Technical Analysis: Introduction to MACD, Stochastics & RSI

By Darrell Jobman   ISSUE 703 | MAR 2008

Fundamental analysis tries to interpret supply/demand, economic statistics and a whole lot of other factors to come to a decision about potential price direction. But that type of analysis requires a rather in-depth background of knowledge about a market if you want to trade the information successfully, and the fundamentals of every market are different. Therefore, many traders find technical analysis more helpful.

Analyzing one thing – price – is a lot easier for most people because you can apply the same expertise to all markets. And, besides, everything that matters to a market is reflected in the price anyway.

As technical analysts, we want to be able to track price by using charts. However, chart interpretation is subjective and, therefore, more of an art than a science. As a result, many traders have turned to technical indicators, which quantify data and provide a precise price point at which action is to be taken, reducing the emotional aspect of trading. Either the price that you select for a given period meets the criteria for action or it doesn’t.

Technical indicators can be placed into two basic categories – the continuation indicators that follow trends such as moving averages, and those that analyze the velocity or momentum of price movement. Momentum indicators detect when changes in that momentum may lead to a trading signal.

Price action can do one of only two things. It can break through a line, whether it is support or resistance from a trendline, a moving average line, a previous high or low or some other point. Or, it can respect that line by bouncing back from it.

Observing price action when it approaches those points is the essence of technical analysis, and traders look for indicators to help them come to a conclusion about future price direction. As with other aspects of technical analysis, traders can only deal with probabilities based on what these indicators have shown in the past and their experience in reading this past.

Here are some of the main technical indicators in the momentum category that provide their best signals when markets are in trading ranges – that is, when prices are staying within generally horizontal boundary lines:

• Moving Average Convergence/Divergence (MACD)
• Stochastics
• Relative Strength Index

You may notice that the first one, MACD, is also sometimes labeled as a trend-following indicator. MACD involves two moving averages but with a twist that smoothes the averages, indicates changes in momentum and provides crossover signals that suggest the beginning of new trends.

If you have any experience with markets, you know that a big problem is that you can never be sure what the market conditions will be, whether they will be trending (up/down) or trading (sideways). That is one reason why you might want to use at least one of these indicators to help identify trade possibilities when conditions are changing.

Before getting into some chart examples, let’s cover some characteristics that the momentum indicators generally have in common. Momentum in technical analysis basically means the velocity of price change and not necessarily the amount of price change itself. For example, if a futures market is locked limit up all day in intraday trading, the amount of price change remains the same all day but momentum diminishes because there is no movement.

A momentum indicator would measure the rates of ascent or descent. In the case of markets, that means whether price changes are accelerating or decelerating. These measures of changes in momentum are usually shown relative to a zero or center line – an indicator reading above it usually means being long because the market is still going up, a reading below it usually suggests being short. But there is a limit to how far above or below the zero line momentum can go before it is likely to change. It’s like the arrow reaching the apex of its flight and then gravity starts to bring it back down. In technical analysis that process may be known as reversion to the mean.

Indicators often are shown on a scale of 0 to 100 and have upper and lower thresholds that suggest when a market has gotten overbought or oversold and is vulnerable to a reversal.

One of the most important warnings from a momentum oscillator involves the concept of divergence – that is, price continues on to a new high or low, but the indicator does not, suggesting there may be underlying weakness or strength in the market that has not been reflected yet by the price action.

Moving Average Convergence/Divergence (MACD)

MACD is a trend-following momentum indicator that works best in wide-swinging trading markets. It involves the difference between two exponential moving averages, generally 12 and 26 periods, and then there is a 9-period moving average of that difference that becomes the smoother MACD signal, or trigger line.

The blue line in the chart below illustrates the use of MACD, which provides trade signals in several ways. First is its position relative to the dashed zero line – MACD reading above it indicates long, below it indicates short. Second, when the 12- and 26-day moving average difference line crosses above the smoother MACD signal line, it indicates buy; when it drops below the signal line, it indicates sell. Note the crossover points indicated by the vertical green lines on this daily 10-year Treasury note futures chart, and what the market did after the signal. Some signals are quite timely, some not so great.

Source: eSignal

A third type of MACD signal occurs when the shorter MACD average rises or falls dramatically compared to the longer moving average, causing a sharply widening gap between the MACD line and the signal line. When the difference between these lines becomes more extreme, it suggests a price move has become overextended and is subject to pulling back or correcting itself.

Another signal is a result of divergence between the indicator and the price trend. In this case, we are using the MACD histogram to provide a clearer picture of changes in the difference between the MACD and the MACD signal line. During December 2007, prices made a new low but the histogram bars did not, suggesting there was not as much pressure to push prices lower as there was earlier. This provided an early clue that the market could move into an uptrend. A month later the situation was reversed, with prices rising to a new high but the MACD histogram showing shorter bars.

Also note that the January 2008 crossover signal and decline in MACD looks like it should have been a good downtrend trade, but it did not perform so well in what became a sideways market.

Stochastics

One of the most popular momentum indicators is stochastics, whose main purpose is to find overbought/oversold areas and potential price reversals. The basic premise of stochastics is that in a rising market, the close tends to be nearer the high of the day, while in a falling market the close tends to be nearer to the low of the day.

