ChartWatchers Newsletter

Finding New Highs and Measuring Trend Strength with Stochastics

The Stochastic Oscillator is best known as a momentum indicator, but a careful look at the formula reveals that it can also be used to measure trend strength. As noted in a previous article on MACD, it is imperative that chartists fully understand an indicator to get the most out of it. The Stochastic Oscillator is a simple indicator that is really easy to understand. This article will start with a basic explanation and a few formula examples to explain the mechanics of the indicator. I will then show how it can be used to measure trend direction and strength over different timeframes. 

 

What does the Stochastic Oscillator Actually Measure? 

Let’s first look at the Fast Stochastic Oscillator (Fast STO) to learn exactly what it is telling us. The Fast STO measures the level of the close relative to the high-low range over a specific period. In other words, the high-low range is the scale and Fast STO plots the position of the close on this scale The classic 14-day setting measures the position of the close relative to the 14-day high-low range. In general, the indicator is above 80 when the close is near the 14-day high and below 20 when the close is near the 14-day low. 

The formula for the 14-day Fast STO is the close less the 14-day low divided by the 14-day high-low range. In mathematical terms, it looks something like this: (Close - 14-day Low)/(14-day High - 14-day Low). The result is then multiplied by 100 to slide the decimal point two places. Three sample calculations are shown below with three bars for a visual. The vertical lines represent the scale (high-low range) and the horizontal lines mark the close. 

The chart below shows Target with four different fourteen day periods on the price chart (shaded areas) and the corresponding levels for Fast STO. The first period shows a trading range and the close is near the middle of this range (Fast STO = 53). The second period shows the close near the upper end of the 14-day range and Fast STO is above 80. The third period shows the close near the low end of the 14-day range and Fast STO is below 20. Prices continued lower in the fourth period and the Fast STO remained below 20 for an extended time. 

Slow STO, %D and %K

The Slow Stochastic Oscillator (Slow STO), which is the most popular version, smooths the Fast STO by applying a 3-day EMA. George Lane, creator of the indicator, also added a 3-day EMA as a signal line. Lane labelled Fast STO and Slow STO as %K, while the 3-day EMA is referred to as %D. In general, I prefer Slow STO because it filters out some of the noise. I do not use the signal line (%K) because I am not looking for momentum turns. %K, therefore, will be set to 1, which means it is a 1-day EMA of %D and the same as Slow STO. The chart below shows Google with three different Stochastic Oscillator to illustrate the differences. 

Using Slow STO to Define the Trend

In general, prices are moving higher when Slow STO stays near the top of its range and lower when the indicator remains near the bottom of its range. Chartists can use a 125-day Slow STO to define the six month trend. In general, I would consider the trend up as long as Slow STO holds above 70. Conversely, the trend is considered down when Slow STO remains below 30. The first chart shows JP Morgan (JPM) with the 125-day Slow STO moving above 70 in mid July and holding above this level the next eight months as a strong uptrend unfolded. This is a stock we want to have on our watchlist for bullish opportunities, such as pullbacks within an uptrend. 

The second chart shows Gilead Sciences (GILD) with a steady downtrend from May 2016 to March 2017. The 125-day Slow STO moved above 30 four times during this downtrend, but did not hold above 30 for long and did not come close to breaking into the top half of the Stochastic range (above 50). Notice that the stock formed lower lows and lower highs as Slow STO floundered in the bottom third of its range. Gilead is clearly a stock to avoid because of the strong downtrend. 

Indentifying 52-week Highs (and Lows)

Stocks trading near 52-week highs are clearly in strong uptrends and Slow STO can be used to capture this kind of strength. Set at 250 days or 52 weeks, the indicator covers one year and measures the position of the close relative to the one year high-low range. Stocks with a Slow STO above 90 are close to 52-week highs and in strong uptrends. Conversely, stocks with a Slow STO near 10 are close to 52-week lows and in strong downtrends. This is valuable information that chartists can use as part of a trading strategy.  The example below shows Apple nearing a 52-week high in mid December as the 250-day Slow STO exceeded 90. The indicator remained above 90 as Apple pushed ahead to 52-week highs in January, February and March. 

