Technical Analysis, Stock Market Abnormalities, and Fear Of Missing Out
Technical analysis is the scientific study of market health for the purpose of spotting stock market abnormalities and predicting price movements. When used in conjunction with investing and/or fundamental analysis for the purpose of trading it is an applied social science.
The technician (practicer of the sacred art of Technical Analysis) believes that all information about a stock is known by some portion of the market, or soon will be, and that knowledge is revealed in price action. If the information about the stock is bullish the stock’s price will move higher if the information about the stock is bearish the price will fall.
The technical indicators are tools the technician uses to measure to measure the strength and direction of price movement in order to reveal the health of a market. These tools and an understanding of stock market psychology are used to make trades with a high probability of success. Investors can use technical analysis to help build a winning stock portfolio.
The Most Effective Tools For Spotting Stock Market Abnormalities
The most effective tools that I know for spotting market anomalies are the oscillators. Oscillators like RSI, MACD, and stochastic are tools that use mathematical equations to measure and track the strength of price action. The formulas vary from tool to tool but all include at least a few of the following pieces of information; opening price, closing price, average price, period (number of trading sessions to include) or volume and a smoothing factor that is used to help make the tools more readable.
There are two basic types of oscillators. The first kind plots each days’ result as a number over or under zero. The MACD Histogram is a primary example. Over time the plot for MACD will move up and down forming peaks and troughs along with the underlying asset.
The second type of oscillator plots its points in a range between 0 and 100. The most commonly used of this type, the one I most commonly use, is the stochastic indicator. The plot in this type of oscillator also moves up and down over time forming peaks and troughs along with the underlying assets but it moves within a range offers a different analysis of the data. Regardless of the type of plot, all oscillators provide the same signals, the two we are interested in today are the Convergence and Divergence.
Stay Ahead Of The Market With These Signals To Avoid Fear Of Missing Out
The basic signal provided by an oscillator type indicator is trend detection. If an indicators plot is moving higher it is because the underlying assets price is moving up. The problem with this is that moving up or moving down isn’t enough information to make a good judgment. That’s why indicators must be read relative to past performance.
Just because an indicators plot is moving up doesn’t mean the trend is up. If the indicator is forming a series of peaks while the underlying assets price is moving up the trend is up and that brings us to the first type of signal an oscillator can give and that is the crossover.
A crossover is when the indicators plot crosses over its signal line. All oscillators have signal lines, the one for MACD is zero. If the plot is above zero the MACD is bullish and if it is below zero MACD’s plot is bearish. When it comes to trading what you want to do is trade when a crossover occurs that is in line with the trend. If the asset’s price is trending higher then you only want to trade when MACD is moving up and above the zero line from below.
This may sound simple but it isn’t. What the bullish crossover means is that you have to wait for prices to fall in order to buy in when the market is selling off. This means that when the market begins to panic and prices to start to fall you have to overcome emotion and do the opposite of what everyone else is doing. Successful trading comes down to stock market psychology if you can control your emotions and trade with a set of rules you can take advantage of anomalous sell-offs and rallies.
The Problem With Stock Market Abnormalities Is That They Aren’t Normal
The best time to own, or sell, an asset is when it is trending. Trending is when an assets price moves steadily up or down in the same direction over time. This could be due to improving or deteriorating earnings, or due to economic or political conditions. The problem is that most assets don’t trend most of the time which makes pinpointing the start, continuation, or end of a trend a very profitable anomaly to spot. Convergences and divergences in the oscillators are one way to do it.
- Convergence – A convergence occurs when an assets price moves up or down to form a new high or low and the indicators plot moves down and forms a new low at the same time. This is a signal of strength in a market and can lead to big moves in the indicated direction. For example, if an assets price is trending higher and sets a new all-time high and the stochastic oscillator forms a new peak that is higher than the last that is convergence. In this case, it indicates a high likelihood that prices will continue trending higher even if they consolidate or pull back from the high. The same is true in a downtrend. If the asset price makes a new low and the oscillator makes a new low alongside it, you can expect to see prices continue to move lower.
- Divergence – A divergence is just the opposite of a convergence and a sign of underlying weakness within a price movement. In an uptrend, if prices move up to set a new high and the oscillator forms a peak that is not higher than the last that is divergence. It is not a guarantee of price reversal but it is a strong indication that the rally is nearing its end. If a divergence forms as prices are testing a target for support or resistance it is an added sign that support or resistance at that level is likely to keep prices from moving any further in that direction.
- Hidden Divergence – A hidden divergence is much like a regular divergence but, instead of signaling potential for a reversal, it signals the potential for continuation. In an uptrend, as prices create new highs, troughs or lows will form between the peaks. If the asset in question forms a higher low than the last low, and the indicator in question forms a lower low than the last low, you have a hidden divergence. This is a signal of continuation because it shows the asset is oversold but at a higher level than the last time which means the market is creeping up behind prices and likely to chase them higher. The same is true in a downtrend. As an assets price trends lower it will form new low with small peaks between them. If the price forms a lower low and the indicator forms a higher low it is signaling the asset is overbought at a lower level and in danger of falling further.
