Magic Indicators – Five Indicators You Must Use to Analyze any

Stock

There are literally hundreds of technical indicators that you

can plot out on a stock chart. If you have your own stock
software you undoubtedly have seen many of them. But if you are
like most investors you may be overwhelmed by the number of
indicators available to you. Many of them are similar to other
indicators so there is a lot of duplication. Over the years I
have found about a half dozen indicators that work best for me.

You should already have learned about the life cycle of a stock
and how a stock can go from being in a bull market and into a
bear market in module two titled Bullish Beginnings – How to
Identify Any Market, ETF, or Sector Just Starting a New Bull
Market with One Simple Indicator. In this module I showed you
how you can use the moving average indicator to determine what
stage a stock, sector, or market is in.

There are several other indicators that I use to detect when a

change in trend is occurring. In the next report I will show
you how I use them to do this and to even make entry and exit
points, but first I need to explain these indicators to you so
that you will know how they are calculated and how they work.
You should use this report as a reference point when you see
these indicators come up again in future lessons and the WSW
Power Investor service. The first report and this one will give
you the basic buildings blocks of knowledge that you will need
to begin to understand how to adapt to any market environment by
employing several different basic trading strategies.

First you must realize that there is no need to put dozens of

indicators on a chart. All of the indicators use only three
variables – price, volume, and time. Most of them are only
different versions of the same things. In fact there are
hundreds of these indicators and you can even make your own if
you want to. Don’t overanalyze things. You are best off to
just use a few simple indicators and get a good feel for them.
Understand what makes them move and then you’ll be able to
better understand what is going on with your stocks.

The indicators themselves cannot tell you what to do. But they
can be extremely useful to someone who knows what they mean and
has a basic knowledge of stock market chart patterns. They can
provide the trained eye information that is not easily available
by just looking at a chart.

In using technical indicators though, it is best to keep things

simple. Some people will show you a chart and put dozens of
indicators on them and use them to fool you. They try to
confuse you so that you’ll just assume that they know what they
are talking about.

Indicators are not magic bullets. You make money in the market
by understanding how markets work and analyzing market trends.
Indicators can help you with the latter, but they do so in a
complimentary fashion. There are indicators that work better in
one stage of a market trend than in others so in the end you
have to understand market stages in order to correctly apply
them.

I already discussed moving averages. In this report I will now

show you the indicators that I’ve found the most useful in my
own investing and analysis: relative strength, on balance
volume, bollinger bands, stochastics, and simple trendlines.
Relative strength:

A relative strength line compares the price action of the stock

or market that you are charting with another one. It is a
simple ratio of X divided by Y. For example, the relative
strength line may compare the price action of a stock with the
Nasdaq or with the S&P 500 to see if it is outperforming the
market or underperforming the market. Or you may want to
compare two markets against one another, such as the Dow Jones
Industrial Average and the gold market to see which one is
stronger. Or you may wish to compare one sector with the
broader market. Such as the semiconductor sox index with the
Nasdaq index. Relative strength takes two items and tells you
which is the stronger.

Dividing the price of one item by another creates the relative

strength line(for example price of a stock divided by price of
the Nasdaq market average). Relative strength is then plotted
as a line underneath the price of the item that you are
charting. If the line is going up then your stock or market is
outperforming the item that you are comparing it too.
I most commonly use relative strength to compare a stock’s price
action to the activity of one of the broad market averages. If
the relative strength line is rising then the stock is
outperforming the Nasdaq and the broader market. This is
important. When the market rallies stocks stronger than the
market will tend to rally more than the market. When the market
drops they will drop less, not at all, and may even continue go
up. The opposite is also true. If the market rallies a stock
may go up, but if it has weak relative strength it will tend to
drop more than the rest of the market when the market has a
correction. You do not want to be long stocks with poor
relative strength. Changes in relative strength can be a
warning sign that you should sell a stock.
What I really use relative strength for is to narrow down a list
of potential buy candidates. If I am interested in going long a
stock and it has poor relative strength then I won’t buy it.
Instead I’ll look for a stock with strong relative strength. I
also use relative strength to help me make a decision on whether
or not to short a stock, which is a way to profit when a stock
declines in value. If a stock’s relative strength line is
rising then I won’t short it. Shorting is a subject we will go
into depth in a future lesson together.

