Chapter 7 - Quantitative Analysis (Done) Flashcards
What is a stochastic?
The stochastic oscillator was popularized by George Lane and is a good tool for assessing the
quality of the market movement. When a market is trending higher, closing prices tend to be near
the higher end of the price range for the timeframe being studied. Conversely, when trending
lower closing prices tend to be near the lower end of the range. These are strong characteristics of
trending markets. The stochastic measures, on a percentage basis, where the most recent close is
relative to the overall price range across a given timeframe.
What is average true range (ATR)?
A volatility indicator that focuses on the
range of price activity, not the underlying
trend.
What are Bollinger bands?
A statistical tool used to analyze the
market’s trend by toning down sharp price
fluctuations; the standard deviation of a
moving average is plotted above and below
the moving average to show a range of
“normal” prices swings; see moving average
envelopes.
What is the commodity channel index (CCI)?
A momentum indicator that measures price
variations from a moving average as
opposed to a range of prices like the %R
and stochastics.
What is the directional movement index (DMI)?
An index that can be used as both a filter to
determine whether or not a market is
trending, or on its own as a trend-following
system that generates buy and sell signals.
What is an exponential moving average?
A geometric average of prices that assigns a
greater weight to more recent price data
and incorporates historical prices beyond
the period that the average is being
calculated for; see moving average.
What is momentum?
The speed of price changes, or the degree to
which prices are accelerating or
decelerating.
What is a momentum indicator?
The momentum indicator measures the rate of change in a stock’s price.
What is the money flow index?
An oscillator that measures money flowing
into and out of a security, conceptually
similar to on-balance-volume.
What is a moving average?
A statistical tool used to analyze the
market’s trend by toning down sharp price
fluctuations; see simple moving average,
weighted moving average, and exponential
moving average.
What is the moving average convergence-divergence (MACD) indicator?
Moving Average Convergence-
Divergence (MACD)
An indicator that is used to track
momentum and conduct divergence
analysis.
What is a moving average envelope?
A statistical tool used to analyze the
market’s trend by toning down sharp price
fluctuations; a fixed percentage of the
moving average is plotted around the
average to show a range of “normal” price
swings; see Bollinger Bands.
What are oscillators?
An indicator that fluctuates back and forth,
usually within a fixed range, and is
designed to identify overbought or oversold
momentum conditions when the oscillator
is near the extreme upper or lower
boundary.
What are rate of change (ROC) indicators?
An indicator that measures the percentage
change between the price today and the
price n days ago.
What is the relative strength index (RSI)?
A measure of the strength of price gains
when a security closes higher compared to
the strength of price declines when a
security closes lower.
What is the signal line of the MACD indicator?
The signal line is a 9-day EMA of the MACD line. As a moving average of the indicator, it trails the MACD and makes it easier to spot MACD turns. A bullish crossover occurs when the MACD turns up and crosses above the signal line. A bearish crossover occurs when the MACD turns down and crosses below the signal line. Signal lines are often moving averages of a technical indicator, such as the moving average convergence-divergence (MACD) or stochastic oscillator. The signal line is applied to the indicator to generate more trade signals than would be available without the signal line.
What is a simple moving average?
An arithmetic average of prices over the
past n time periods; see moving average.
What is a weighted moving average?
A geometric average of prices over the past
n time periods that gives more weight to
recent price data; see moving average.
What is Williams %R?
The Williams %R measures overbought or oversold levels by
subtracting the current close from the high of the price range, then dividing by the overall range
for that timeframe. The %R can be thought of as an upside down stochastic, and the same
methods discussed above for analyzing and interpreting oscillators apply. Values in the range
of 80-100 suggest an oversold condition, whereas readings in the 0-20 range indicate the asset is
overbought.
Explain the concept of moving averages.
- Moving averages smooth price fluctuations by averaging past price data over a specified
period of time. - There are three different types of moving averages: simple, weighted and exponential.
- A simple moving average assigns an equal weighting to each price over the time frame
being studied. - A weighted moving average assigns a greater weight to the more recent prices over the
time frame being studied. - An exponential moving average assigns a greater weight to the more recent prices over
the time frame being studied, and also includes price beyond the time frame being
studied. - Moving averages are typically used to identify critical turning points; by graphing the
moving average right onto a chart, crosses over or under a moving average can identify
possible trend changes.
Explain the concept of Bollinger bands and moving average envelopes.
- Bollinger bands and moving average envelopes graph lines above and below a calculated
moving average. - Once plotted, they are used to identify possible support and resistance levels, as well as
aiding in the identification of trend reversals. - Bollinger bands are plotted at a certain number of standard deviations above and below
the moving average. - Standard deviation measures volatility. Therefore, Bollinger bands expand in volatile
markets and contract in less volatile markets. - Moving average envelopes are plotted at fixed percentages above and below the moving
average.
Explain the concept of average true range (ATR) and directional movement index (DMI).
- The ATR is a volatility indicator that focuses on the range of price activity not the close.
- The ATR minimizes false breakout signals.
- The DMI can be used as either a filter to help identify whether a market is trending, or
on its own as a trend-following system that generates buy and sell signals. - A DMI reading of less than 25 means that a market is not trending; if the reading is
above 25 and rising, the market is trending.
Explain the concept of oscillators.
- Oscillators are indicators that move back and forth within a fixed range and are
designed to identify overbought or oversold conditions. - Oscillators measure momentum, which is the speed at which prices are changing.
Explain what the moving average convergence-divergence (MACD) is.
- The MACD indicator tracks momentum by plotting the difference between two
exponential moving averages. A signal line is then plotted by taking an exponential
moving average of the MACD line. - The MACD can be used by itself to generate buy and sell signals, or it can be used to
identify areas of divergence. - On its own, buy signals are generated when the MACD line crosses above the signal
line, and sell signals are generated when the MACD line crosses below the signal line.
