Chapter 10 Oscillators and contrary opinion

Introduction The oscillator is extremely useful in non-trending market where prices fluctuate in a horizontal price band. It provides traders with a tool that allow for making profits from a trendless market. As “Oscillator usage in conjunction with trend”, the oscillator is only a secondary indicator in the sense that it must be subordinated to basic trend analysis. * Near the beginning of important moves, oscillator is not that helpful and can even be misleading. Toward the end of moves, however, oscillators become extremely valuable. *先看是否有trend, 再決定是否使用oscillator Zero line: midpoint line

*General rules When the oscillator reaches an extreme value in either the upper or lower end of the band, this suggests that the current price move may have gone too far too fast and is due for a correction or consolidation. [pre signal] The trader should be buying when the oscillator line in the lower end of the band and selling in the upper end. [crossing] The crossing of the midpoint line (in the direction of price trend) is often used to generate buy and sell signals. 上面二則需配合趨勢 [Again] Oscillator analysis should not be used as an excuse to trade against the prevailing market trend. (p. 231)

*The 3 most important uses for the oscillators [Overbought/oversold] The market is said to be overbought when it is near the upper extreme and oversold when it is near the lower extreme. [Divergence] A divergence between the oscillator and the price action when the oscillator is in an extreme position. [Crossing] [Tactic] The crossing of the zero line can give important trading signals in the direction of the price trend.

Oscillator Momentum 減法 To construct a 10 day momentum line (M), simply subtract the closing price 10 days ago (P10) from the last closing price (P). M=P-P10 Rate of change (ROC) 除法 To construct a 10 day change oscillator, the latest closing price is divided by the close 10 days ago. Constructing an oscillator using two moving averages (MACD) Commodity channel index (CCI) CCI was originally developed for commodities, it is also used for trading stock index futures and options like S&P100 (OEX).

1. Momentum Momentum measures the differences between prices at two time intervals. Hence, it measures the velocity of price changes. To construct a 10 day momentum line (M), simply subtract the closing price 10 days ago (P10) from the last closing price (P). M=P-P10 Figures Momentum should be used in conjunction with the market trend. (Figure10.1a) *The longer version momentum is more helpful in catching major market turns. (Figure 10.1b) Momentum measures rates of ascent or descent *The momentum line leads the price action [Tactic] The crossing of the zero line as trading signal if it takes the same direction as the trend.

Momentum should be used in conjunction with the market trend (Is it trendless now?)

The longer version momentum is more helpful in catching major market turns (40d vs. 10d)

Momentum measures rates of ascent or descent If the prices are rising, the momentum line is above the zero line and rising, this means the uptrend is accelerating. 向上趨勢增強中 If the up-slanting momentum line begins to flatten out, this means that the new gains being achieved by the latest closes, are the same as the gains 10 days earlier. While prices may still be advancing, the rate of ascent has leveled off. 平 When the momentum begins to drop toward the zero line, the uptrend in price is still in force, but at a decelerating rate.減速 *When the momentum line moves below the zero line, the latest 10 day close is now under the close of 10 days ago and a near term downtrend is in effect. As momentum continues to drop farther below the zero line, the downtrend gains momentum. The downtrend is decelerating.向下趨勢增強中 If the last price gain is less than the that of 10 days ago, the momentum line begins to decline even though prices are still rising.

*The crossing of the zero line as a trading signal if it takes the same direction as the current trend [Again] Oscillator analysis should not be used as an excuse to trade against the prevailing market trend. (p. 231) [*Tactic] Following the current market trend: (Figures 10.2a,b) Long (buy) positions should only be taken on crossing above the zero line if the market trend is up. Short (sell) positions should be taken on crossing below the zero line only if the price trend is down.

**Tactic: The crossing of the zero line as a trading signal if it takes the same direction as the current trend (Figure 10.2a)

**Tactic: If you take the crossing the zero line as a trading signal, MA is helpful to confirm trend changes. (Figure 10.2b)

The need for an upper and lower boundary

* The 13 weeks momentum line changed direction before the price at each major turn

3. Constructing an oscillator using 2 moving averages Plotting the difference the two averages The 3 uses of this ‘difference’ oscillator To help spot divergence To help identify short term variation (from the long term trend), when the shorter average moves too far above or below the longer average. To pinpoint the crossing of the two moving average, which occur when the oscillator crosses the zero line. The shorter average is divided by the longer. In both the “difference and divided” methods, The shorter average oscillate around the longer average, which is in effect the zero line. If the shorter average is above (under) the longer, the oscillator would be positive (negative).

3. Constructing an oscillator using 2 moving averages Figure 10.5 Figure 10.6 **[Buy Tactic] In an uptrend, the shorter average dips back to the longer, but should bounce off it. This usually represents an idea buying area. **[Sell Tactic] In a downtrend, the shorter average rises to (near) the longer usually represents an idea selling area unless the longer average is crossed, in which case a trend reversal signal would be registered.

