prices swing back and forth, as in much of our rolling stock activity, oscillators perform better. These are termed “neutral” markets by the “buy & hold” gang, but neutral is not how we play them. Next week we will spend more time on oscillator applications, particularly divergences, then two weeks hence we will consider an oscillator that follows the trend. Is this the best of both worlds? Stay tuned.

May 14 - Applications: Wilder's relative strength index (RSI) Divergences, Convergences

May 21 - Stochastics, MACD, On Balance Volume (OBV)

May 28 - TC-2000 proprietary indicators (BOP, MS, TSV)

We provide TC-2000 tutorials to members upon request.