A Practical Guide to Indicators 12 Pgs

8/6/2019 A Practical Guide to Indicators 12 Pgs

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Rombout H. Kerstens

Including Turtle Trading

A Practical Guide

to Indicators

Learn to profitably apply technical analysis indicators to equity,

derivative and forex trades


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'A Practical Guide to Indicators'leads you through

the selection and application of technical analysis

indicators and trading systems, with a bias towards

practical and useful information rather than

theoretical depth. It describes the most commonly

used trend-following indicators, trend indicators,

oscillators and volume indicators. It also covers thebacktesting and optimization of indicators, and

discusses DIY trading systems.

A crucial element of successful trading is the

correct buy/sell timing based on technical analysis.

However, this book also deals with other key

subjects that are equally important, like

psychological factors and money management. In

addition, the pros and cons of various financial

instruments futures, options and CFDs arediscussed.

The ultimate goal is to arrive at a complete trading

plan that can be applied with discipline and

confidence.

Subjects covered include:

Technical analysis

Backtesting and optimization

Trend-following indicators

Oscillators

Trend indicators

Volume indicators

Seasonal indicators

Volatility indicators

Turtle Trading technique

Do-it-yourself trading systems

Leveraged investment: options, futures and CFDsMoney management

The psychology of investing

ISBN 978-90-77553-09-1

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Copyright 2009Keyword Info Systems BV.

P.O. Box 677

2600 AR Delft

the Netherlands

All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in

any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without prior written

permission of the publisher.

Insofar as the copying of this publication is permitted on the basis of article 16b and 17 of the 1912 Dutch

Copyright Act, the required fee must be paid to Stichting Reprorecht, P.O. Box 882, 1180 AW Amstelveen, the

Netherlands. If you wish to copy one or more sections of this publication for anthologies, readers or other

compilations, please contact the publisher.

ISBN 978-90-77553-09-1

Disclaimer: The descriptions of indicators and trading systems in this book are only intended for educative

purposes. The book is explicitly not intended as advice on buying or selling security products. If readers decide to

buy or sell security products using the indicators and trading systems described in this book, then they do this

entirely on their own initiative and their own responsibility.

We reiterate emphatically that the opening of securities positions clearly entails certain risks.

Translation: PassworD text fusion B.V.

Lay-out: Douwe de Haan, Delft

Software: Wall Street Professional, Excel

Printing: Thieme Media Services, Delft


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Preface 5

1 Introduction to technical analysis 7

2 Applying and analyzing indicators 11

2.1 Introduction 11

2.2 Backtesting 11

2.3 Return and risk 13

2.4 Optimization 19

3 Indicators 22

3.1 Trend-Following Indicators 24

3.1.1 Moving Average 25

3.1.2 Dual Moving Average 28

3.1.3 MACD 30

3.1.4 DMI 323.1.5 Parabolic SAR 34

3.1.6 MSL 36

3.1.7 ROCEMA system 38

3.1.8 Performance Indicator 40

3.1.9 Aroon Indicator 42

3.1.10 Relative Strength 44

3.1.11 KST 46

3.1.12 Multiple Time Frame 48

3.1.13 Simple Outbreak Indicator 50

3.2 Oscillators 53

3.2.1 RSI 54

3.2.2 Stochastics 56

3.2.3 Momentum (ROC) 60

3.2.4 CCI 62

3.2.5 TRIX 64

3.2.6 Williams %R 66

3.3 Trend indicators 68

3.3.1 ADX 70

3.3.2 RAVI 72

3.3.3 VHF 74

3.4 Volume Indicators 77

3.4.1 Money Flow 78

3.4.2 On Balance Volume 80

3.5 Seasonals 82

3.5.1 Sell in May indicator 84

3.6 Volatility Indicators 86

3.6.1 Bollinger Bands 88

3.6.2 Volatility 90

3.7 Charts with modified time axis 923.7.1 Range Bars 94

3.8 Various technical tools 96

3.8.1 Pivot Points 97

3.8.2 Performance measurement 98

3.8.3 Beta 100

3.8.4 Average True Range 102

3.8.5 Keltner Channels 104

3.9 Table of indicators 106

3.10 Explanation of divergence 108

4 Do-it-yourself trading systems 111

4.1 System Trading 1114.2 Examples 113

4.2.1 Moving Average + DMI 113

4.2.2 Moving Average + RS 114

4.3 DIY programming of trading systems 115

5 Active trading with indicators and

trading systems 117

5.1 Psychology 117

5.1.1 The psychology of investing 117

5.1.2 The 5 basic rules for a

successful trader 118

5.2 Money management 120

5.3 Instruments 122

5.3.1 Futures, Options, Turbos 122

5.3.2 Forex and CFDs 125

5.3.3 Tradability and liquidity 128

6 Turtle Trading: a complete trading plan 129

Bibliography 137

Appendix 1: Programming code for

MA + DMI trading system 138

Subject index 142

CONTENTS


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Market prices are subject to constant change. Everybody obviously wants to know how