I want to be long stocks that are stronger than the market and
short stocks, which are weaker than the market. And I want to
stay that way. That means I also use the relative strength line
as a warning signal for all of my positions. If I have been
long a stock, which has been rising and doing well for me, but
the relative strength line begins to move down then I will
consider that a big warning flag. Usually relative strength
peaks out and changes its trend before a stock begins to
decline. What happens is that, during a market rally, the stock
price will often go up, but not as quickly as the rest of the
market. The stock lags the rally. Once the market pulls back
such stocks will tend to lead the decline.
Relative strength cannot tell us when to buy or sell a stock by
itself. But it can help us to make a decision on whether or not
to enter a position and more importantly whether or not to keep
it.

Are you long a lot of stocks now? Chart them out and look at
their relative strength lines. If they have been declining
while the market has been rallying you may want to consider
selling them, or at least making sure that you have stops on
them to protect yourself. If the market corrects – which it
eventually will – you are in danger of having these positions
put big dents in your portfolio. And you don’t need that.
Stick with the strong stocks, they are your friends, and
eliminate the weak before they eat your capital.

If the market is in a correction then you can use relative

strength to find strong stocks, which will lead the next market
rally. Stocks that hold up well while the rest of the market
drops tend to go up a lot when the market comes back. The
relative strength line can help you find these gems.
On Balance Volume:

Like relative strength, on balance volume is plotted as a single

line on a stock chart. However, unlike relative strength, which
is concerned solely with price activity, on balance volume looks
at both the price and the volume action of a stock. On balance
volume is a running total of the volume on days when a stock
rises minus the volume on days when the stock drops. The total
volume for each day is assigned a positive or negative value
depending on whether prices closed higher or lower that day.
Adding or subtracting each day’s volume based on the direction
of the close keeps a running total. As long as the stock has
more volume on up days than down days then the on balance volume
line will move up. If a stock has more volume when it drops
than it does when it goes up then the on balance volume will
trend down.

The formula for on balance volume is simple:

If Today’s Close > Yesterday’s Close THEN OBV = Yesterday’s OBV

+ Today’s Volume

If Today’s Close < Yesterday’s Close THEN OBV = Yesterday’s OBV

– Today’s Volume

If Today’s Close = Yesterday’s Close THEN OBV = Yesterday’s OBV

On balance volume is used to tell us whether there is more

volume going into a stock or out of a stock. It is used for two
things: to confirm a stock’s trend or to alert us to a possible
change in trend.
If a stock is in a stage two price advance then on balance
volume should trend up along with price. If a stock is
advancing then volume on up days should be greater than the
volume on down days for the advance to be considered healthy.
If not then the price advance is questionable. The reverse is
true of price declines. On balance volume should drop along
with price if the decline is going to be sustainable.

Some examples follow:

On balance volume, though, is more useful when it alerts us to a
change in trend. Movements in on balance volume often lead
movements in stock price. If on balance volume rises, while the
stock consolidates in a base, a strong breakout usually follows.
In this type of situation the rising on balance volume tells us
that there is more volume on up days than on down days. If this
happens while the stock is in a base then it is likely that the
stock is under heavy accumulation.

The reverse is also true. If a stock makes a lengthy run and

then forms a base watch the on balance volume carefully. If it
drops while the stock bounces in a narrow range then the next
likely move is down. What you are seeing is money flowing out
of the stock. Once the buyers run out the stock usually drops.

Just like relative strength lines, on balance volume cannot tell

us when to get in and out of a stock by itself. But on balance
volume can be used as a strong confirmation of your own stage
analysis of a stock. If you think a stock is about to break out
of a stage one base and on balance volume is dropping then you
may want to question your analysis. If it confirms your
analysis then get ready to put in a buy order.
Bollinger bands

Plotted above and below the price of a stock, Bollinger bands

appear as two moving lines that sandwich the price of a stock.
What they do is tell you whether or not prices are high or low
based on a relative history of how the stock has traded. Is the
stock price high in its range or low? Bollinger bands can tell
you.

Some people construct parallel lines to a moving average in

order to create a trading envelope. These lines are drawn at an
identical proportional distance to the moving average. When a
stock is at the top of the envelope they take that as a sign
that it may be overbought and vice versa.

Bollinger Bands are a little different. Bollinger Bands are two

lines that are plotted as two standard deviations above and
below the 20 day moving average. A standard deviation is a
statistical measure of volatility.

Unlike regular trading envelopes, which remain at a fixed

distance from the moving average, Bollinger Bands will widen as
a stock becomes more volatile and narrow as its trading range
shrinks.
Most people use Bollinger Bands to pick out tops and bottoms.
If a stock moves below the lower band than they consider it
oversold and if it moves above the upper band than it is
overbought.
I mainly use Bollinger Bands to measure the volatility of a
stock. When a stock becomes less volatile and begins to trade
in a smaller and smaller range usually a big move soon happens,
because as volatility shrinks, the buying and selling pressure
on a stock becomes more equal.

