The Game of Moving Averages
This article is designed to introduce the concept of technical indicators and explain how to use them in your analysis. We will shed light especially on MACD and RSI. Before diving into the topics directly let me explain some key concepts.
What are Moving Averages?
Moving Averages is a tool in technical analysis that are used to identify the trend or determine the support or resistance levels. It is a lagging indicator because it uses past prices. Moving Averages tend to smoothen the normal day to day price fluctuations. We have different moving averages such as 5 day,10 day or a 20 day.
For example, a moving average of 20 day will calculate the average price of a specific instrument over the past 20 days .
Moving Average = ( Day1+Day2+Day3…..)/ No of days
For example a 5 day MA would be ($5+$6+$7+$2+$4)/5
Each time a new period occurs the MA will move forward dropping the first price.
Lets check out how to use moving averages on charts.
1.MA to detect price trend :
Traders can use moving averages to detect the trend of a certain financial product. We plot one moving average on the chart with a specific period and trade the crosses between the price and the moving average. In other words, if the price moves above the moving average, we can enter a long (buy) position, and if the price moves below the moving average, we can enter a short (sell) position.
2.MA to determine Support and Resistance:
Traders expect a falling price to bounce when touching a moving average. Therefore, the moving average will act as support (heavy buying overcomes selling power) and vice versa. A rising price is expected to falter when touching a moving average. Therefore, the moving average will serve as a resistance (heavy selling overcomes buying power)and vice versa. A rising price is expected to falter when touching a moving average. Therefore, the moving average will serve as a resistance (heavy selling overcomes buying power).
There are two types of moving averages.
1.Simple Moving Average(SMA)
A five-day simple moving average (SMA) adds up the five most recent daily closing prices and divides it by five to create a new average each day. Each average is connected to the next, creating the singular flowing line.SMA gives equal weighting to all price.
2.Exponential Moving Average
The calculation is more complex, as it applies more weighting to the most recent prices. Since EMAs place a higher weighting on recent data than on older data, they are more reactive to the latest price changes than SMAs are, which makes the results from EMAs more timely and explains why it is the preferred average among many traders.
What is an Oscillator?
Oscillators is a tool that has high and low bands and then builts an indicator to find out the overbought and the oversold conditions. RSI is one such oscillator. When the oscillator is reaching is upper extreme value technical analysis estimates that the its overbought whereas when the oscillator reaches it lower extreme value it is interpreted as oversold. The basic idea is to pick two values and then let the oscillator oscillate between these two values, creating a trend.
What is MACD?
Gerald Appel introduced it in the late 70s as a tool that utilise the moving average to determine momentum of the asset. The moving average convergence/divergence (MACD) is a technical analysis indicator that aims to identify changes in a share price's momentum. The MACD collects data from different moving averages to help traders identify possible opportunities around support and resistance level.
MACD LINE: Subtracts 12 day EMA with 26 day EMA.
SIGNAL LINE: A nine-day EMA of the MACD called the "signal line," is then plotted on top of the MACD line, which can function as a trigger for buy and sell signals.
HISTOGRAM: Represents the difference between the MACD and the signal line
The chart below shoes a MACD line along with the signal line. When the MACD line crosses the signal line from below and rises it is a bullish signal and it is seen as a time to buy. When the MACD line crosses the signal line from above and the MACD falls it is a bearish signal and time to sell.
Lets take a real life example,
The picture below depicts the chart of Sun Pharma’s 5 day chart.
There are several points mentioned lets go throw through them.
The MACD line crosses the signal line from above which gives us the indication that the price is going to go down. This is exactly what is seen on the price chart, you can see that the price is coming down after the cross.
This point also shows the same concept mentioned above that is the price moves down as the MACD crosses from above.
This point is however the opposite here we can see that the MACD crosses the signal line from below indicating that the price will move up .This is clearly visible when you see the price chart ,that the price has moved upwards after the cross.
MACD tracks the relationship between moving averages and correlation between 2 lines as convergent or divergent .Convergent when they move in the same direction and divergent when they move in the opposite direction.
What is MACD divergence?
When the indicator (MACD) does not confirm the movement of the price it is called as divergence.When the stock price moves lower and MACD moves higher or rises it is called as bullish divergence. Also,if the MACD is making higher lows and the price is making lower highs.
Conversely when the stock prices moves higher but the MACD on the other hand moves lower it is called as bearish divergence,or the price is making higher highs and the MACD line is making lower highs.
One potential drawback is that the MACD is a short-term indicator, as the longest measurement that it takes into account is the 26-day moving average. If a trader has a longer-term outlook that this, the MACD may not be suitable. Another potential downside is that the MACD is a trend following indicator. This means that the indicator gives its signals as the trend occurs, not before it starts. So, if you are looking to recognise an upcoming trend, the MACD is not the best indicator for this function.
What is RSI?
RSI was inventedby J.Welles Wilder and introduced the conceptof RSI in his book New Concepts In Technical Trading System which was released in 1978.RSI is used to measure the speed and change of price movements. It oscillates between 0 to 100 and can lethelp you to determine if the market is overbought or oversold.
Overbought > 70
Oversold means that the market has move too much towards the downside and overbought means the opposite, moved too much to the upside.
How is RSI calculated?
RSI=100 - 100
Where, RS= Average no of upside in x days
Average no of downside in x days
Let us go through a real life scenario,
The chart below shows Tata motors 10 day chart.
Point1 & Point2:RSI is in the overbought region which is it is >70 .People usually starts selling when they enter this region therefore we also see that the price moves down.
Point3:RSI here lies in the oversold region that is, it is <30.People here start buying which is visible on the price charts, the price rises.
Just as we had divergences in MACD ,we have divergence in RSI too.
1.Bullish Divergence: Bullish divergence in RSI is the same as MACD divergence. When the RSI is making higher low and the price is making lower high it is known as bullish divergence.
2.Bearish Divergence : Bearish divergence is one where RSI making a lower high and the price chart making a higher high.
Like any other indicator ,real market conditions make not always line up or agree with technical analysis. Markets are dynamic and quite irrational. Technical indicators can only ‘indicate’ and not predict. The following chart depicts USDJPY and shows hat even when he RSI was at an overbought region, the market prices were still soaring high.
As with any indicator, both of these indicators have their own pros and cons. Observe and take trades wisely.