A Practical Guide to Indicators

Including Turtle Trading

Rombout H. Kerstens
Learn to profitably apply technical analysis indicators to equity, derivative and forex trades

'A Practical Guide to Indicators' leads you through the selection and application of technical analysis indicators and trading systems, with a bias towards practical and useful information rather than theoretical depth. It describes the most commonly used trend-following indicators, trend indicators, oscillators and volume indicators. It also covers the backtesting and optimization of indicators, and discusses DIY trading systems. A crucial element of successful trading is the correct buy/sell timing based on technical analysis. However, this book also deals with other key subjects that are equally important, like psychological factors and money management. In addition, the pros and cons of various financial instruments futures, options and CFDs are discussed. The ultimate goal is to arrive at a complete trading plan that can be applied with discipline and confidence. Subjects covered include:
G G G G G G G G G G G G G

Technical analysis Backtesting and optimization Trend-following indicators Oscillators Trend indicators Volume indicators Seasonal indicators Volatility indicators Turtle Trading technique Do-it-yourself trading systems Leveraged investment: options, futures and CFDs Money management The psychology of investing

ISBN 978-90-77553-09-1

Copyright 2009 Keyword Info Systems BV . P Box 677 .O. 2600 AR Delft the Netherlands All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without prior written permission of the publisher. Insofar as the copying of this publication is permitted on the basis of article 16b and 17 of the 1912 Dutch Copyright Act, the required fee must be paid to Stichting Reprorecht, P Box 882, 1180 AW Amstelveen, the .O. Netherlands. If you wish to copy one or more sections of this publication for anthologies, readers or other compilations, please contact the publisher. ISBN 978-90-77553-09-1 Disclaimer: The descriptions of indicators and trading systems in this book are only intended for educative purposes. The book is explicitly not intended as advice on buying or selling security products. If readers decide to buy or sell security products using the indicators and trading systems described in this book, then they do this entirely on their own initiative and their own responsibility. We reiterate emphatically that the opening of securities positions clearly entails certain risks.

Translation: Lay-out: Software: Printing:

PassworD text fusion B.V . Douwe de Haan, Delft Wall Street Professional, Excel Thieme Media Services, Delft

CONTENTS

Preface 1 Introduction to technical analysis 2 Applying and analyzing indicators 2.1 Introduction 2.2 Backtesting 2.3 Return and risk 2.4 Optimization 3 Indicators 3.1 Trend-Following Indicators 3.1.1 Moving Average 3.1.2 Dual Moving Average 3.1.3 MACD 3.1.4 DMI 3.1.5 Parabolic SAR 3.1.6 MSL 3.1.7 ROCEMA system 3.1.8 Performance Indicator 3.1.9 Aroon Indicator 3.1.10 Relative Strength 3.1.11 KST 3.1.12 Multiple Time Frame 3.1.13 Simple Outbreak Indicator 3.2 Oscillators 3.2.1 RSI 3.2.2 Stochastics 3.2.3 Momentum (ROC) 3.2.4 CCI 3.2.5 TRIX 3.2.6 Williams %R 3.3 Trend indicators 3.3.1 ADX 3.3.2 RAVI 3.3.3 VHF 3.4 Volume Indicators 3.4.1 Money Flow 3.4.2 On Balance Volume 3.5 Seasonals 3.5.1 Sell in May indicator

5 7 11 11 11 13 19 22 24 25 28 30 32 34 36 38 40 42 44 46 48 50 53 54 56 60 62 64 66 68 70 72 74 77 78 80 82 84

Volatility Indicators 3.6.1 Bollinger Bands 3.6.2 Volatility 3.7 Charts with modified time axis 3.7.1 Range Bars 3.8 Various technical tools 3.8.1 Pivot Points 3.8.2 Performance measurement 3.8.3 Beta 3.8.4 Average True Range 3.8.5 Keltner Channels 3.9 Table of indicators 3.10 Explanation of divergence 4 Do-it-yourself trading systems 4.1 System Trading 4.2 Examples 4.2.1 Moving Average + DMI 4.2.2 Moving Average + RS 4.3 DIY programming of trading systems 5 Active trading with indicators and trading systems 5.1 Psychology 5.1.1 The psychology of investing 5.1.2 The 5 basic rules for a successful trader 5.2 Money management 5.3 Instruments 5.3.1 Futures, Options, Turbos 5.3.2 Forex and CFDs 5.3.3 Tradability and liquidity