Conclusions

The Stochastic Oscillator is clearly more than just a short-term momentum oscillator. This becomes clear when we fully understand the formula and timeframe settings. Chartists can use 21 days to determine the position of the close relative to the high-low range over the past month. I prefer to use it as a long-term measure of trend strength with look-back periods that cover six to twelve months (125 to 250 days). The level of smoothing is also a choice to consider. The Fast STO has no smoothing and will hit 100 when the close is at the exact high of the look-back period. Slow STO, which has built in smoothing, will not hit 100 as often. Chartists can also consider tinkering with this smoothing parameter. Bottom Line: the Stochastic Oscillator can be used to measure trend strength and find stocks in strong uptrends.  

Follow me on Twitter @arthurhill  - Keep up with my 140 character commentaries.

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Thanks for tuning in and have a good day!
--Arthur Hill CMT

Plan your Trade and Trade your Plan
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Apparel Retailers Printing Bullish Inverse Head & Shoulders Pattern

Over the past year, the Dow Jones U.S. Apparel Retailers Index ($DJUSRA) has been one of only four industry groups in the consumer discretionary space that has posted a loss.  And over the past three months the DJUSRA is the worst performing area of consumer discretionary.  But keep in mind that March is the best calendar month of the year for apparel retail stocks historically and April is solid as well.  From a longer-term perspective, there's a bullish upsloping inverse head & shoulders pattern in play so I'm not ready to write off this group.  Check out the chart:

Continue reading "Apparel Retailers Printing Bullish Inverse Head & Shoulders Pattern" »

All-World Index Hits New Record

Chart 1 shows the FTSE All-World Stock Index ($FAW) trading at a new record high. The FAW includes stocks from 47 developed and emerging markets. It just recently cleared its 2015 high which resumed its major uptrend. That's a positive sign because it shows that the stock market rally is global in scope. The FAW, however, is heavily influenced by the U.S. market which is also at record highs. A better way to judge the performance of foreign stocks it to look at global stock indexes that don't include the U.S.

Foreign stocks are on the rise as well. Chart 2 shows the Vanguard FTSE All-World ex-US ETF (VEU) rising to the highest level since June 2015. It still needs to clear its 2014-2015 highs, but is heading in that direction. The VEU is a combination of foreign developed and emerging markets. Interestingly, the VEU has actually done better than the U.S. this year. The VEU is up 8.5% in 2017 versus a 6.3% gain for the S&P 500. Most of those gains have come from emerging markets which are up 13% this year. Most of those gains have come from Asian countries like China, South Korea, Taiwan, and India. Commodity exporters like Brazil and Russia have pulled back with commodity prices, but are starting to bounce again. Foreign developed stocks have also outpaced the U.S. this year by 1.3%. Emerging Markets and EAFE iShares (EEM and EFA) have both reached the highest levels since the middle of 2014.

Reward to Risk Calculation a Must

As part of our service at EarningsBeats.com we send trade alerts to our members on stocks that beat earnings expectations. But before we notify members of any trade candidates we look closely at the "Reward to Risk' ratio as we want to make sure it is favorable before we pull the trigger.

The basic concept is this. We only want to get involved in trades that have much more upside than downside potential. At a bare minimum it needs to be 2 to 1 but 3 to 1 and greater is even better.

As an example, we issued a trade alert to members last week on ARNC. We had two entry levels, both that hit, at a blended price of $26.59. Our price target was $29.85 while our stop loss was $26.07. So, if our price target hit it would be a gain of $3.26 and if our stop loss hit it would be a loss of .52. So in this case we had a slightly greater than 6 to 1 reward to risk ratio. I like those odds.

When we come up with a stop loss it is listed as either "Intra Day" or as a "Closing Stop." An Intra Day stop means a stock moves below a specific level during the course of the trading day. A Closing Stop means the stock closes below a specific level when the closing bell rings. Both have merits but we have found that stocks that move below key support levels during the trading day can often recover by day's end.

We never set a stop unless their is a very specific and valid reason to do so. In other words, our stops are going to be at key price or technical support levels; no guessing allowed!

