Tuning in to Volatility
By Peter Ashton
Friday, June 29th, 2018
In this news article published by CIBC Investor's Edge Exchange, Peter Ashton writes about three of the most widely used indicators.
Canadian and U.S. markets have provided a very profitable backdrop for investors over the nine-year bull market that began in 2009. However, the ride has been far from smooth, with many ups and downs in the market along the way. Although buy-and-hold remains a very solid investment strategy, today’s market volatility provides opportunities for more active investors looking to time their entry and exit points with the aim of boosting their overall returns.
Technical traders often refer to market conditions as being “overbought” or “oversold.” These terms are rooted in the idea that an individual stock (or even the market as a whole) will tend to revert to its long-term trend. In other words, stocks that have risen too far, too fast are overbought and likely to decline back towards their longer-term trend. Similarly, stocks that are oversold are likely to rise. Over the years, technical analysts have developed a number of mathematical indicators that help traders identify overbought and oversold conditions such that they can better time their entry and exit points.
Three of the most widely used indicators for this purpose are Bollinger bands, MACD and RSI.
Developed by John Bollinger in the 1980s, Bollinger bands were one of the first adaptive envelope volatility tools. Bollinger bands use standard deviation and a simple moving average to help traders identify overbought and oversold levels. When calculating Bollinger bands, you first calculate a 20-day moving average of the price data. The upper and lower Bollinger bands then typically appear two standard deviations above and below the 20-day moving average. When the price touches the upper Bollinger band, the stock is considered overbought and likely to decline back towards the 20-day moving average. When the price touches the lower Bollinger band, it is considered oversold and likely to rise.
Figure 1: Bollinger Bands
MACD is an abbreviation for Moving Average Convergence/Divergence. This indicator helps identify overbought and oversold signals by calculating the difference between two moving averages of different time periods. Typically, MACD is calculated by comparing the difference between a 26-day and 12-day exponential moving average. A 9-day exponential moving average is also plotted and called the signal line. When the MACD is rising, it indicates upward price momentum as the short-term moving average begins to pull away (diverge) from the longer-term one. When MACD crosses the signal line in the upward direction, it indicates an oversold (bullish) level. When MACD crosses the signal line in the downward direction, it indicates an overbought (bearish) condition.
Figure 2: MACD
Relative Strength Index
The Relative Strength Index (RSI) is an oscillator that measures a stock’s current relative strength compared to its own price history. RSI is plotted on a scale of 0 to 100. Leaving out the mathematical details, RSI looks at the average closing price in “up” days divided by the average closing price during “down” days over a 14-day calculation period. An RSI level below 30 implies that a stock is oversold while an RSI above 70 implies it’s overbought. The RSI moving above 30 is considered a bullish event whereas a move below 70 is considered a bearish event.
Figure 3: Relative Strength Index
If this sounds complicated, you are not alone! Technical analysis is powerful, but it can be daunting for the novice investor or trader. The good news is that automated software tools make it easier to find and research stocks displaying overbought and oversold indicators.
CIBC Investor’s Edge offers Trading Central Technical Insight™ free of charge to account holders. Technical Insight automates the standard practices of technical analysis, making it easy to identify new trade ideas or evaluate the technical perspective for a given stock or ETF. Technical Insight automatically detects the Bollinger bands, MACD and RSI indicators, as well as many other common types of technical events.
With Technical Insight, you can look up a stock or ETF and see all its active technical patterns and indicators. Featured Ideas highlights ten trade ideas per day based on what’s poised to move from a technical perspective. Use the technical event screener to search for trade ideas in a given sector or based on a specific technical indicator like MACD or RSI. Set up email alerts to stay on top of your positions and tune in to signs of weakness.
To use Technical Insight, sign on to CIBC Investor’s Edge and select Quotes and Research, Market Centre. Select the Technical Analysis tab.
The investment ideas presented here are for information only. They do not constitute advice or a recommendation by Trading Central in respect of the investment in financial instruments. Investors should conduct further research before investing.