3.6

86 88 90 92 94 96 97 98 100 102 104 106 108 111 111 113 113 114 115

117 117 117 118 120 122 122 125 128

6 Turtle Trading: a complete trading plan 129 Bibliography Appendix 1: Programming code for MA + DMI trading system Subject index 137

138 142

1 INTRODUCTION TO TECHNICAL ANALYSIS

Market prices are subject to constant change. Everybody obviously wants to know how prices will behave tomorrow or the day after. Unfortunately, this is not an easy task. Even the best-trained financial experts struggle with this. And dont forget human emotion, a factor that most definitely complicates matters further. Technical analysis is very suitable for studying the markets with a certain degree of objectivity without letting emotions get in the way. But what exactly is technical analysis? Technical analysis is the study of historical equity prices and volumes to arrive at a prognosis for future price developments. So technical analysis does not predict prices exactly. It doesnt concern itself with corporate financial data and background research that is the task of fundamental analysis. Technical analysis assumes that this information will be reflected in the prices anyway. The cornerstone of technical analysis is the theory that prices move in trends and that history repeats itself. Technical analysis is primarily used for short-term trading on the stock exchange. It is no Holy Grail and is certainly not infallible. However, fundamental analysis offers no solace to short-term investors. Generally speaking, fundamental analysis proves its worth over the longer term, while technical analysis is more suitable to a short-term horizon. Prognoses generated by technical analysis techniques often do not materialize. A success rate of sixty percent is already considered to be successful. If a prognosis does not materialize, the position must be closed using a predetermined exit scenario, for instance a stop-loss order. Equally important is a clear and decisive scenario for taking profits. However, for active investors, technical analysis is not the whole story: disciplined execution and money management are at least as important. We will discuss these factors in depth later in the book. Technical analysis consists of two distinct branches: visual analysis and statistical analysis. This practical guide concentrates mainly on the latter of these two methods. Visual Analysis Technical analyses often utilize graphs also known as charts, hence the term chart reading. A chart or graph is clear and concise, and offers at a glance the state of play at any given moment. Charts can be constructed in a number of different ways, but most employ bar-chart or line-chart methods. Visual analysis is the domain of the trend lines, price patterns, head & shoulders formations, etc. The chart reader tries to detect patterns and trends by applying clear rules. Unavoidably, however, visual analysis still has a subjective component. One analyst will recognize a certain pattern, while another wont. Statistical Analysis Statistical analysis is the domain of indicators and trading systems. Indicators are arithmetically deduced from price charts. Mathematical formulas are used to develop a greater understanding of the patterns in historical price movements. This knowledge then forms the basis for developing a vision of future price developments. Statistical
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1 INTRODUCTION TO TECHNICAL ANALYSIS

analysis is objective. The calculations are not open to multiple interpretations. This eliminates human emotions from the picture, which often cause people to trade inconsistently and irrationally. Indicators come in all shapes and sizes. Some perform well in a trend market, others better in a sideways market (trading market). If an indicator can objectively indicate market buy and sell points, then it is also called a trading system. Finding the bestperforming indicator settings for a certain market or individual stock is called optimizing an indicator. Calculating how a certain indicator would have performed with the detected buy and sell points using historical price data is called backtesting. The so-called trend-following indicators do well in a trend market, while oscillators theoretically perform better in a trading market. Special indicators trend indicators have been developed to determine whether a market is moving sideways or in trends. Trends in fluctuating markets Figures 1.1 to 1.3 clearly illustrate whether one is dealing with a trend market or a trading market. Unfortunately, it is by no means always clear whether one is facing a trend or a trading market. Sometimes the trend is obscured by severe price fluctuations. The more volatile the market is, the more difficult it often is to identify a trend. Chapter 3.3 (trend indicators) covers this subject in greater detail.

