Technical Analysis Tutorial: A Practical Guide

Technical Analysis: Momentum and Volatility

Momentum and volatility are two characteristics of the price. They indicate the price behavior. Studying momentum and volatility of the price helps traders make better decisions.

Momentum

Momentum is a fancy word for speed. Yes. Momentum equals speed.

Momentum is change over time.

Let me explain,

We calculate the speed of any moving object like a car by dividing distance over time.

Speed = distance/time.

So, if am driving my car with a speed of 60 miles per hour, that simply means I would cover 60 miles distance in an hour. In this case my momentum is positive (60miles/h) and if I continue to move with same speed then my momentum is positive and stable at 60m/h.

If I accelerate further and my speed rise to 80miles/hour then momentum is rising again after being flat at 60m/h.

In market terms, the change of price speed is the momentum of price. It’s the change of price rate of change over time. I.e. if the price upside move keeps accelerating , meaning the price is moving upward but the upside move speed keeps getting faster and faster(accelerating), then momentum moves higher.

On the other hand, if the price speed decreases(decelerate) momentum should start to fall.

Note: All technical indicators, including momentum indicators take the prices and process it in a mathematical equation. Then produce the result on a chart.

Why Momentum Can be Useful?

Momentum indicators can indicate when an upwards or downward move in the price is decelerating. Prices are rising or falling at a slower speed. And this could be an early sign of price reversal.

That’s why momentum indicators are called leading indicators. They can give signals before the actual price change.

Also, momentum indicators can give indication if the price momentum is at extreme levels. One of the momentum indicators that can indicate that is the Relative Strength Index. Which we will explain right after the concept of divergence.

The Concept of Divergence

Divergence is simply when the momentum indicator diverges from price. i.e., when the price is rising but momentum is not rising at a similar pace (called bearish divergence). Or when the price is falling but momentum is not falling at a similar pace (bullish divergence).

The bullish divergence signals that the price might reverse higher. The opposite for a bearish divergence.

We will discuss further how to use divergence in the following section about momentum indicators and oscillators.

Popular Momentum Indicators (Oscillators)

Relative Strength Index (RSI)

The RSI is a momentum indicator that measure the strength/speed of the current price movement on a scale from 0 to 100.

The RSI is calculated by this formula:

RSI = SI = 100 – [100 / (1 + (Average of Upward Price Change / Average of Downward Price Change) ) ]

The calculation formula for “average upward and downward moves” is complex and lengthy. And not needed at this stage.

What you need to know is that the average of upward prices and downard prices are calculated for a period you specify in the settings of the indicator.

The default period in most charting platforms is 14. But you can change it to what you prefer. I personally prefer 9 and 14 for RSI.

How to Use RSI (General Guidelines)

• Just like the price, the RSI can form chart patterns or support and resistance levels. Therefore, some practitioners use the RSI line solely to generate trading signals.

• The RSI is used as an indicator of momentum extremes up or down. Where if the RSI exceeds 70, that suggests the price is overbought and could be reversing down soon. On the other hand, if the RSI falls below 30, that suggests the price is oversold and could be reversing upwards soon.

• The 50 level in RSI is like ZERO. If RSI above 50 then momentum is positive. If RSI is below 50 then momentum is negative. If the RSI crosses above 50 then it is a buy signal. And if the RSI crosses below 50, it is a sell signal.
• Another way to use the RSI or many other momentum indicator is through divergences. Bullish and bearish divergences.

Remember:

Using the RSI – whichever was the method- to trade in the opposite direction of the longer term trend is not reliable, and will probably result in a negative outcome. We will explain now the best ways to use these signals. Note the following chart.

How to Use the RSI (Practical Guide)

To use the RSI effectively you must first define the current price trend.

If in sideways trend:

If the price is moving sideways, usually, overbought and oversold signals are reliable.

• Consider selling near the resistance of the sideways trend if RSI is overbought.
• Consider buying near the support of the sideways trend if RSI is oversold.

• Consider buying near support if RSI shows bullish divergence.
• Consider selling near resistance if RSI shows bearish divergence.

If the price is moving in an uptrend:

• Consider buying if RSI is oversold or near oversold.

• Consider buying if RSI shows bullish divergence.

• Consider buying if RSI completes a pattern or breaks resistance.

Remember:

In a strong trend, the corrections are usually shallow and short-lived. Therefore RSI does not reach oversold in an uptrend, or overbought in a down trend. That’s why you may consider using a shorter time period instead of the default 14 period.

Alternatively, you may not wait for the RSI to reach oversold or overbought. In a strong uptrend, if the RSI falls below 50 as the price corrects, you might start considering long trades. And the opposite for a downtrend.

If the price is moving in a downtrend:

• Consider selling if the RSI is overbought or near overbought.

• Consider selling if RSI shows bearish divergence.

• Consider selling if RSI completes a pattern or breaks support.