prices will behave tomorrow or the day after. Unfortunately, this is not an easy task. Even

the best-trained financial experts struggle with this. And dont forget human emotion, afactor that most definitely complicates matters further. Technical analysis is very suitable

for studying the markets with a certain degree of objectivity without letting emotions get

in the way. But what exactly is technical analysis?

Technical analysis is the study of historical equity prices and volumes to arrive at a

prognosis for future price developments. So technical analysis does not predict prices

exactly. It doesnt concern itself with corporate financial data and background research

that is the task of fundamental analysis. Technical analysis assumes that this information

will be reflected in the prices anyway. The cornerstone of technical analysis is the theory

that prices move in trends and that history repeats itself. Technical analysis is primarilyused for short-term trading on the stock exchange. It is no Holy Grail and is certainly not

infallible. However, fundamental analysis offers no solace to short-term investors.

Generally speaking, fundamental analysis proves its worth over the longer term, while

technical analysis is more suitable to a short-term horizon.

Prognoses generated by technical analysis techniques often do not materialize. A success

rate of sixty percent is already considered to be successful. If a prognosis does not

materialize, the position must be closed using a predetermined exit scenario, for instance

a stop-loss order. Equally important is a clear and decisive scenario for taking profits.

However, for active investors, technical analysis is not the whole story: disciplined

execution and money management are at least as important. We will discuss these factors

in depth later in the book.

Technical analysis consists of two distinct branches: visual analysis and statistical analysis.

This practical guide concentrates mainly on the latter of these two methods.

Visual Analysis

Technical analyses often utilize graphs also known as charts, hence the term chart

reading. A chart or graph is clear and concise, and offers at a glance the state of play at

any given moment. Charts can be constructed in a number of different ways, but most

employ bar-chart or line-chart methods.

Visual analysis is the domain of the trend lines, price patterns, head & shoulders

formations, etc. The chart reader tries to detect patterns and trends by applying clear

rules. Unavoidably, however, visual analysis still has a subjective component. One analyst

will recognize a certain pattern, while another wont.

Statistical Analysis

Statistical analysis is the domain of indicators and trading systems. Indicators arearithmetically deduced from price charts. Mathematical formulas are used to develop a

greater understanding of the patterns in historical price movements. This knowledge

then forms the basis for developing a vision of future price developments. Statistical

1 INTRODUCTION TO TECHNICAL ANALYSIS


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Figure 1.1: Rising trend market: higher Figure 1.2: Falling trend market: lower

tops and bottoms (Bullish) tops and bottoms (Bearish)

Figure 1.3: Sideways market: tops and Figure 1.4: Trading system with signals

bottoms of equal measure (Trading)


analysis is objective. The calculations are not open to multiple interpretations. This

eliminates human emotions from the picture, which often cause people to trade

inconsistently and irrationally.

Indicators come in all shapes and sizes. Some perform well in a trend market, others

better in a sideways market (trading market). If an indicator can objectively indicate

market buy and sell points, then it is also called a trading system. Finding the best-

performing indicator settings for a certain market or individual stock is called optimizing

an indicator. Calculating how a certain indicator would have performed with the detected

buy and sell points using historical price data is called backtesting.

The so-called trend-following indicators do well in a trend market, while oscillators

theoretically perform better in a trading market. Special indicators trend indicators

have been developed to determine whether a market is moving sideways or in trends.

Trends in fluctuating markets

Figures 1.1 to 1.3 clearly illustrate whether one is dealing with a trend market or a

trading market. Unfortunately, it is by no means always clear whether one is facing a

trend or a trading market. Sometimes the trend is obscured by severe price fluctuations.

The more volatile the market is, the more difficult it often is to identify a trend. Chapter

3.3 (trend indicators) covers this subject in greater detail.