I'm going to conduct a Webinar on Tuesday, March 21 at 4:30 PM eastern. During this FREE event I will be sharing with attendees some examples of high reward to risk trading candidates including identifying appropriate target prices and stop loss levels. If you would like to join me for this event just click here to register.

If you're going to put your money to work you might as well have as much upside to downside potential in your favor. Obviously not every trade is going to work out but if you do your homework in advance you can maximize your reward to risk before you put your money on the line. 

--
John Hopkins
President
Invested Central/EarningsBeats.com
john@investedcentral.com
www.investedcentral.com

 

Kickin' It Up Globally

In my Chartwatchers article for March 4th, I was focused on some Country Indexes like Germany's $DAX and India's $BSE. The commentary revolved around watching these markets for potential breakouts. You can follow this link to check it out. 5 Foreign Markets Are At Must Watch Levels. There was a big push in overseas markets on the back of the Fed meeting and the following day. Rather than show the foreign markets, it might be better to point to some ETF's that are investable here.

The iShares Germany ETF (EWG) is pushing higher this week and looks to be breaking out of a wide base.

Continue reading "Kickin' It Up Globally" »

Ignoring Signals is the First Step to Taking Signals - How Well do you Know MACD?

 Two Indicators in One

Indicators generate lots of signals and many of these signals are just noise. It is imperative that chartists understand how their indicators work and exactly what these indicators are saying. Understanding the ins and outs of an indicator will help chartists determine which signals to take seriously and which signals to ignore. Today we will look at MACD, one of the most popular momentum indicators. 

MACD, which stands for moving average convergence divergence, measures the convergence and divergence of two exponential moving averages by subtracting the longer EMA from the shorter EMA. The moving average crossovers make MACD a trend indicator, while the moving average differential adds a momentum aspect. In fact, MACD is really two indicators in one. 

MACD as a Trend Indicator

Moving averages are classic trend indicators and MACD can be used to identify moving average crossovers. The trend turns up when a shorter moving average moves above a longer moving average and down when a shorter moving average moves below a longer moving average. Using the default settings, this means MACD turns positive when the 12-period EMA moves above the 26-period EMA and negative when the 12-period EMA moves below the 26-period EMA. Thus, MACD, in its purest form, is simply a trend indicator that identifies moving average crossovers. The chart below shows Accenture with MACD turning positive  (uptrend) and negative (downtrend). Notice that the EMA crossovers coincide with MACD crossing the zero line. 

MACD as a Momentum Indicator

The convergence and divergence of these moving averages captures the momentum aspect of MACD. The chart below shows Medtronic with four different combinations. The first two examples show MACD moving from uptrend to downtrend (positive to negative). First, the positive difference between the two EMAs is narrowing when MACD is in positive territory and falling. This means upside momentum is slowing, but the trend is still up. Second, the negative difference between the EMAs is widening when MACD is in negative territory and falling. A downtrend with increasing downside momentum is the most bearish combination for MACD. 

The next two examples show a move from downtrend to uptrend (negative MACD to positive MACD). First, the negative difference between the two EMAs is narrowing when MACD is in negative territory and rising. This means downside momentum is slowing, but the trend is still down. Second, the positive difference between the EMAs is widening when MACD is in positive territory and rising. An uptrend and increasing upside momentum is the most bullish combination for MACD.  

Beware of Trends that are Simply Slowing

The momentum aspect of MACD is a double-edged sword. Decelerating momentum seems to warn of a an impending trend reversal, but does not always result in an actual trend reversal. The chart below shows Microsoft with MACD and the MACD signal line, which is a 9-period EMA of MACD. First, notice that MACD surged in July when the stock surged over 20% and then plunged in August when the stock traded flat. This is typical for momentum oscillators because they gravitate towards the centerline during a consolidation or flat trading period. This can be expected because momentum is essentially flat during a trading range. Thus, a surge-plunge sequence in MACD is not always bearish because a consolidation after a sharp advance is just a rest designed to alleviate overbought conditions. 