Stochastic Oscillator

The stochastic oscillator measures the position of the latest closing price relative to the high and low of the security over a period of time. Its plotted on a scale from 0 to 100.

Stochastic is based on the fact that the price trends to close each period near the highs when in an uptrend, and near the lows when in a downtrend. As it compares the current closing price with the highest high and the lowest low of the period you specify. If the stochastic fails to move higher in an uptrend, that would suggest that the price is not closing higher enough to confirm the trend.  And the opposite is true in a down trend.

Stochastic formula has three variables;   %K(fast line),  %D(slow line)  and  N(period)

You set the values for these variables through the indicator settings.

For example, the default settings are:

%K= 14%D= 3N(smoothing)= 5

%D = 3-period simple moving average of %K .

The equation of to calculate %K will be :

%K = [(Current Close – Lowest Low in the last 14 periods)/(Highest High in the last 14 period – Lowest Low in the last 14 periods) x 100]

%K is then multiplied by 100 to get the value in percentage form( from 0 to 100)

Then a 5-period Simple moving average is applied to %K.

 

How to Use Stochastic (General Guidelines)

• Just like the RSI, the Stochastic is used as an indicator of momentum extremes up or down. Where if the Stochastic exceeds 80, that suggests the price is overbought and could be reversing down soon. On the other hand, if the Stochastic falls below 20, that suggests the price is oversold and could be reversing upwards soon.
• When Stochastic is in overbought, wait for line K to cross below D for a sell signal.
• When Stochastic is in oversold, wait for line K to cross above line D for a buy signal.

• When Stochastic show a bullish or bearish divergence with the price.
• Bull and Bear divergences (also called hidden divergences).

A hidden divergence is the exact opposite of normal divergence. i.e. the price is making lower highs but Stochastic is making higher highs. Or, the price is making higher lows but stochastic making lower lows (as in the chart example above). Hidden divergence can happen on all type of momentum indicators not just stochastic.

Remember: You should not give hidden divergence that attentions or use them solely. As they are weak trading signals. 

How to Use Stochastic (Practical Guide)

Just like the RSI, to use the Stochastic effectively you must first define the current price trend.

If in sideways trend:

If the price is moving sideways, usually, overbought and oversold signals are reliable.

• Consider selling near the resistance of the sideways trend if Stochastic is overbought and fast line %K cross below %D.
• Consider buying near the support of the sideways trend if Stochastic is oversold and fast line %K crosses to the upside slow line %D.
• Consider buying near support if Stochastic shows bullish divergence.
• Consider selling near resistance if Stochastic shows bearish divergence.
• Consider buying if near support and Stochastic completes a bullish pattern or breaks resistance.
• Consider selling if near resistance and Stochastic completes a bearish pattern or breaks support.

Chart examples:

If the price is moving in an uptrend:

• Consider buying if Stochastic is oversold or near oversold and completes a crossover.
• Consider buying if Stochastic shows bullish divergence.
• Consider buying if Stochastic completes a bullish pattern or breaks resistance

Chart examples:

If the price is moving in a downtrend:

• Consider selling if the Stochastic is overbought or near overbought and completes crossover
• Consider selling if Stochastic shows bearish divergence.
• Consider selling if Stochastic completes a bearish pattern or breaks support.

Chart examples:

A Side Note on Momentum Indicators:

Most indicators are based on the same concept. Their developers examined the price action and behavior to conclude some assumptions or facts about the price. They then used these assumptions to implement their indicators.

For example, George Lane the creator of stochastic, assumed the price tend to close near the highs in an uptrend, and near the lows in a downtrend. Then based on this assumption, he created the formula for the stochastic that reflects this assumption.

You can have your personal assumptions about the price, and then derive your personal indicator. This is the main principle of mechanical system building.

There are dozens of indicators, these indicators are a mere representation of the price.   

Volatility

The prices do not move in straight line. They fluctuate while moving. 

Simply, volatility is a measure of how much the price fluctuates or move in a specific period of time. 

For example, if the price of Crude Oil Futures moves 2 percent up then 2 percent down in few hours. Then this is very volatile!

Some securities, like Oil and Silver, have higher tendency to fluctuate or move more than other instruments like the EURCHF pair.

Observe this hypothetical example, 

If the price of “A share” has closed around  $2 for the past 3 days. 1.90 for day one,  $2 for day 2 and $2.1 for day 3.

To calculate the average also called the mean,  we add the three values and divide by 3.

Average closing =(1.9+2+2.1)/3=  $2.

To calculate how much the price deviated from the average. We subtract each value from the mean and find their average. 

Deviation for A= (0.1 + 0.1) / 2 = $0.1. Then the price average deviation from the mean is $0.1. A tiny amount. We can conclude that the volatility of instrument is low.

Now, If the price of “B share” has closed at $1 for the first day, 2 for the second day and 3 dollars for the third day. The average or mean for the price is also $2.

But the deviation of price is totally different.