- Extreme Peaks – Extreme peaks are on my favorite technical signals because they are easy to spot and very reliable. The problem is that they don’t happen very often, a condition that is key to spotting them. An extreme peak is, quite simply, the highest (or lowest) peak an indicator has made in a long time. What it signifies is an incredible amount of strength within a price movement and a high likelihood the rally, or decline, will continue. What I like the most about extreme peaks is that, if the initial signal fails, the assets price is just about guaranteed to retest the original price peak or trough with which it was set.
For example, the price of oil moved up to set a new three year high in July of 2018 and formed an extreme peak with the MACD. This peak is very extreme because it is more than twice as tall as any bullish peak the MACD formed over the previous three years. The first trade, an assumption the July rally would continue, obviously failed and WTI moved back to retest support levels. A few months WTI rallied again and not only retested the previous three-year high, but it also moved up to set a new three year high.
Market Internals And Stock Market Psychology
The market internals are measures of the market itself. They are used by traders and investors to gauge the feeling, sentiment and strength of other traders, the very people who drive the stock market. These tools can be very helpful when looking for anomalies because you can assume the smart traders will spot them first and act accordingly. When you see anomalous readings in the internals you can be assured there is something afoot.
New Highs And New Lows – The new highs and new lows is a count of how many stocks in a given venue are making new highs or new lows at any given time. As a rule of thumb when the market is trending higher there will be more stocks making new highs than making new lows, and when the market is trending lower there be more stocks making new lows than making new highs. When the market is just trending sideways there may be even numbers of both new highs and new lows, and the number of each may be low.
The most important anomaly to watch for is an imbalance of power. If the market is trending higher and all of a sudden you start seeing more new lows than new highs you should be watchful for reversal. Other Anomalous readings in this indicators include times when the number of new highs increases or decreases, or when the number of new lows increases or decreases, which can both signal a change or continuation of trend.
Side note; A new high or new low in an individual stock is also a powerful signal that should not be ignored. When combined with other types of anomalies a new high or low in a stock is a high-probability trading scenario.
Advancing And Declining Stocks – This measure is very similar to the new highs and new lows except it measures how many stocks are simply rising and falling in a given day. The basis thing you want to look out for is that there are more stocks making rising when in an uptrend and more stocks falling when in a downtrend. This indicator gives similar signals to the new highs and new lows too, when you see an imbalance in powers you need to pay close attention. You also want to pay attention to how many are rising and falling in a given venue, the New York Stock Exchange (NYSE) and NASDAQ (COMP) are the two most commonly watched.
In general, you can expect to see between 1000 and 2000 publicly listed stocks advancing and declining each day. On an average day during an uptrend, you may see 1500 advancing and 1000 declining, the same is true for a downtrend. On a day of strong activity within a trend, you may see the advancers or decliners are outpacing their counterpart by a wide margin like 3:1 or 4:1.
Volume – Volume is a measure of the number of shares traded in a given period, usually days, and a telling indication of market commitment. Volume can be applied to any asset that tracks shares, ticks, or trades and is often reason why otherwise high-probability trades fail to produce desired results. The best way to measure volume is over time and relative to previous volume levels. Most trading platforms and stock market websites will display today’s volume (often adjustable to different time-frames) and a 30 day moving average of volume.
The 30-day moving average of volume is the baseline, any variation from that is an anomaly. If today’s volume, or this hour or this minute, is higher than average it may lead the market to continue in the direction it is moving. If the volume is rising while an assets price is testing support or resistance it may lead to a breakthrough. If the volume of an assets spikes to an extreme high while price is bouncing off of support or resistance it is a confirmation that support or resistance is strong, the move is likely to produce price reversal.
The Traders Index – The Traders Index, originally known as the Arms Index, is a measure of advancing and declining stocks that includes volume. It measures the relationship between supply and demand is most commonly used on an intraday basis to determine sentiment. What the TRIN aims to do is measure the amount and direction of price momentum in an effort to predict future price direction. It works on the assumption that an object in motion tends to remain in motion.
When applied to the market we can assume that a stock on the move will attract new traders who will add additional force to future price movements. Because the raw data is so wildly variable traders tend to track a 10 or 20 day moving average. The most commonly used anomaly is a variation from equilibrium. The index is said to be in equilibrium when it is at 1, a reading below 1 suggests a bullish bias to the market and a reading over 1 suggests a bearish bias. The further from 1 the reading the stronger the indication, when in divergence to price action the signals are stronger.
The Fear Index – The VIX, otherwise known as the volatility index, is often referred to as the fear index. It, like its cousin the VXN (The NASDAQ volatility index), is a measure of the relationship between the price of the S&P 500 and options contracts for the S&P 500. The theory is that when option prices rise the market thinks the price of the index is going to fall. It is most commonly used as a gauge of market sentiment and to determine the potential for market reversal. When the VIX is low, trending lower or declining you can assume that fear is in decline and the broad market is moving higher. When the VIX is high, trending higher, or rising in today’s action it is safe to assume the underlying market is in decline.
Understand The Market And Profit From Abnormalities
Understanding what makes the market work, and what the market looks like when it is normal, is the key to spotting abnormalities. This article is a great start, now its time to practice what you’ve learned.