Stochastics features two lines, %K and %D. The %K line involves the location of the current close relative to the high and low price for a specific length of time, typically 14 periods. The total range for that length of time is 100 percent and %K reflects the percentage of that range where the close occurs. The %D line is a moving average of the %K line, typically three periods. This produces a version known as fast stochastics. Another three-period moving average of %D produces what is known as slow stochastics, which is what many traders use. Fortunately, a computer does all of the work nowadays so you don’t have to do these complex calculations.

What is more important is how this indicator can be used in trading. Stochastics is displayed on a scale of 0 to 100. When the reading is above 80, the market is considered to be overbought; when the reading is below 20, the market is considered oversold. Different thresholds such as 70-30 can be used but 80 and 20 seem to be the preferred choices. A sell signal is generated when the faster, more sensitive %K line (the light blue line on the chart below) crosses below the %D line (the dark blue line) when both are above the upper threshold of 80. Similarly, a buy signal is generated when %K crosses above %D when both are below the lower threshold of 20.

Source: VantagePoint Intermarket Analysis Software

Not to beat the concept of divergence to death, but it is an important element of stochastics and momentum oscillators in general. Keep in mind that the more important line is %D, the darker blue line, and the important area to watch is above 80 or below 20. When prices reach a higher high but stochastics display a lower high while above the upper threshold at 80, it is a good sign that upward momentum is diminishing and that prices could head the other way.

In the same way, when prices make a new low or are on about the same plane as the previous low, (as this triple low in crude oil futures illustrates) and stochastics is below 20 and makes a higher low, momentum is on the side of an upswing in prices. This became very evident amid crude oil's run to record highs in February-March.

Several important considerations about stochastics and other momentum oscillators need to be pointed out here: First, although stochastics can make some great calls, trending markets can produce a lot of false stochastics signals, as you will note during the trending periods on this chart. That can be maddening for a trader who relies solely on a stochastics signal. Second, because of this, stochastics should be used in conjunction with some other indicator and should definitely be used in conjunction with chart analysis. Do not try to rely on stochastics alone.

Relative Strength Index (RSI)

The Relative Strength Index (RSI) is another momentum oscillator. Like stochastics, RSI tries to gauge the current strength or weakness of a market relative to prices over a specified period of time. One of the problems with other measures of momentum is that sudden, sharp moves in prices can cause the indicator readings to be rather erratic as these big changes come into or out of the time window covered by the indicator.

RSI smoothes out those changes by adding together the number of points gained on the up days for a selected time, say 14 periods, to get an average up value. An average down value is calculated the same way, adding the number of points lost on the down days. The up average is then divided by the down average. The length of time can be varied, depending on how sensitive you want the oscillator to be, based on the time frame you are trading.

Like other oscillators, RSI is measured on a scale from zero to 100 as seen in the chart below. However, the threshold for overbought is usually 70 (rather than 80 with other indicators), and the threshold for oversold is usually 30 rather than 20. RSI also tends to stay in overbought or oversold positions for extended periods of time when a market is trending but vacillates back and forth in choppy conditions. Like other oscillators, the best RSI signals are based on divergence or on turns beyond the 70-30 thresholds.

Source: VantagePoint Intermarket Analysis Software

Putting It All Together

To get a better idea of how some of these momentum indicators compare with each other, here is a composite look at several of the major indicators as applied to crude oil futures prices. The vertical green lines highlight the MACD crossover signals and show how the stochastics and RSI indicators looked at the same point. Sometimes the signals from the various indicators confirm each other and sometimes they do not. During choppy trading periods, I think it’s a good idea to look at an indicator like stochastics, but I generally rely more on moving averages and MACD.

Source: VantagePoint Intermarket Analysis Software

There are many other indicators and hundreds of variations in applying the indicators. You could spend all your time researching all the possibilities with indicators in different market conditions. To sum up the momentum indicators, keep in mind that they are based primarily on one thing, prices. The prices all occurred in the past, so they do lag the current market. But if you do want to use momentum indicators, here are a few suggestions:

1. Do your research to find indicators that fit your trading style and time horizon.
2. Use more than one indicator to verify a signal.
3. Include a type of indicator that works in trending markets and a type that works best in trading markets.
4. Although we have talked about the shortcomings of subjectivity with chart analysis, you should always be looking at a chart in conjunction with any indicator.
5. Focus on moves above or below established thresholds to indicate potential trend changes, remembering that momentum indicator readings can remain above or below these thresholds for extended periods of time when a market is trending so not all signals may be reliable
6. Divergence is an important concept with momentum indicators and may provide an early alert to trend changes.

Darrell Jobman is Editor-in-Chief of TraderEducation.com, a Web site that provides free information and education for traders. It includes daily and weekly market commentaries, tutorials and a number of other resources for traders. Darrell Jobman can be reached by email at Darrell@tradingeducation.com.

You can find an archived webinar on which this article is based, as well as register for upcoming events, on Lind-Waldock's Events page.

Kristina Zurla Landgraf is editor of Lind eWire. She can be reached by email at editor@lind-waldock.com.

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