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Figure 1.5: Bars

Figure 1.6: Line chart Figure 1.7: Bar chart


Lines and Bars

Price charts often comprise a continuous price line that links closing prices. An

alternative is to use bars. For instance, opening, highest, lowest and closing prices areindicated in units of time as so-called bars (see figure 1.5). These bars can be constructed

at any level e.g. per minute, hour, week or month. Bars therefore provide more

information than a continuous price line. A commonly used bar is the so-called Japanese

candlestick. This bar construction gives the bar a different color depending on whether

prices have risen or fallen over the period concerned. Figures 1.6 and 1.7 illustrate the

difference between a line chart and a bar chart. A bar chart provides much more

information. Support and resistance lines can only really be generated correctly using a

bar chart. Figures 1.6 and 1.7 converge both support and resistance lines in a so-called

triangle pattern. (The generation of a triangle usually signifies the imminence of an

important price movement.)

Time frames

Every investor has an individual investment horizon. An extreme short-term trader a

so-called scalper thinks in seconds or minutes, a day trader in 15-minute intervals or

hours, and a position trader in days or weeks. A longer-term investor thinks in months or

years. They all envision a different time horizon for their trades. Which means each will

generate analyses in corresponding time frames. A day trader might for instance relate


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his analyses to bars of 5 minutes, and a position trader to bars of daily prices. This only

relates to the time horizon. However, the techniques of visual and statistical technical

analysis are basically applicable to any time frame.

Analyzing multiple time frames

Different traders can therefore each analyze and trade in a different time frame. But an

individual trader will also take account of overlying time frames. A day trader will also

often consider the longer-term trend on a daily and weekly basis. To prevent himself

from trading against the trend, for example. There are also trading methods that

simultaneously exploit one or more indicators with multiple time frames and only trade

when the indicator signals of several time frames corroborate each other.