Figure 1.1: Rising trend market: higher tops and bottoms (Bullish)

Figure 1.2: Falling trend market: lower tops and bottoms (Bearish)

Figure 1.3: Sideways market: tops and bottoms of equal measure (Trading)
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Figure 1.4: Trading system with signals

1 INTRODUCTION TO TECHNICAL ANALYSIS

Lines and Bars Price charts often comprise a continuous price line that links closing prices. An alternative is to use bars. For instance, opening, highest, lowest and closing prices are indicated in units of time as so-called bars (see figure 1.5). These bars can be constructed at any level e.g. per minute, hour, week or month. Bars therefore provide more information than a continuous price line. A commonly used bar is the so-called Japanese candlestick. This bar construction gives the bar a different color depending on whether prices have risen or fallen over the period concerned. Figures 1.6 and 1.7 illustrate the difference between a line chart and a bar chart. A bar chart provides much more information. Support and resistance lines can only really be generated correctly using a bar chart. Figures 1.6 and 1.7 converge both support and resistance lines in a so-called triangle pattern. (The generation of a triangle usually signifies the imminence of an important price movement.) Time frames Every investor has an individual investment horizon. An extreme short-term trader a so-called scalper thinks in seconds or minutes, a day trader in 15-minute intervals or hours, and a position trader in days or weeks. A longer-term investor thinks in months or years. They all envision a different time horizon for their trades. Which means each will generate analyses in corresponding time frames. A day trader might for instance relate

Figure 1.5: Bars

Figure 1.6: Line chart

Figure 1.7: Bar chart

1 INTRODUCTION TO TECHNICAL ANALYSIS

his analyses to bars of 5 minutes, and a position trader to bars of daily prices. This only relates to the time horizon. However, the techniques of visual and statistical technical analysis are basically applicable to any time frame. Analyzing multiple time frames Different traders can therefore each analyze and trade in a different time frame. But an individual trader will also take account of overlying time frames. A day trader will also often consider the longer-term trend on a daily and weekly basis. To prevent himself from trading against the trend, for example. There are also trading methods that simultaneously exploit one or more indicators with multiple time frames and only trade when the indicator signals of several time frames corroborate each other.

Figure 1.8: Daily and weekly price bars over same period

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SUBJECT INDEX

9/11 18 %D line 56 %K line 56 24-hour trade 126 ABN AMRO 123 Acceleration factor 34 Accumulation 80 Adam White 74 ADX 32, 70 ADXR 70, 72 AEX Index 82, 130 AFL 116 Agricultural products 82 Alex Pro 116 Alpha 100 AmiBroker 116 Anomalies 82 Aroon Indicator 42 At-the-money 86, 123 Average Directional Movement 70 Average Profit/Average Loss 11, 15 Average result per trade 13 Average True Range (ATR) 87, 102, 104, 130 Backtesting 8, 11, 12 Band factor 88 Bar chart 9 Bars 9 Base currency 125 Bearish 8 Bearish divergence 108 Ben Jacobsen 82, 84 Beta 100 Bid-offer spread 128 Bollinger Bands 88 Box size 92 Breakout systems 50 Breakouts 131 Bullish 8 Bullish divergence 108 Buy and Sell signals 22 Call option 122 Call warrant 122 Candlesticks 9, 59 Catastrophic risk 121, 134 CCI 62 CFD 125, 127 CFD brokers 127 Charts 7 ChartScript 116 Chester Keltner 104 Closing prices 12 Commodity Cycle Index 62

Complex indicators 22 Continuous process 12 Contract 122 Contract For Difference 127 Contract size 130 Correlation 100 Credit crisis 18 Currency pair 125 Currency trading 125 Curve fitting 19, 25 Cyclical price-development patterns 62 Daily prices 11 Day trader 9 Decimals 125 Dedication 118 Directional Movement Index 32 Discipline 111, 118, 129 Distribution 80 Diversification 121, 131 DIY programming 115 DMI 32, 70, 113 Donald R. Lambert 62 Donchians Channel Breakout System 131 Drawdown 11, 14 Dual Moving Average 28 Easy Language 116, 138 Entry signals 135 Equity curve 12, 17, 18, 84, 112, 140 Euphoria 122 EUR/USD 125 Excel 18, 20, 116 Exit points 134 Expected return per trade 15 Expiration date 123 Exponential Moving Average 25, 26 Financing costs 127 Financing level 124 Flat tops 21 Forex 125 Forex brokers 125 Forums 116 FTI futures 129 Fundamental analysis 7 Futures 122, 123 George Lane 56 Gerald Appel 30 Greed, fear and regret 117 Head & shoulders formations 7 Herd mentality 118 H-factor 128 Historical Price 11 Hit rate 11, 15, 18

