Three Key Trend Indicators for Investors
Staying ahead of a trend is a tricky thing; just ask any high-school student. In investing, staying ahead of a current or future trend can be the difference between riches and rags.
The idea, obviously, is to get in on a changing trend right at the beginning. Easier said than done; investing too early leaves room for the trend to turnaround – too late, and profits will be left on the table.
If you’re feeling bewildered by this volatile dance, take notice: watching shares rise and fall doesn’t have to be a purely reactive event. This article will teach you three tools to stay ahead of the trends.
MACD: Moving Average Convergence-Divergence Indicator
The moving average convergence-divergence indicator, thankfully known only as the MACD is one of the most important indications that a trend is emerging.
Here’s how it works:
For this step, you need to draw three lines. The first line is called the fast line, showing you an average of the stock’s price over a period of days, with the most recent days counting the most (it’s actually called an exponential moving average, and making one is a bit a trick: you might try this online calculator).
The second line is called the signal line. This is a line against which you will measure and analyze the fast line. It’s typically a nine-day average using the data points on the fast line for the computations.
The third step in making a MACD chart is to create the histogram. This line is typically a bar graph that shows when the prices on the fast line and the signal line differ, and by how much.
Hint: Most charts can draw MACD for you! All you have to do is change the inputs.
How to use these lines:
- Buying and Selling: When the histogram shows the fast line above the signal line, you should buy. When the fast line dips below the signal on the histogram, you should sell. Patience is required, though, and some acceptance of the fact that what you see can be a tenuous mix: seeing a fast line react to a signal line doesn’t always mean a trend is underway, and it doesn’t always mean that if it is a trend, it’s going to last.
- Market Turning Points: Rather than use the MACD to simply trigger a buy or a sell, use it to look for reinforcement — or contradiction — of what you see in your analysis of a share-price’s support and resistance levels. For more on these two factors in technical analysis, read our first entry in this series.
RSI: Relative Strength Index
The relative strength index, or RSI, informs traders if a stock is overbought or oversold. If everyone is buying up shares of a company, its stock price will likely jump in reaction to the increased demand (econ: demand up, price up). However, at some point that price is going to top out. Similarly, if everyone is selling shares in a company, then its price is likely to drop
What RSI does is give traders a way to estimate where that outermost edge may lie. You take an average of x number of days the price has closed up. You take the average of x number of days its price closed down. Divide the former by the latter. That value is called the RS.
The RSI computation is: 100-100/(1+RS).
If the result is above 70, then the shares are overbought. If the result is below 30, then the shares are oversold. In both cases, an impending trend reversal is likely.
Lastly, the Stochastic Oscillator (sorry, no acronyms this time) measures the momentum of a price in both directions: up and down.
How it works:
Take a 14-day period and focus on three numbers: the most recent closing price, the highest closing price, and the lowest closing price.
With those numbers in hand, take the difference between the current close and lowest low and divide it by the difference between the highest low and the lowest low. Then multiply by a hundred.
Confused? Maybe a formula will help:
(Current close – lowest low) / (highest high – lowest low) * 100
How to use it:
If the stochastic oscillator is above 80, the price is overbought and likely to drop in the near future.
If the stochastic oscillator is below 20 then the price is oversold and likely to rise in the near future.
Note though, that an overbought stock on this, or any other, indicator’s measurement doesn’t ensure traders that the shares are about to plummet. Similarly, oversold shares aren’t always bound to bounce. Both can hum along for quite a while, just where they are. But traders do know that either condition means that they should look at the trends for that stock and see if similar conditions have preceded a low price going high, or a high price declining.
In our next installment, we’ll look even more closely at trends, and how to generate trendlines to track stock prices over time. Until then, good luck, investors!