Moving Averages

What are Moving Averages?

• Moving averages are one of the most popular and easy to use tools available to the technical analyst. They smooth a data series and make it easier to spot trends, something that is especially helpful in volatile markets. They also form the building blocks for many other technical indicators and overlays.

Significance of Moving Average

• The Moving Average Technical Indicator shows the mean instrument price value for a certain period of time. When one calculates the moving average, one averages out the instrument price for this time period. As the price changes, its moving average either increases, or decreases. 

• Moving averages may also be applied to indicators. That is where the interpretation of indicator moving averages is similar to the interpretation of price moving averages: if the indicator rises above its moving average, that means that the ascending indicator movement is likely to continue: if the indicator falls below its moving average, this means that it is likely to continue going downward.

• The two most popular types of Moving average are Simple Moving Average (SMA) and Exponential Moving Average (EMA)  

Uses of Moving Average

Trend identification/confirmation

• The first trend identification technique uses the direction of the moving average to determine the trend. If the moving average is rising, the trend is considered up. If the moving average is declining, the trend is considered down. The direction of a moving average can be determined simply by looking at a plot of the moving average or by applying an indicator to the moving average. In either case, we would not want to act on every subtle change, but rather look at general directional movement and changes.

• The second technique for trend identification is price location. The location of the price relative to the moving average can be used to determine the basic trend. If the price is above the moving average, the trend is considered up. If the price is below the moving average, the trend is considered down.

• The third technique for trend identification is based on the location of the shorter moving average relative to the longer moving average. If the shorter moving average is above the longer moving average, the trend is considered up. If the shorter moving average is below the longer moving average, the trend is considered down.

Support and Resistance level identification/confirmation

Another use of moving averages is to identify support and resistance levels. This is usually accomplished with one moving average and is based on historical precedent. As with trend identification, support and resistance level identification through moving averages works best in trending markets.

Conclusion

• Moving averages can be effective tools to identify and confirm trend, identify support and resistance levels, and develop trading systems. However, traders and investors should learn to identify securities that are suitable for analysis with moving averages and how this analysis should be applied. 

• The advantages of using moving averages need to be weighed against the disadvantages. Moving averages are trend following, or lagging, indicators that will always be a step behind. This is not necessarily a bad thing though. Moving averages will help ensure that a trader is in line with the current trend. However, markets, stocks and securities spend a great deal of time in trading ranges, which render moving averages ineffective. Once in a trend, moving averages will keep you in, but also give late signals. Don't expect to get out at the top and in at the bottom using moving averages. As with most tools of technical analysis, moving averages should not be used on their own, but in conjunction with other tools that complement them. Using moving averages to confirm other indicators and analysis can greatly enhance technical analysis.

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Relative Strength Index

What is Relative Strength Index?

RSI is one of the most popular technical analysis indicators. Relative Strength Index (RSI) is an oscillator that measures current price strength in relation to previous prices. The RSI is a versatile tool, it can be used to:

• Generate buy and sell signals
• Show overbought and oversold conditions
• Confirm price movement
• Warn of potential price reversals through divergence

RSI Calculation - 

The steps in calculation of the Relative Strength Index are:

1. Decide on the RSI Period, based on the time frame that you wish to analyze.
2. Compare Closing price [today] to Closing price [yesterday].
3. For the RSI Period, add all upward movements in Closing price.
4. For the RSI Period, add all downward movements in Closing price.
5. Calculate the exponential moving average* of price movements:
   
   Average Upward Price Move = Exponential Moving Average of Upward Movements
   Average Downward Price Move = Exponential Moving Average of Downward Movements
6. Calculate Relative Strength (RS):
   
   RS = Average Upward Price Move / Average Downward Price Move
7. Calculate the Relative Strength Index (RSI):
   
   RSI = 100 - 100 / ( 1 + RS )

Interpretations - 

• Tops and Bottoms.
  The RSI usually tops above 70 and bottoms below 30. It usually forms these tops and bottoms before the underlying price chart.

• Overbought/oversold levels: The RSI value will always move between 0 and 100; the value will be 0 if the stock falls on all 14 days, and 100, if the price moves up on all the days). This implies that the RSI can also be used to identify the overbought/oversold levels in a counter. As suggested by J Welles Wilder, the developer of this indicator, most technical analysts consider the RSI value above 70 as 'overbought zone' and below 30 as 'oversold zone'.

• Failure Swings.
  (also known as support or resistance penetrations or breakouts). This is where the RSI surpasses a previous high (peak) or falls below a recent low (trough).

• Support and Resistance.
  The RSI shows, sometimes more clearly than price themselves, levels of support and resistance.

• Divergences.
  Divergences occur when the price makes a new high (or low) that is not confirmed by a new high (or low) in the RSI. Prices usually correct and move in the direction of the RSI. A positive divergence occurs when the RSI makes a higher bottom despite lower trending by share price. Similarly, a negative divergence occurs when the RSI starts falling and makes a lower top despite the share price moving higher. 

A bullish divergence occurred during May and June as prices were falling while the RSI was rising. Prices subsequently corrected and trended upward.


Significance of RSI

• The relative strength indicator (RSI) measures the relative strength or weakness of a stock when it is compared to itself over a specified period. It is an OSCILLATOR with an upper and lower band that ranges from 0 to 100 on a vertical scale. 

• To understand the RSI, we need to know what is meant by Relative Strength and Relative Weakness, two of the most important concepts in technical analysis. Relative strength means that a stock is strong compared to another stock or to an index. Generally, you avoid buying stocks with relative weakness.

• When used in conjunction with other technical indicators such as moving averages and OBV, the RSI is a powerful tool that can help to identify whether a stock is OVERBOUGHT or OVERSOLD. This allows you to determine which stocks are going to run out of energy and succumb to the bears (overbought). On the other hand, the RSI will also help you to identify stocks that have fallen and are about to reverse and move higher (oversold).

For example, if the stock price is dropping, but the RSI rises above 70 and then crosses back down, this is a sign that the stock might reverse direction (this price reversal is called DIVERGENCE). Conversely, if the stock price is rising, but the RSI drops below 30 and crosses back up, the stock might reverse. The idea is that the stock price will eventually move in the direction of the RSI.

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