Enhancing Technical Analysis with Indicators: Moving Averages, Bollinger Bands, and Volume-Based Indicators
Enhancing technical analysis with indicators such as moving averages, Bollinger Bands, and volume-based indicators provides valuable insights into market trends and potential trading opportunities.
Moving Average (MA): The Neutral Zone Method
In this method, we work with two moving averages, one longer and one shorter, such as 50 and 21 days. The neutral zone refers to the range between these two moving averages. When the stock enters the neutral zone, we exit the position. If it enters from below, we exit the LONG position, and vice versa, rather than reversing the position. We filter out noise by entering the neutral zone when exiting the current position but only opening a new position when the stock exits the neutral zone in the same direction. This approach reduces the risk of changing the position every time the stock crosses the short-term moving average.
For example, in an uptrend, if the stock falls below the short-term moving average, we close the LONG position, and when it falls below the long-term moving average, we open a SHORT position. The same applies when the stock rises above the short-term moving average, returning to the LONG position.
One issue attributed to simple moving averages is that they are equally influenced by adding new days and subtracting old days. This means that if we calculate a 5-day moving average by adding today's data and subtracting the data from five days ago, the moving average is affected equally by the added and subtracted days. For example, if we subtracted 495, which was five days ago, and added 517 when the current value is around 518, the moving average would increase even though the index decreased. This occurs because we subtracted a relatively low value and added a high value, although slightly lower than the current level. To resolve this issue, we use the Exponential Moving Average (EMA).
The Exponential Moving Average (EMA) gives more weight to the most recent data and does not drop off older data exponentially but rather incorporates them exponentially:
EMA = Today's price * K + (K-1)
The moving average gives higher weight, for example, 10% or 15%, to the most recent day and the remaining weight to the previous day's average. The difference is noticeable in short-term moving averages.
There is a transition formula to find K.
Some prefer working with a simple moving average because introducing complexity does not contribute significantly. Generally, when something becomes more complex, it is better to work with simpler approaches.
Bollinger Bands
Bollinger Bands are an indicator placed on the chart. The default setting is typically 20/2, indicating a 20-day moving average and two standard deviations.
Bollinger Bands combine statistics and moving averages. They utilize a moving average, typically a 20-day moving average, with two bands plotted above and below at a distance of ± two standard deviations all the time. The idea is that statistically, in most cases, the stock should remain within the ±2 standard deviations range, and from a statistical perspective, the stock should be within this range. When the stock reaches the lower band, statistically, there is little chance that it will continue to decline. In such cases, it is recommended to buy at the lower band and sell at the upper band.
However, Bollinger himself did not intend for the indicator to be used in isolation. It should be combined with other indicators, support and resistance levels. Additionally, there are situations where the bands are breached. According to the bands, this indicates that there is something exceptional in the breakout direction. However, there are also situations where the stock moves alongside an upper or lower band.
If the stock is trading between the moving average and the upper band, it is an indication of a strong trend. And if the stock has been in the upper half for a period and starts oscillating between the moving average and the two bands, it indicates a weakening trend.
In options trading, a significant portion of the trading is based on standard deviation, and the distance between the bands provides an indication of the standard deviation. It is possible to add an indicator for the distance between the bands. If the indicator shows that the distance is at its peak, I would lean towards writing options because there is a chance that the standard deviation will decrease.
How to trade with Bollinger Bands
Look at the bands in conjunction with the chart and then assess where the stock appears statistically, whether it is at the edge of the standard deviation range or in the middle.
Indicators that help identify the strength of the trend:
Volume-related indicators
Volume is an important indicator because it shows how much money is behind the trend. It is significant because it is an independent indicator. Other indicators rely on prices. Two indicators that work with volume are:
OBV (On Balance Volume)
Starting from a certain baseline, the values do not change, there is no scale. From the starting point, if the stock price goes up, the trading volume is added to the baseline or the cumulative sum. On days when the stock price goes down, the trading volume is subtracted from the cumulative sum. Each day has a cumulative sum to which the trading volume is added or subtracted based on the upward or downward trend, according to closing prices.
The idea is that if the stock price goes down and OBV goes down, it means that on days of declines, the trading volume was high, and on days of increases, the trading volume was lower. This supports the downward trend in terms of trading volume. If OBV follows the same direction as the stock price, it supports the trend. If OBV behaves opposite to the stock price (e.g., the stock price goes down and OBV goes up), it is an indicator of a change in the trend.
The problem with OBV is that it does not consider how much the stock has gone up or down. Another issue is that OBV does not consider the intraday trading structure. If the stock goes down 3% during the day but closes only down 0.1%, it means that intraday, the stock was strong, but OBV will still receive a "-" sign. It is a somewhat problematic indicator.
Accumulation Distribution
This indicator solves the two issues of OBV. It does not always give the same weight, meaning it does not add or subtract all trading volume. Additionally, it considers intraday trading.
The method is similar to OBV. We start from a specific point and add or subtract. It divides the trading day range into two parts: if the stock is in the upper half, the trading volume receives a "+" sign, and if it closes in the lower half, the trading volume receives a "-" sign. Based on the closing range between high and middle, or high and low, we decide how much trading volume to add. If the stock closes in the middle, we don't add anything. If it closes at the daily high, we add all the trading volume, and if it closes at the daily low, we subtract all the trading volume. And if it's in between, it's relative.
The indicator provides a ratio of what happens within the day and also the significance of the volume in relation to the price.
With the help of this indicator, it is possible to see when accumulation or distribution of stock begins. According to the indicator, strong hands are accumulating the trend, which is an advance indication that the stock may rise. If there is a prolonged period of accumulation, the breakout will be very dramatic.
It is a very good leading indicator.