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Indicator 7, 11, 20, 22 Instruments 122 Insurance 86 In-the-money option 123 Intraday 11 Intrinsic values 123 J. Wellis Wilder Jr. 32, 34, 54 Jack Huton 64 Japanese candlestick 9 John Bollinger 88 Joseph Granville 80 Kaufman 13 Keltner Channel 104 KST 46 Lag 22, 24 Lagging 68 Lagging indicator 25 Larry Williams 66 Leading indicators 22 Leverage 122, 125 Leverage factor 126 Leveraged investments 13 Limit order 135 Limited order 12 Linda Raschke 104 Line chart 9 Liquidity 128 Losing streak 15, 111 Lucan & LeBeau 13, 16, 17 MACD 30 MACD differential 30 MACD histogram 30 Majors 125 Margin 123, 126 Margin call 13 Market order 135 Martin Pring 46 Maximum loss 11, 13 Maximum successive losing trades 15 Metastock 116 Metastock code 116 Modified time axis 92 Momentum 60 Money Flow 78 Money Management 111, 117, 120, 129 Moving Average 25, 113 Moving Average Convergence/Divergence 30 Moving Stop Loss (MSL) 36 Multiple Time Frame 10, 48 Negative divergence 108 Net profit 14 Noise 69, 74

Number of trades Obligation On Balance Volume Opening prices Optimization Optimization curve Optimizing Optimum-f method Options Options prices Oscillators Out-of-the-money Overbought Overheated market Oversold Overtrading P/L Parabolic SAR (Stop And Reverse) Parameter settings Parameters Patience Peak/valley equity curve Percent time in the market Performance Indicator Performance lines Performance measurement Perseverance Pieter Bos Pips Pivot points Point & Figure POR risk Portfolio Position size Position trader Positions Positive divergence Premium Price line Prices Probability of Ruin Profit per trade Prognosis Programming code Psychological factors Psychology Put option Put warrant Quote currency Range Action Verification Index Range bars Range bars indicator

14 123 80 12 19 20 8 121 86, 122 88 8, 22, 53 86, 124 53, 54 68 53, 54 120 15, 18 34 53 19 118 14 13, 14 40 98 98 119, 129 40 125 97 92 16 86 121, 129 9 120 108 86, 122 9 7 16, 17 15 7 138 11 117, 129 86, 122 122 125 72 94 92

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Rate of Change Ratio RAVI Real-life trading Reinvesting Relative Strength Relative Strength Index Relative volatility Reversal size Richard Dennis RINA Index Risk Risk and Reward Risk level Risk of a stock Robert Krausz Robust ROCEMA Roulette table RS RSI RSI indicator Rule-based trading systems Rules Scalper Script languages Seasonals Select Net Profit Sell in May indicator Short-term trader Signal arrows Simple Outbreak Indicator Simple Outbreak System Slippage Speeders Spikes Spread Spreading risk Spreadsheet Sprinters Stan Weinstein Standard deviation Statistical analysis Statistically significant Statistics Stochastics Stop price Stop-loss Stops Strike price Support and resistance TA script

60 124 72 11 121 44, 114 54 100 92 129 13 120, 131 11, 13 86 90 107 19 38 16 114 54 13 138 111 9 115 82 14 84 9 23 50 131 12, 14, 128 123 20 14 111 116 123 114 87, 89 7 11 18 56 135 22, 53, 87, 124 133 122 9, 97 116, 140

Technical Analysis Technical tools Term Theoretical values Theory of play Tick size Time Frames Time Horizon Time zones Tradability Trader activity TradeStation Trading Trading account Trading markets Trading plan Trading rules Trading simulation Trading systems Transaction costs Trend indicators Trend market Trend-following indicators Triangle pattern TRIX TRIX Dynamic True Range Turbos Turtle trading Tushar S. Chande Typical price Underlying asset Units Vertical Horizontal Filter VHF Vision Visual analysis Volatility Volatility indicators Volume histogram Volume indicators Wall Street Professional Warrants WealthLab Weekly prices Weighted Moving Average Williams %R Working capital WS Index

7 96 122, 124 123 16 125 9 9 126 128 77 116 8 120, 130 8, 53 112 112 15 7, 18, 111 12 8, 23, 24, 68 8 8, 22, 24 9 64 64 102, 130 122 129 42, 72 78 123 130 74 74 119 7 86, 90, 130 86, 90 77 77 15, 20, 116, 138 122 116 11 26 66 120 13

144