Technical analysis and the theories behind the study of price are the bases for many trading indicators. Indicators often lead to the development of trading systems or strategies, through the combining of a trader’s selected tools and the analyzing of long-term and short-term time frames.
However, many traders aren’t aware of some of the most useful technical indicators for this task. Often it is the more obscure tools that provide the in-depth knowledge necessary to uncover exploitable market tendencies.
Many such indicators are based on Fibonacci numbers. Leonardo Pisano Fibonacci developed this number set through his studies of patterns in nature. The Fibonacci number sequence conforms to linear recurrence. Through the use of the number set, and adjacent figures, Fibonacci discovered what today is called the Golden Mean (1.618).
The number set (0,1,1,2,3,5,8,13, 21,34,55…..), in which each successive number is the sum of the two proceeding numbers, can often be mined for reliable inputs for technical indicators (for example, a 13-period moving average or a 21-period momentum indicator).
But before you settle on input values for the indicator parameters, you need to select the indicators themselves. To select our indicators it’s necessary to recognize the key market variables that capture the current market make-up and condition. These key market variables are trend, overbought/oversold, momentum, support and resistance, volatility and regression analysis. These are the variables we want to measure as we plan our trades.
TOOLS FOR TRENDS
To determine or analyze the trend, a trader can choose from several indicators: Herrick Payoff Index, the Aroon indicator, the directional movement indicator and the Average Directional Index. One of the most flexible of these is the Aroon indicator, which was created by Tushar Chande. Aroon determines the direction and strength of the trend, and a sideways market or consolidated trading. Aroon consist of two lines, Aroon (up) usually depicted as green and Aroon (down) usually depicted in red. Here’s the formula:
Aroon (down) = [(total number of periods – number of periods since lowest close) / total number of periods] x 100
Aroon (up) = [(total number of periods – number of periods since highest close) / total number of periods] x 100
When Aroon (up) falls below 50 it indicates a reduction in the momentum of the uptrend. When Aroon (down) falls below 50 it indicates a slowing of the momentum of the downtrend.
If Aroon (up) is above a 70 level, this would indicate an uptrend is in place and the closer Aroon (up) comes to 100 the stronger the uptrend. If Aroon down is above the 70 level, it indicates a downtrend is in place and the closer Aroon (down) comes to 100 the stronger the downtrend.
If Aroon (up) and Aroon (down) are parallel or moving together, it indicates a sideways trading market or consolidation, and the trader would then look to his overbought/
oversold oscillators.
In “Strength of trend” (right), the period of the Aroon indicator is 21, which is in accordance with the Fibonacci number sequence.
WHERE’S THE PRESSURE?
Trend is only part of the picture. In this example, we have chosen to use %R as our overbought/oversold indicator. %R was developed by Larry Williams and measures extremes in trading activity.
The value of the oscillator at any one time is based on the relationship of two component values. Here’s the formula:
Value 1 = Highest High – Lowest Low of period under study (we’re using 21)
Value 2 = Close – Lowest Low
of the period.
%R = Value 2 / Value 1
The upper and lower limits for %R — that is, the values that indicate an overbought or oversold market — are generally 10% and 90%. We also look for the angle of %R, or the direction it is pointing, to be in line with the direction we ultimately trade, whether it be bullish or bearish.
USING REGRESSION
The Forecast Oscillator (FO) measures the percentage relationship of the forecasted price of the market and the actual price. Also popularized by Tushar Chande, the FO generates its forecasts through linear regression, calculated throughout some period. In this case, we again use 21 periods.
In times when the forecast price is greater than the actual price, the oscillator will be above zero, or positive. In times that the forecast price is less than the actual price, the oscillator will be below zero, or negative. If the forecast price is equal to the actual price, the oscillator will plot zero.
