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Technical Analysis Indicators
The Smart Profits Report: Issue #367
Wednesday, November 1, 2006
Technical Analysis Indicators: Harness The Power Of Leading Indicators And Bollinger Bands
By D.R. Barton, Jr.
Quantitative Analyst, Mt. Vernon Research
Everyone hates slow service. If your waiter or waitress doesn’t bring your meal on time, they get no tip. If FedEx delivers your package late, you don’t pay. And if a kid shows up at your doorstep on November 3 and yells “Trick or treat!” - they’re likely to be very disappointed that you ran out of candy three days ago.
Yet in the investment world, millions of people use technical analysis indicators every day that are slow, late and lagging… and think nothing of it. So let’s see if your favorite technical indicators are just rehashing history - or predicting the future.
And with yesterday being Halloween, the answer just might be frightening…
Lagging Technical Analysis Indicators: Staying Firmly “Behind” the Curve
In simple terms, lagging technical analysis indicators trail the price action of the instrument they’re tracking. The best example of a lagging technical indicator is a moving average or a moving average crossover system.
So take a look at the following chart, showing Google’s (Nasdaq: GOOG) performance this year, and let’s see what kind of lag we get with a standard crossover system using 20-day (the blue line) and 50-day (the red line) moving averages.
In a traditional moving average crossover system, when the fast line (blue) crosses the slow line (red), you change the direction of your trade. As you can see, price lags of $40 to $90 per signal occurred on Google just this year alone!
This is the age-old problem with lagging technical analysis indicators - they give the signal long after the price has moved in your direction (sort of like the kid coming to your door for “Trick or Treat” in the middle of November).
So in order to execute a successful trade using lagging indicators, you need to see a really big trend. That way, even if you get in late, you still have some of the move left. The problem is that big trends happen infrequently.
For example, the chart shows that Google stock endured a huge down move at the beginning of the year, followed by a strong move back up from March to the end of April. Immediately afterwards, it moved down, and recently shares have climbed strongly again.
And amazingly, a trading system designed to catch parts of big moves only made money on the current move that is in progress because it took so long to recognize a trend and enter it.
Lagging Technical Analysis Indicators Hate Sideways Markets
The other big problem with trend-following technical analysis indicators is that they get chopped up in sideways markets. In the Google chart, you can see three crossovers between May and August, where the lag was so bad that you would have shorted near the bottom and bought near the top every time.
Of course, savvy analysts do many innovative things to reduce the lag. For example, they employ exponential or adaptive moving averages, and use shorter time periods. Or they add a third moving average to attempt to keep out of the market during sideways moves.
The bottom line is this: Lagging indicators work okay when the market is in big trends - whether it’s:
- Moving averages,
- ADX,
- MACD crossovers
Take your pick.
But here’s the problem: Most studies show that markets are only in a trend 20% to 40% of the time! This means that in predominant market conditions, lagging indicators are pretty useless.
Fortunately, there’s a better way…
Leading Technical Analysis Indicators: Predicting Market Moves
Rather than reacting to previous price action, I like to act in advance. That’s why I like to watch leading technical analysis indicators. These tools seek to predict the time and price where a stock, futures contract or currency is most likely to change direction.
Widely used leading indicators include:
- Oscillators like stochastics…
- Relative Strength Index (RSI)…
- And bands and envelopes.
These indicators tell us when the asset we’re following has most likely stretched too far in one direction.
So let’s look at the same Google chart… but with a simple Bollinger Band added.
Break Out the Bollinger Bands
Simply put, Bollinger Bands show an upper and lower band, which is plotted a set number of standard deviations away from a moving average. Since standard deviation is a measure of volatility, this type of band adjusts itself to market conditions.
The usual way to apply this band is to anticipate that anytime the price closes outside of the band, it will move back inside the band, or regress toward the mean. Phew - that’s a lot of statistical mumbo-jumbo! So let’s look at a simpler explanation…
Another way to view Bollinger Bands is to think of the price as a rubber band: When the price stretches too far (outside of the bands), it’s likely to snap back, like an over-stretched rubber band.
On the chart, I plotted the number of occasions on which Google’s price moved outside the Bollinger Bands during the year. The signal in January was $20 early… but a very good shorting signal. In March, the predictive technical indicator nailed the low, and again forecast the high in April perfectly. And it predicted the June high within $10 dollars of the turn (not too bad for a $400 stock…)
Of course, no indicator is perfect. The stock saw only $30 of follow-through to the downside after the September high, and wouldn’t have made much money unless you got out quickly. And the October high was pre-mature.
With predictive technical analysis indicators, you have to have a full system in place to help you avoid calling tops and bottoms too soon. But a well-run system can catch short- and long-term gains with regularity.
Great trading,
D. R. Barton, Jr.
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Today’s Smart Profits Cribsheet
- Easy trades happen for a reason - you just need the right system, or strategy to get you in at the right time. Back in an earlier Smart Profits issue, I explained how catching market moves is similar to riding the waves on the ocean - and gave three key trading lessons that you can learn from rising trades, falling trades, or flat trades. Check it out in Smart Profits #349, Trading Lessons: Catching The Market Waves for Stress-Free Trades.
- My colleague and technical analysis compadre, Jim Stanton, emphasizes the importance of Dow Theory within chart pattern recognition and how this type of technical analysis can show what the market may have in store for the future in Smart Profits #362, Dow Theory: The Most Important And Powerful Concept In Technical Analysis.
Related Articles:
- Technical Analysis: Two Simple Tools for Spotting a Technical Trend
- Continuation Patterns: Cashing In On Technical Analysis
- Head and Shoulders Pattern: A Proven Sell Signal Called Breaking the “Neckline”
The Chart of the Week
Yahoo! (Nasdaq: YHOO) has shown a history of snapping back after closing outside of Bollinger Band. With a recent close outside of the band, look for a snap back to the downside.
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