Deviation for B= (1+1) / 2 = $1 

For share A the deviation is narrow only $0.1, when compared with the price deviation of share B.

This is a measure of volatility. B is much more volatile because it can spread or deviate on a wider range around the price average.

Bollinger Bands are a volatility indicator that’s constructed based on the standard deviation calculation.

Bollinger Bands

Bollinger Bands is a volatility indicator. It is constructed by plotting a X-period simple moving average of the price. Then, two lines are plotted X standard deviations above and below the moving average.

The default Bollinger’s setting and the one widely used, is a 20-period simple moving average for the mid band. And two standard deviations for the upper and lower bands.

2 standard deviation is added to the 20-SMA to plot an upper band. And the lower band is constructed by subtracting two standard deviations from the 20-SMA.

The bands adjusts with the price volatility. It automatically become wider during periods of substantial price changes, and narrow(squeeze) when the price volatility drops.

The squeeze is the most important concept of Bollinger Bands. When the bands narrow it is called a squeeze. A squeeze signals a period of low volatility and is considered a sign of future increased volatility and possible directional breakout or a substantial move.

 

Remember:

– Bollinger bands represent the price direction through the 20-period SMA. And the price volatility through the upper and lower bands .
– The bands contain more than 80% of price action. Therefore, a break above or below the bands following a period of low volatility(squeeze) has some indicative value. It can be used in junction with other technical tools in your analysis strategy.

The Average True Range (ATR)

The ATR aims to provide the trading range for the instrument under analysis for a specified period. It gives indication how much the price tends to change. For example, the ATR for the EURUSD for the past 7 days is 125 pips. That means that the EURUSD had a trading range average of 125 pips per day for the past 7 days.

The ATR is an average of the true range of each candle. And the true range is the greatest value of the following:

• The difference between the current candle high and low
• The difference between the prior candle close and the current candle high(absolute)
• The difference between the prior candle close and the current candle low (absolute)

Absolute means : ignore the negative sign.

In order to provide a better representation of volatility. We get the Average True Range of all the true range values for the period specified,

For example, Average true range with 14 period equals

(TR for day 1 + TR for day two +…. TR for day 14) / 14

But, to smooth the data even further, the creator of the indicator, Mr. Wilder, incorporated the previous period’s ATR value.

Current ATR = [(Prior ATR x 13) + Current TR] / 14

Remember: ATR is not a directional indicator like Stochastic or RSI. It reflects the volatility of the price in the specified period. See the following chart.

Note how the price is rising in a steady uptrend but volatility(ATR) is falling. The price is moving in an uptrend but with low volatility.

How Can the ATR Help

Using the ATR for Breakout Filtering

The ATR can help us optimize and reduce trading false breakouts.

A highly volatile security will have a wider filter, to reduce its likelihood of making a false breakout.

On the other hand, a slow security that has few sharp moves will have a narrow filter.

In the above chart, the price of USDCAD has closed below a horizontal support at 1.32635. That is a legitimate closing basis breakout for many traders.

Let’s say we are using 0.5 the 14-period ATR as a filter. The ATR reading at the time of breakout was 80 pips. In this case the price has to close at least 40 pips below the support level to be confirmed, and that didn’t happen. So if you have incorporated the ATR in as a filter, you would avoid this breakout.

Here is the result after forwarding in time

Using ATR for Stop Loss Placement

ATR can also help optimize stop loss placement. As it i will take into account the recent market volatility.

Using the same above example, if we decided to buy the USDCAD at that support at 1.3263 and used the 1 ATR as our stop loss. Then our stop will be 80 pips below that support at 1.3183. The low of the next candle was at 1.3223. Thus, that helped us avoid getting stopped out from the trade before the price headed back higher in our expected direction.

The ATR can also be used in trailing stops, particularly useful if you want to ride a trend and catch a big move. Instead of taking profit at a specific price.

After initiating a trade and setting your initial stop. The price moved in your expected direction, you can adjust your stop loss 2 or 3 ATR below the live price if you are buyer, and above it if you are a seller .

let’s say that we bought gold at $1280, and put our initial stop loss at $1273. We planned to start trailing stop if the price reaches above $1290, because we expect big upside potential if the price breaks $1290.

The price has reached $1290 and the ATR was $2.15. We decided to move the stop loss price to 3 ATR below the live price. The live price was at $1291.63.

Our new stop loss is at $2.15×3= $6.45 below 1291.63.

The ATR changes with the price volatility change. If volatility picks up, ATR will have a larger value, and therefore you can adjust your stop loss every day based on the new ATR value.

You can see that ATR has risen to 3.04 at the live price of 1306.27. So we adjusted our stop loss to 3×3.04= $9.12 below 1306.27. So our stop loss is now at 1297.15.

Eventually, the price will fall towards our stop to close our order.

 

ATR Spikes as Reversal Signals

Unusual spikes in ATR can be an indication of a near reversal in direction.