#18 Newsletter Mr.Advice

#18 Newsletter Mr.Advice

Technical analysis: MACD, RSI, Stochastic RSI, CHOP

The next few newsletterss will cover technical analysis and the most commonly used indicators. In today’s issue we will discuss:

  • MACD (Moving Average Convergence / Divergence ; Moving Average Convergence / Divergence):
  • RSI (Relative Strength Index / Relative Strength Index):
  • Stochastic RSI (Stochastic RSI):
  • Chopiness Index (Chopiness Index):

MACD (Moving Average Convergence / Divergence ; Moving Average Convergence / Divergence):

  • An indicator created by analyst Gerard Appel in 1979. 
  • It examines the convergence and divergence of moving averages. 
  • It is the difference in value between the long-term and short-term exponential averages.
  • The indicator is presented in the form of two lines: MACD and the so-called signal line 
  • The MACD line is formed by subtracting the long term average from the short term average. Usually these are 26 and 12 period averages. Most often exponential averages and closing prices are used.
  • The signal line is the average of the MACD line formed above, usually an exponential average of period 9 is used.
  • Used to test buy and sell signals for investment assets.
  • The indicator is best used in long-term investments (intervals H4, H6, H12, D1, D3, W1).
  • Buy and sell signals are intersections of two lines. We interpret the indicator as follows:

(a) The MACD line [orange] crosses the signal line [blue] from below – this is a signal to buy the stock and the announcement of an uptrend.

b) MACD [orange] line crosses the [blue] signal line from above – it is a signal to sell the stock and a sign of the trend reversal.

  • An overbought state of the market is indicated when the lines are too high above the zero line, and an oversold state when they fall too far below this line. 
  • On the histogram we can see green and red bars:
  • Green – uptrend, the darker the colour and higher the bars the stronger the trend strength, the lighter the colour and lower the bars the weaker the trend strength.
  • Red – downward trend, the darker the colour and higher the bars the stronger the trend, the lighter the colour and lower the bars the weaker the strength of the trend.

RSI (Relative Strength Index):

  • An indicator that determines the strength of a trend in technical analysis.
  • It was invented by Welles Wilder and first presented in Commodities magazine in June 1978.
  • It includes a weighting factor and is therefore a weighted moving average.
  • It takes a value from 0 to 100.

a) RSI at 100 increases the probability of a trend reversal into a downtrend.

b) RSI at 70-80 and above is a sell signal (market is overbought, possible trend reversal).

c) RSI at 20-30 and below is a buy signal (market is oversold, possible trend reversal).

d) RSI at 0 increases the probability of a reversal into an uptrend.

  • The standard RSI setting is 14-period which means that the indicator takes into account the values of the last 14 candles or timeframes.
  • For example if all 14 candles were bullish the RSI would indicate 100. However if all 14 candles were bearish the RSI would indicate 0 (or relatively close to 100 and 0). However, when the RSI is at 50 it means that the last 7 candles were up, 7 were bearish, and the average profit and loss were equal.

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Stochastic RSI (Stochastic RSI):

  • StochRSI was first described by Stanley Kroll and Tushar Chande in a 1994 book they published entitled The New Technical Trader.
  • It is used in technical analysis to calculate the stochastic RSI to identify overbought and oversold market levels.
  • The stochastic RSI is an oscillator with values between 0 and 100 or between 0 and 1.
  • It is represented graphically as a curve on a chart. 
  • Stoch RSI = (current RSI – lowest RSI)/(highest RSI – lowest RSI).
  • For the StochRSI, the most commonly used time range is 14 periods. These periods relate directly to the time frame set on the chart. Thus, for a daily chart the last 14 days (candles) are used to calculate the StochRSI, for an hourly chart the StochRSI is generated based on the last 14 hours.
  • The periods can be days, hours or even minutes, and their use depends directly on the trading strategy adopted by the trader. The number of periods can also be adjusted up or down to identify long-term or short-term trends.
  • The StochRSI is most relevant near the upper (value from 80 upwards) and lower (value from 20 downwards) boundaries of the indicated range. This is why the primary use of this indicator is to identify potential entry and exit points and price movements. 
  • Thus, values of 20 and below indicate that the market is oversold, while values of 80 and above suggest that the market is overbought.
  • Values closer to the midline can also provide useful information on market trends. For example, when the midline acts as support and the StochRSI lines move steadily above the 0.5 value, it may suggest a continuation of an uptrend or an upward trend – especially if the lines begin to move toward the 0.8 value. Conversely, consistent values below 0.5 and an overall trend toward the 0.2 value indicate a downtrend or an impending bear market.
  • The Stochastic RSI indicator is much more sensitive to changes than the RSI and therefore works much faster, thus generating many more opportunities to buy or sell in the market.
  • On the other hand it is riskier because it generates a lot of noise giving often wrong signals to enter a position.
  • Simple Moving Averages (SMAs) are one of the most widely used methods to reduce the risk of false signals generated by the StochRSI. Importantly, in many cases the 3-day SMA is already included as a default setting for the StochRSI indicator.
  • The StochRSI should be used simultaneously with other technical analysis indicators that can help confirm the signals generated by the StochRSI.

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Choppiness Index:

  • The Choppiness Index was created by Australian commodity trader E.W. Dreiss.
  • The Choppiness Index (CHOP) is an indicator that aims to determine whether the market is “agitated” (sideways trend) or the opposite (upward or downward trend).
  • The Choppiness index is an example of a directionless indicator. 
  • CHOP is not meant to determine the future direction of price movement in the market – it is only used to determine the nature of the trend in a given market. 
  • Generally speaking, the higher values of the indicator the more “agitated” is the described market and vice versa – the lower values, the more directional is the trend on the market.
  • As an oscillator the Choppiness index reaches values which are always within a certain range. CHOP generates values between 0 and 100.
  • The closer the value is to 100, the higher the level of “agitation” (lateral movement).
  • The closer the value is to 0, the stronger the trend in the market (directional movement)
  • Technical analysts often use a higher threshold to indicate that the market is entering an area of agitation. Similarly, in the lower area is the threshold to indicate a trend area. Typical threshold values are the popular Fibonacci retracements. 61.8 for the upper threshold and 38.2 for the lower threshold.
  • The first way technical analysts can use CHOP is to confirm the current market situation. At values above the upper threshold, an expected sideways movement is possible.
  • The time period to be used to calculate the CHOP (The default value is 14).

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