As the sellers and buyers put more and more pressure on each
other the stock’s trading range narrows. After one side is
defeated the stock breaks out and makes a big move. Think of it
like a spring. It takes a lot of force to push a spring
together and make it smaller. If you do that and then let go it
will leap out in one direction.

One of the laws of physics is that for every action there is an

equal and opposite reaction. The stock market is not much
different. However, while physicists use gravity and motion as
their two main variables stock market technical analysts use
price and volume in order to understand how the forces of supply
and demand are affecting a stock.

I use Bollinger Bands to alert me when a stock’s volatility is

dropping. The stock price usually makes a large swing soon
after the two Bollinger Bands come closer together.

Stochastics

The stochastics indicator, developed by George Lane, compares a

stock price level to its price range over a period of time.
Lane theorized that in an upward trend stock prices tend to
close near their highs and during a downtrend stock prices tend
to close near their lows. Stochastics attempt to identify a
change in trend by identifying when an upward moving stock’s
prices begin to close further away from their high and vice
versa. I use stochastics to determine when a stock may be
overbought or oversold.

The stochastics indicator is plotted as two line, the %D Line

and the %K Line. Both lines are plotted on a chart with values
ranging from 0 to 100. Readings above 80 indicate a stock price
closing near its high and below 20 indicate a stock closing near
its lows.
The stochastic lines are calculated as follows:

%K = 100[(C – L5close)/(H5 - L5)]

%D = 100 X (H3/L3)

Whereas C = recent close, L5 = lowest low for last five trading

periods, H5 = highest high of last five trading periods, etc.

Once the stochastics go above 80 and then cross back below it a

change in trend is indicated. Likewise if the stochastics fall
below 20 and then cross back above 20 they indicate a potential
price bottom.

I have found that stochastics do not reliably indicate a change

in trend by themselves. In an uptrend stocks will tend to
remain overbought and when they are in a phase three decline
stochastics will give many false indications of a bottom.

However, I have found stochastics to be useful for picking tops

during declines and bottoms during advances. During the 2000-
2003 bear market, for instance, I used stochastics to identify
short term Nasdaq tops when it was in an extended price decline
with the use of a 60 minute intraday chart and during stage two
uptrends I use stochastics to make entry points on pullbacks.
My usage of these indicators will become clearer to you in the
next lesson as we begin to bring these things together.

Trendlines and Simple Trend Detection

One of the most basic principles of charting is simple trend

detection. The simplest way to detect a stock's trend is to
look at the stock's price action on a line chart. Is the stock
making new highs or new lows?

A line chart turns the stock price action into peaks and
valleys. If each peak is higher than the last one and the
valleys are higher than the previous valleys then the stock is
in an uptrend. The trend changes if this pattern changes. If
an uptrending chart takes out the lower valley then its uptrend
ends and the stock enters a downtrend. If a stock has been
making higher peaks and then fails to make a higher peak then
the price movement becomes a warning sign that the trend may
end.
Trendlines are a way to display the stock's trend on a chart.
If a stock is in an uptrend then the trendline is drawn by
drawing a line that connects the valleys of a stock. If the
stock is in a downtrend then trendline is drawn connecting the
stock's valleys.

Trendlines are also used to alert you when a stock's trend

changes. If a stock is in an uptrend then the trendline will
act as support. The stock remains in an uptrend as long as it
does not close below the trendline. The opposite is true when a
stock is in a downtrend. As long as a downtrending stock
continues to close below its resistance trendline then its trend
remains in place.
People use line charts and trendlines to make entry points in
stocks and to set stops. They can be used in any time frame so
anyone from daytraders to long term buy and hold investors can
find them useful.

I use trendlines all of the time in my charts and want you to

understand how I draw them and the theory behind them. I do not
usually use them by themselves to make buy or sell decisions -
although some people do that with individual stocks, especially
daytraders. I use them to define where a stock's resistance
area is and use them to give me an idea of where to place a sell
stop. If I expect to hold a stock for several months then I'll
often give it more leeway, but even then I take a close below
the trendline seriously and take it into consideration when I
ask myself whether I should keep holding a position.

We will go over using these indicators for entry points in the

next report. The chart examples in this report are several
years old. To see these concepts put into use in real time take
a 30-day risk free subscription to WSW Power Investor. Just
click here:

http://www.wallstreetwindow.com/wswpowerinvestorservice.htm