Sunday, October 24, 2010

Percent R ... Just What is it?

A deeper look at Percent R

Have you ever scanned through the list of indicators to see whether there is anything interesting that you think you can use? Did you input Percent R? Maybe you thought it was useful, perhaps not. Did it remind you of anything? It looks similar to Fast Stochastics possibly…

Just for a look I have inserted both Fast Stochastics (above in blue) and Percent R (below in red). They do seem to have similarities and certainly a similar reaction in timing but the scaling for Percent R is negative while that of Fast Stochastics is positive.

Actually they are the same.

Let us just look at the formula for each:

Fast K = 100 * ( Close - Lowest Low ) / ( Highest High - Lowest Low )

% R = -100 * ( Highest High - Close ) / ( Highest High - Lowest Low )

Quite clearly they are measuring the same relationship between the position of the close within the range of the chosen number of recent bars. The difference between the two is that Stochastics measures the position of the close from the highest high in the range while %R measures the close from the lowest low in the range.

You will also see from the formula of %R that the result is multiplied by -100 and this results in a scale of zero to -100 while Stochastics has a scale from zero to +100. Then why is there a difference between the two in Dealbook? That is because the default period used in Stochastics is 8 while %R uses 14.

What I did was change the %R calculation to use +100 as the multiplying factor to arrange the results in a scale from zero to 100. I then used a period of 14 for both indicators and then plotted them in the same chart:

Now you can see that the two are in fact identical. Why does %R provide an alternative method of displaying the same information? To be honest I really don’t know why and since they are exactly the same I personally do not use %R and if I want to use this type of momentum indicator I apply Stochastics.

Percent R ... Just What is it?

A deeper look at Percent R

Have you ever scanned through the list of indicators to see whether there is anything interesting that you think you can use? Did you input Percent R? Maybe you thought it was useful, perhaps not. Did it remind you of anything? It looks similar to Fast Stochastics possibly…

Just for a look I have inserted both Fast Stochastics (above in blue) and Percent R (below in red). They do seem to have similarities and certainly a similar reaction in timing but the scaling for Percent R is negative while that of Fast Stochastics is positive.

Actually they are the same.

Let us just look at the formula for each:

Fast K = 100 * ( Close - Lowest Low ) / ( Highest High - Lowest Low )

% R = -100 * ( Highest High - Close ) / ( Highest High - Lowest Low )

Quite clearly they are measuring the same relationship between the position of the close within the range of the chosen number of recent bars. The difference between the two is that Stochastics measures the position of the close from the highest high in the range while %R measures the close from the lowest low in the range.

You will also see from the formula of %R that the result is multiplied by -100 and this results in a scale of zero to -100 while Stochastics has a scale from zero to +100. Then why is there a difference between the two in Dealbook? That is because the default period used in Stochastics is 8 while %R uses 14.

What I did was change the %R calculation to use +100 as the multiplying factor to arrange the results in a scale from zero to 100. I then used a period of 14 for both indicators and then plotted them in the same chart:

Now you can see that the two are in fact identical. Why does %R provide an alternative method of displaying the same information? To be honest I really don’t know why and since they are exactly the same I personally do not use %R and if I want to use this type of momentum indicator I apply Stochastics.

Thursday, October 14, 2010

Things to Watch for... MACD

Avoiding the pitfalls of using MACD in your trading

MACD is used quite widely among traders mainly, it would seem, because the basis for the indicator is something they can visualize - effectively measuring the degree of convergence or divergence of two exponential moving averages. Commonly traders will consider buying or selling on crossover of the MACD lines. However, there can be problems and it is worth understanding when these may occur.

Let us take a look at the MACD plot on a weekly chart of USDJPY:

Broadly we would be pleased with the general signals being generated from MACD in this chart. While the crossover of the MACD across the signal line never really occur at market extremes, in this case they are pretty close and one cannot expect a lagging indicator to provide signals at price extremes.

It can be seen that before the moving averages cross the MACD is signaling a reversal earlier and allowing an early entry into a potential trade. Perfect. We can begin to trade on this indicator then… Or can we..?

Take a look at the second chart, still the weekly chart of USDJPY but from a year or two later:

At first it looks quite good. MACD signals a sale into the large decline to the historic 79.70 low and a little later a reversal higher. There is lots of profit to be taken there. However, watch as the MACD peaks out soon after the initial rally from the 79.70 low. The two exponential moving averages continue to point higher and indeed do not cross lower until after the 147.65 peak. However, MACD spends around one year in a decline while price has continued to rally.

This is a recipe for losses.

Why is it that MACD can provide such a bad signal since it is based on two exponential moving averages?

The answer lies in the name: Moving Average Convergence and Divergence.

While the exponential moving averages are rising, the trend has slowed to the point that while only slightly the averages are converging - that is, moving closer together and this has caused the MACD to cross below the signal line.

Well, is there any way to control the trades to make sure that we do not make those trades? Indeed. One of the best tips I can offer is to remember the definition of a trend. An uptrend is where both highs and lows are moving higher. Thus, until the most recent low s broken there is no break/reversal of the trend.

Let us look at how this would have worked:

As can be seen, I have drawn a horizontal line under each successive swing low. At no point is one of these broken until after the final high to the upper right of the chart. Thus, by combining information garnered from the price chart you can avoid many loss making trades.

Monday, October 4, 2010

Head & Shoulders

The EURUSD (1-Hour Chart) has now established what appears to be a classic "Head and Shoulders" pattern over the course of the past few weeks. This pattern is essentially a 'triple top' pattern, where the center top (Head) stands higher than the first or third tops (Shoulders). The rational occurs as the result that the market was not able to revisit recent high prices established during the center top, and therefore is inherently a sign of an imminent reversal to come. Typically, to complete the head and shoulders pattern, we must wait for the market to break below the lows established during this triple top patter; (neckline). However in regards to placing the actual trade, it is in our best interest to sell-short the market as it tests and fails to break above the highs of the 2nd shoulder, while placing protective stops above the highs of the shoulders and perhaps the highs of the center top (head). By doing so, this trade can provide us with a favorable risk to reward scenario if the market does in fact breakdown below our horizontal support line to new low's.