Looking further down the chart, Microsoft traded flat into October and then resumed its advance with a gap. Again, MACD surged as upside momentum accelerated and then fell back as momentum decelerated the next five weeks.  Upside momentum in late November was not as strong as in late October, but MACD was still positive and the trend was still up. The same thing happened in December as MACD surged, fell back and flattened. Again, upside momentum in February was not as strong as in December, but the trend was still up and decelerating momentum did not derail the uptrend. 

Keep the Big Trend in Focus

Chartists must also analyze the actual price chart to put MACD signals into perspective. MACD, after all, is just an indicator and indicators are secondary to price action. The chart below shows Abercrombie & Fitch (ANF) breaking down in May with a move below support and the 200-day SMA. The long-term trend was clearly down at this stage and this means chartists should ignore bullish signals. In other words, do not fight the bigger downtrend. Even though MACD turned positive from mid July to late August, a look at the price chart revealed a bounce back to broken support, which turned into resistance. ANF was just retracing a portion of the prior decline with a counter-trend bounce. 

MACD fell sharply when ANF plunged in late August and then started moving higher in October. Downside momentum decelerated and MACD even edged into positive territory in late November. The move into positive territory was not a robust signal because the bigger trend was down. Conversely, the subsequent moves back below zero were robust signals (gray oval) and foreshadowed a move to new lows in the stock. 

Qualify Signal Line Crossovers

The signal line crossover is by far the most prevalent signal - and the most dangerous. MACD can cross its signal line at the high end of its range, at the low end and in the middle. This means signal line crossovers should be qualified with other chart information. At the very least, chartist should consider signal line crossovers when MACD is near the centerline (zero line), not when MACD is at extremes. Consider bearish signal line crossovers when price is below the 200-day moving average and MACD is near the zero line. Consider bullish signal line crossovers when price is above the 200-day moving average and MACD is near the zero line. 

Conclusions

MACD and other momentum indicators can add value to the analysis process, but chartists must first understand what they are implying and when to ignore signals. Decelerating upside momentum does not always lead to a sustainable trend reversal. Similarly, decelerating downside momentum does not always reverse the downtrend. Even crosses of the centerline should be viewed in context with the bigger trend. In short, chartists should focus on robust bullish signals when the bigger trend is up and robust bearish signals when the bigger trend is down. Ignore the rest! 

Follow me on Twitter @arthurhill  - Keep up with my 140 character commentaries.

****************************************
Thanks for tuning in and have a good day!
--Arthur Hill CMT

Plan your Trade and Trade your Plan
*****************************************

Two-Year Treasury Yield Reaches Seven-Year High, Dollar Turns Up

Chart 1 shows the 2-Year Treasury yield climbing above 1.30% on Thursday, for the first time in seven years. That shorter term yield is more sensitive to the potential for a rate hike than longer-range maturities. That suggests that fixed income traders are taking expectations for a March rate hike by the Fed more seriously. Fed fund futures Wednesday placed the odds for a March hike near 66%. That suggests that bond yields in general are probably headed higher as well. That's also giving a big boost to the U.S. dollar.

Chart 2 shows the U.S. Dollar Index ETF (UUP) climbing to the highest level in six weeks. The dollar is following the 2-Year Treasury yield higher on increased expectations for a March rate hike. Chart-wise, the UUP was due for an upturn anyway. Previous messages showed the UUP having retraced 50% of its August/January rally, which put it in a logical support point. Chart 2 also shows "gap support" formed in mid-November right after the election (see box). One final point. The numerals show that the UUP has been in a "wave four" Elliott wave correction since the start of the year. Uptrends usually have five waves. That makes the 2017 decline a correction in an ongoing uptrend. That increases the odds that a "wave five" advance is starting.

5 Foreign Markets Are At Must Watch Levels

The USA has been a bit of an island in terms of the global markets. It continues to push above previous all-time-highs and usually leads global markets higher. This week is an interesting week as Germany, India, Canada, and Australia are all trying to break through to new highs. Notice the spike in the German market on the last high in 2015. It rolled over the next week and it has taken two years to get back there. India in the lower panel is trying to close at new 52-week highs. India is about a 1100 points from all time highs.

Continue reading "5 Foreign Markets Are At Must Watch Levels" »