*The histogram turns well before the actual (price cross MA) signal

**Histogram finds support at zero line in an uptrend

Easy to see overbought/oversold in histograms

The relative strength index (RSI) New concept in technical trading systems by Wilder 1978. The RSI solves the problem of erratic movement and the need for a constant upper and lower boundary. RSI=100-100/(1+RS), 除法 where RS = (average of x days’ up closes) / (average of x days’ down close) Usually use 14 days, 14 weeks The shorter the time period, the more sensitive the oscillator becomes and the wider its amplitude. (Figure 10.11) (9, 14 days) most common, (5, 7 days) to increase volatility, (21, 28 days) to smooth out the RSI Overbought 70, oversold 30 (Figure 10.10) * Overbought 80 in bull market , oversold 20 in bear market

RSI: overbought 70, oversold 30

7days and 14days RSI

+ RSI *Trendline analysis can be employed to detect changes in the trend of the RSI. (Figure 10-13) Some traders treat RSI crossing above 50 in a uptrend and crossing below 50 in a downtrend as buying and selling signals respectively. * Divergence between the RSI and the price line, when the RSI is above 70 or below 30. Top failure swing occurs when the RSI is over 70 and (RSI) fails to exceed a previous peak while price is still in an uptrend, followed by a downside break of the previous RSI trough. (Figure 10.12b) Bottom failure swing occurs when the RSI is under 30 and fails to set a new low while price is still declining, followed by a upside break of the previous RSI peak. (Figure 10.12a) [Experience] The greatest value of RSI lies in failure swings or divergences that occur when the RSI is over 70 or under 30.

Using trendlines on RSI

*RSI bottom/Top failure swings

[**Tactic] RSI Divergence In strong uptrends, market can stay overbought for some time. Just because the RSI has moved into the upper region is not reason enough to liquidate a long position. *The first move into the overbought or oversold region is just a warning (1). If the second move fails to confirm the price move into new highs or new lows (forming a double top or bottom on the RSI), a possible divergence (2) exists. *Suppose the trader thinks a market is about to bottom and is looking for a buying opportunity. He or she watches the RSI dip under 30. Some type of divergence or double bottom may develop in the oscillator in the oversold area. An RSI crossing back above 30 at that point is taken by many traders as a confirmation (3) that the trend in the oscillator has turned up.

**Use 9 Months RSI to pinpoint market top

Stochastics (K%D) Lane developed K%D, which is based on the observation that in uptrends (downtrend), closing prices tend to be close to the upper (lower) end of the price range. * The %D line is the one that provides the major signal. (formula) %K 14? %D (fast stochastic) is a 3 period moving averages of the %K line. Most traders use slow stochastic (more reliable) which takes another 3 period average of the %D. K%D can be used on weekly, monthly, and intraday charts.

+ Stochastics (K%D) ** (major signal) Divergence between the D line and the price of the underlying market when the D line is in an overbought or oversold area. (Figure 10-15) A bearish divergence occurs when %D is over 80 and forms two declining peaks while prices continue to move higher. A bullish divergence is present when %D is under 20 and forms two rising bottoms while prices continue to move lower. * [confirm] Assuming a bullish divergence or bearish divergence is in place, the actual buy or sell signal is triggered when the faster K line crosses the slower D line.

*the K%D divergence tactic (k cross d at overbought) Figure 10.15

Stochastics (K%D) [**Tactic] Combining daily and weekly stochastic K%D by using weekly signals to determine market direction and daily signals for timing trade. (Figure 10.16) Using weekly filter is also true for MACD [** Tactic] Combining stochastic (K%D) with RSI (Figure 10.17)

*Use 14 weeks K%D for direction (filter), then 14 days to trade (Figure 10.16)

*Combining 14 weeks K%D and RSI (Figure 10.17)

Some points? Williams %R is used the same as other oscillators. Reading over 80 or under 20 identify market extremes. 28 calendar days (20 trading days) represent an important dominant monthly trading cycle and the other numbers (14, 56) are related harmonically to that monthly cycle.

Williams %R

*Some tactics: Use oscillators with the trend [***Tactic] Trading in the direction of the major trend. If the trend is up (down), then a buying (selling) strategy is called for. [**Tactic] Buy when the market is oversold in an uptrend. Sell short when the market is overbought in a downtrend. [**Tactic] Buy when the oscillator crosses back above the zero line when the major trend is bullish; sell a crossing under the zero line in a bear market. [Again] The oscillator is not a substitute for basic trend analysis.