Figure 1.8: Daily and weekly price bars over same period



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SUBJECT INDEX

9/11 18

%D line 56

%K line 56

24-hour trade 126

ABN AMRO 123

Acceleration factor 34

Accumulation 80

Adam White 74

ADX 32, 70

ADXR 70, 72

AEX Index 82, 130

AFL 116

Agricultural products 82

Alex Pro 116

Alpha 100AmiBroker 116

Anomalies 82

Aroon Indicator 42

At-the-money 86, 123

Average Directional Movement 70

Average Profit/Average Loss 11, 15

Average result per trade 13

Average True Range (ATR) 87, 102, 104, 130

Backtesting 8, 11, 12

Band factor 88

Bar chart 9Bars 9

Base currency 125

Bearish 8

Bearish divergence 108

Ben Jacobsen 82, 84

Beta 100

Bid-offer spread 128

Bollinger Bands 88

Box size 92

Breakout systems 50

Breakouts 131Bullish 8

Bullish divergence 108

Buy and Sell signals 22

Call option 122

Call warrant 122

Candlesticks 9, 59

Catastrophic risk 121, 134

CCI 62

CFD 125, 127

CFD brokers 127

Charts 7

ChartScript 116

Chester Keltner 104

Closing prices 12

Commodity Cycle Index 62

Complex indicators 22

Continuous process 12

Contract 122

Contract For Difference 127

Contract size 130

Correlation 100

Credit crisis 18

Currency pair 125

Currency trading 125

Curve fitting 19, 25

Cyclical price-development patterns 6 2

Daily prices 11

Day trader 9

Decimals 125

Dedication 118Directional Movement Index 32

Discipline 111, 118, 129

Distribution 80

Diversification 121, 131

DIY programming 115

DMI 32, 70, 113

Donald R. Lambert 62

Donchians Channel Breakout System 131

Drawdown 11, 14

Dual Moving Average 28

Easy Language 116, 138Entry signals 135

Equity curve 12, 17, 18, 84, 112, 140

Euphoria 122

EUR/USD 125

Excel 18, 20, 116

Exit points 134

Expected return per trade 15

Expiration date 123

Exponential Moving Average 25, 26

Financing costs 127

Financing level 124Flat tops 21

Forex 125

Forex brokers 125

Forums 116

FTI futures 129

Fundamental analysis 7

Futures 122, 123

George Lane 56

Gerald Appel 30

Greed, fear and regret 117

Head & shoulders formations 7

Herd mentality 118

H-factor 128

Historical Price 11

Hit rate 11, 15, 18


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Indicator 7, 11, 20, 22

Instruments 122

Insurance 86

In-the-money option 123

Intraday 11

Intrinsic values 123

J. Wellis Wilder Jr. 32, 34, 54

Jack Huton 64

Japanese candlestick 9

John Bollinger 88

Joseph Granville 80

Kaufman 13

Keltner Channel 104

KST 46

Lag 22, 24Lagging 68

Lagging indicator 25

Larry Williams 66

Leading indicators 22

Leverage 122, 125

Leverage factor 126

Leveraged investments 13

Limit order 135

Limited order 12

Linda Raschke 104

Line chart 9Liquidity 128

Losing streak 15, 111

Lucan & LeBeau 13, 16, 17

MACD 30

MACD differential 30

MACD histogram 30

Majors 125

Margin 123, 126

Margin call 13

Market order 135

Martin Pring 46Maximum loss 11, 13

Maximum successive losing trades 15

Metastock 116

Metastock code 116

Modified time axis 92

Momentum 60

Money Flow 78

Money Management 111, 117, 120, 129

Moving Average 25, 113

Moving Average Convergence/Divergence 30

Moving Stop Loss (MSL) 36

Multiple Time Frame 10, 48

Negative divergence 108

Net profit 14

Noise 69, 74

Number of trades 14

Obligation 123

On Balance Volume 80

Opening prices 12

Optimization 19

Optimization curve 20

Optimizing 8

Optimum-f method 121

Options 86, 122

Options prices 88

Oscillators 8, 22, 53

Out-of-the-money 86, 124

Overbought 53, 54

Overheated market 68

Oversold 53, 54Overtrading 120

P/L 15, 18

Parabolic SAR (Stop And Reverse) 34

Parameter settings 53

Parameters 19

Patience 118

Peak/valley equity curve 14

Percent time in the market 13, 14

Performance Indicator 40

Performance lines 98

Performance measurement 98Perseverance 119, 129

Pieter Bos 40

Pips 125

Pivot points 97

Point & Figure 92

POR risk 16

Portfolio 86

Position size 121, 129

Position trader 9

Positions 120

Positive divergence 108Premium 86, 122

Price line 9

Prices 7

Probability of Ruin 16, 17

Profit per trade 15

Prognosis 7

Programming code 138

Psychological factors 11

Psychology 117, 129

Put option 86, 122

Put warrant 122

Quote currency 125

Range Action Verification Index 72

Range bars 94

Range bars indicator 92


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Rate of Change 60

Ratio 124

RAVI 72

Real-life trading 11

Reinvesting 121

Relative Strength 44, 114

Relative Strength Index 54

Relative volatility 100

Reversal size 92

Richard Dennis 129

RINA Index 13

Risk 120, 131

Risk and Reward 11, 13

Risk level 86

Risk of a stock 90Robert Krausz 107

Robust 19

ROCEMA 38

Roulette table 16

RS 114

RSI 54

RSI indicator 13

Rule-based trading systems 138

Rules 111

Scalper 9

Script languages 115Seasonals 82

Select Net Profit 14

Sell in May indicator 84

Short-term trader 9

Signal arrows 23

Simple Outbreak Indicator 50

Simple Outbreak System 131

Slippage 12, 14, 128

Speeders 123

Spikes 20

Spread 14Spreading risk 111

Spreadsheet 116

Sprinters 123

Stan Weinstein 114

Standard deviation 87, 89

Statistical analysis 7

Statistically significant 11

Statistics 18

Stochastics 56

Stop price 135

Stop-loss 22, 53, 87, 124

Stops 133

Strike price 122

Support and resistance 9, 97

TA script 116, 140

Technical Analysis 7

Technical tools 96

Term 122, 124

Theoretical values 123

Theory of play 16

Tick size 125

Time Frames 9

Time Horizon 9

Time zones 126

Tradability 128

Trader activity 77

TradeStation 116

Trading 8

Trading account 120, 130

Trading markets 8, 53Trading plan 112

Trading rules 112

Trading simulation 15

Trading systems 7, 18, 111

Transaction costs 12

Trend indicators 8, 23, 24, 68

Trend market 8

Trend-following indicators 8, 22, 24

Triangle pattern 9

TRIX 64

TRIX Dynamic 64True Range 102, 130

Turbos 122

Turtle trading 129

Tushar S. Chande 42, 72

Typical price 78

Underlying asset 123

Units 130

Vertical Horizontal Filter 74

VHF 74

Vision 119

Visual analysis 7Volatility 86, 90, 130

Volatility indicators 86, 90

Volume histogram 77

Volume indicators 77

Wall Street Professional 15, 20, 116, 138

Warrants 122

WealthLab 116

Weekly prices 11

Weighted Moving Average 26

Williams %R 66

Working capital 120

WS Index 13

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A Practical Guide to Indicators 12 Pgs

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