By plotting an x-period moving average of the oscillator, Chande created a trigger line that can be used to determine trend or, more important, changes in trend. If FO makes a bearish crossing of the signal line, expect lower prices ahead. If FO makes a bullish crossing of the signal line, expect higher prices ahead. A fairly reliable value for the signal line moving average is five (once again, a Fibonacci number).
Based on finding the “best-fit” linear, or straight line, relationship between price and time within a set of historical data, linear regression simply extends that straight line one period into the future to generate its forecast. The only input is time. It’s a simple model, but for our purposes, it is a much more valid and less lagging indicator than moving averages.
ANTICIPATING CHANGE
Market movement from consolidated or low-volatility price action into trending or high-volatility price action can be tracked and capitalized on through the Relative Volatility Index (RVI).
Volatility indicators used to confirm and implement trading strategies rely upon mean reversion. Mean reversion refers to a time series’ tendency to oscillate between extremes to maintain a relatively stable average value. This concept is the basis for the RVI, which was developed by Donald Dorsey.
The RVI takes the formula used to create the Relative Strength Index (RSI) and replaces the daily price change with the standard deviation of the past 10 days. This allows the trader to draw upon a measurement other than price to determine market strength and sentiment. The RVI measures volatility movement on a scale from 0 to 100.
When the RVI is greater than 50, the volatility of the market is bullish. When the RVI is less than 50, the volatility is bearish.
Used as a wide-ranging filter, these rules and variations on these rules can be used to improve on many trading systems. For example, a system could be directed to only buy if RVI is greater than 50, or sell if RVI is less than 50. Similarly, more extreme values could be used, such as 60 for a buy or 40 for a sell.
TIME ON YOUR SIDE
Traders should rely on a range of time frames to look for trades. This is important no matter what indicators you are using for your analysis. But some time frames better lend themselves to different aspects of your analysis.
One market that offers a particularly interesting challenge is the forex market. For forex markets, which don’t have a set trading day, the four-hour chart is useful in determining the current market trend using the FO and the Aroon indicator. However, it is better to base trades upon a shorter time frame, such as a 15-minute chart. Entries should only be made when the analysis on the shorter-time frame chart confirms the longer time frame chart.
For example, if the 21-period FO breaks through the five-period signal line on the four-hour chart to the bearish side of the market, attention turns to the 15-minute chart. Once a breakout occurs to the downside on the shorter-time frame, it’s time to consider action.
Other occurrences to look for include an Aroon (down) indicator above 70, but most likely as close as possible to 100. An RVI value at 40 or below the cause, and the FO on the 15-minute chart also should be below the signal line.
The %R also should be consulted, but in the case of a strong trending market, which you’ll often find when the other indicators are falling into line, you’ll only be able to confirm that the %R line is in bearish territory.
If we have confirmation of all these market integrals and signals, a limit order should be placed at the closest resistance level on the chart to sell short. Alternatively, if the market is approaching a support level, you can place a sell stop one tick below the level that the market is threatening to pressure.
If all goes as planned, we can move our stop one tick above the closest resistance level and confirm a profit-taking order by looking for the RVI to approach a reading of 50. That said, profit-taking and stop trailing should be determined by an individual trader’s risk tolerance and reward goals — such as whether they’re looking for large price trends or just short, fast and sometimes low-risk profits.
Correctly choosing and understanding the indicators you use is critical, particularly with highly leveraged markets such as what is available in the forex markets. In these markets extra care should be taken before you establish a position. The idea is to use an indicator for each component of the market, and to exploit Fibonacci conformity as much as possible. Then, look at multiple time frames to determine market strength and sentiment.
This extra care should help a trader fully analyze the make-up of the market, and hopefully eliminate some of the emotional swings that are a part of trading and can often derail an otherwise profitable plan.
Matthew Reynolds is President of Derivative Concepts Inc. a futures and forex trading education and systems writing corporation. He has developed several trading systems and proprietary indicators. He has written courses on daytrading, position trading and advanced options strategies. Email: derivativeconceptsinc@gmail.com.