* Check oscillators with the trend! Q: Should we buy the bullish breakout in the face of an overbought oscillator reading? Or, should the downside breakout be sold into an oversold market? A: In such cases, the oscillator is best ignored for the time being and the position take. The reason for this is that in the early stages of a new trend, following an important breakout, oscillators often reach extremes very quickly and stay there for awhile. Basic trend analysis should be the main consideration at such times, with oscillators given a lesser role. Later on, as the trend approaches maturity, the oscillator should be given greater weight. The fifth and final wave in Elliot Wave analysis is often confirmed by bearish oscillator divergences. Many dynamic bull moves have been missed by traders who saw the major trend signal, but decided to wait for their oscillators to move into an oversold conditions before buying. **To summarize, give less attention to the oscillator in the early stage of an important move, but pay close attention to its signals at the move reaches maturity.

Moving average convergence/divergence (MACD) MACD uses a dual moving average crossover approach. (Appel) The MACD line (faster) is the difference between the 2 exponentially smoothed averages of closing prices (12, 26 days or weeks). The signal line (slower) is a 9 period exponentially smoothed average of the MACD line. (Figure 10.19a) * As with all technical indicators, signals on weekly charts are always more important than those on daily charts. [**Filter Tactic] A daily signal is followed only when it agrees with the weekly signal. This is especially true for the two crossover systems, MACD and Stochastics K%D.

MACD line crossing over signal line

+MACD A crossing by a faster MACD line above (below) the slower signal is a buy (sell) signal. An overbought (oversold) is presented when the lines are too far above (below) the zero line. The best buy signals are given when oscillators are well below the zero line (in a uptrend). MACD line crossings above and below the zero line generate buy and sell signals respectively. *Divergences appear between the trends of the MACD line and the price line. Simple trendlines can be drawn on the MACD lines to help identify important trend changes. (Figure 10.19b)

*Negative divergence of MACD

The MACD histogram The histogram consist of vertical bars that show the difference between the two MACD lines. (MACD and signal lines) Crossing by the histogram above and below its zero line coincide with the actual MACD crossover buy and sell signals (2 lines crossover). * No actual buy or sell signal is given until the histogram crosses its zero line. [Meanings] The uptrend/downtrend is weakening or losing its momentum when the histogram is over/below its zero line (positive/negative) but starts to fall/rise toward the zero line. * Histogram turns轉向 (see histogram trendline) back to the zero line always precede the actual crossover signals. Histogram turns are best used for spotting early exits from existing positions. Figure 10.20a-b, “turn to zero line” shows up 2 to 4 weeks earlier than buy/sell “crossover”. It is dangerous to use histogram turns as an excuse to initiate new positions against the prevailing trend.

Advanced warning of the MACD histogram turns

The weekly MACD histogram turns

The principle of contrary opinion in futures Both oscillator analysis and the principle of contrary opinion can be used to the study of market extremes. A form of psychological analysis-by determining the degree of bullishness and bearishness among participants in the various markets. The principle of contrary opinion holds that when the vast majority of people agree on anything, they are generally wrong. Bullish consensus numbers: Weekly survey results taken among commodity professionals (traders are influenced by advisory services) Bullish bias features of the bullish consensus numbers The equilibrium point is 55%. Contrarian position occurs when the bullish consensus numbers are above 90% or below 20%. Consensus Index of bullish market opinion (Warning zone) Above 75% overbought, below25% oversold

The principle of contrary opinion in futures Contrary opinion measures remaining buying or selling power. If 80-90% of traders are bullish, it is assumed that they have already taken their market positions. Who is left to buy and push the market higher? Contrary opinion measure strong versus weak hands. If 80% traders are on the long side of a market, then the remaining 20% must be financed enough to absorb the longs held by the other 80%. The shorts. therefore, must be holding much larger positions than the longs. The importance of open interest Study the Commitments of Traders Report to ensure that hedgers 双邊下注者hold less than 50%. It is not advisable to trade against large hedging interests. Contrary opinion works better when most of the open interest is held by speculators投機者, who considered to be weaker hands.

The principle of contrary opinion in futures Watch the market’s reaction to fundamental news The failure of prices to react to bullish (good) news in an overbought area is a clear warning that a turn may be near. The first adverse news is enough to push prices in the other direction. The failure of prices in an oversold area to react to bearish news can be taken as a warning that all bad news has been discounted in the current low prices. Any bullish news will push prices higher. Combine with other technical tools Divergences on oscillator charts are useful when the Bullish Consensus numbers are overbought or oversold

The principle of contrary opinion in futures Barron’s investor sentiment readings: Too much bullish is bad. Too much bearish is good. Investors intelligence numbers (future) over 55% too much optimism, under 35% too much pessimism. (stocks) Measure the number of stocks that are above their 10 and 30 week averages. Reading above 70% suggests an overbought market, below 30% oversold. The 10 (30) week readings are good for measuring short to intermediate (major) market turn. Pay attention to the numbers rise back above 30 or fall back below 70.