Explain the concept of momentum and rate of change.
- The momentum indicator measures the difference between the price today and the price
some number of periods ago. The rate of change indicator measures the percentage
change in price from a previous period to today. - While mainly used to identify divergence between a security’s price and its momentum,
these indicators can also be used to generate buy and sell signals.
Explain the concept of stochastics.
- The stochastic measures, on a percentage basis, where the most recent close is relative to
the overall price range across a given timeframe. - Stochastics quantify a market’s tendency to close near the upper end of the range in an
uptrend, or near the lower end of the range in a downtrend. - Stochastics consist of two plots: a %K line and a %D line.
- The %K line measures the momentum of the security or market; the %D is a moving
average of the %K. - Stochastics can be used to generate buy and sell signals through identification of
crossover points between the %K and %D lines.
Explain the concept of relative strength index (RSI).
- The RSI measures, over a certain number of periods, the relative strength of price gains
on up days to the price losses on down days. - Like the other momentum indicators, the RSI can be used on its own for buy or sell
signals, or in identifying divergences.
Briefly explain the concepts of Williams %R, commodity channel index (CCI), and money flow index.
- Two other popular momentum indicators similar to stochastics are the Williams %R
and the Commodity Channel Index (CCI). - The Money Flow Index is a volume-related oscillator.
What is the difference between convergence and divergence?
Divergence generally means two things are moving apart while convergence implies that two forces are moving together. In the world of economics, finance, and trading, divergence and convergence are terms used to describe the directional relationship of two trends, prices, or indicators.
How do Bollinger bands measure volatility?
A Bollinger Band consists of a middle band (which is a moving average) and an upper and lower band. These upper and lower bands are set above and below the moving average by a certain number of standard deviations of price, thus incorporating volatility.
What is meant by “a week’s trading range?”
“A week’s trading range” refers to the difference between the highest and lowest prices at which a stock, commodity, or other financial instrument was traded over a week. It shows how much the price fluctuated during that period.
What does it mean for something to be range bound?
A range-bound market is one in which price bounces between a specific high price and a low price. The high price acts as a major resistance level in which price can’t seem to break through. Likewise, the low price acts as a major support level in which price can’t seem to break as well.
What is volume weighted average price (VWAP)?
VWAP is the average price of a stock weighted by volume. By monitoring VWAP, a trader might get an idea of a stock’s liquidity and the price buyers and sellers agree is fair at a specific time. The VWAP indicator can be used by day traders to monitor intraday price movement. VWAP, or Volume Weighted Average Price, is a trading benchmark that calculates the average price of a stock based on how many shares are traded at different prices throughout the day. Essentially, it means that higher volume trades at certain prices have more influence on the average price calculation than lower volume trades at other prices. This way, the average price reflects where most of the money was transacted during the day. Essentially, VWAP is a measure of fair value. Fair value is the reasonable and unbiased price at which an asset, like a stock, would be bought or sold in a normal market condition. It represents a price that is agreed upon by both the buyer and seller, assuming both have adequate information and neither is under any pressure to trade. Therefore, trading above VWAP can suggest that a security is overvalued, while trading below VWAP can suggest that a security is undervalued.
What is anchored VWAP?
Anchored VWAP is a variation of the standard VWAP that starts the average price calculation from a specific point in time, like a significant market event, rather than the beginning of the trading day. This allows traders to measure the average price based on the volume from that specific event onward, providing insights tailored to particular market movements or periods. You set where you want the VWAP measurement to start from. That is the difference between VWAP and anchored VWAP.
What do quantitative indicators attempt to determine?
- if the market is trending and which direction the trend is (trend-following indicators);
- the strength or weakness of the trend (momentum indicators); and
- whether or not the market is overbought or oversold (contrary indicators).
In what scenarios are signals given the greatest validity?
- The moving average direction changes in favour of the new developing trend.
- The moving average is of significant enough length. A crossover of a short-term moving
average does not have any significance with respect to a long-term trend. - The moving average, through historical testing, is found to be significant for that particular
market. For example the 200-day, or 40-week, moving average is considered a very key
moving average for equities. Moving averages of different lengths may be found to be more
suitable for other markets. - The crossover (price track crossing the moving average) is supported by the chart action such
as breaking of a trendline or confirmation of a reversal formation.
The true range is the greatest of the…
- difference between today’s high and low (or the high and low for whatever timeframe is
being analyzed); - difference (absolute value) between the prior close and the current high; or
- difference (absolute value) between the prior close and the current low.
The Average True Range (ATR) is another volatility indicator, but this focuses on the range of
price activity, not the underlying trend. The ATR is an average (typically, 14-day) of the True
Range.
Explain the concept of DMI in depth.
The directional movement index (DMI) can be used as both a filter to determine whether or
not a market is trending, or on its own as a trend-following system that generates buy and sell
signals. The DMI indicator was created by Welles Wilder in his book New Concepts in Technical
Trading.
As a filter, the DMI indicator produces what is referred to as the ADXR line that is plotted
between 0 to 100. When the line is over a certain level (25 is used for most markets) and moving
higher, the market is considered to be trending. Traders can then use a trend-following system,
such as Bollinger Bands, to pick entry and exit points. When the line is under 25, the market is
considered to be non-trending. Traders should either ignore this type of market or use a trading
system that is designed to take advantage of a sideways market, such as oscillators (covered below)
or the range-bound application of Bollinger Bands.
The DMI indicator can also be used as a trend-following system. Buy signals are given when
the +DI line, which measures upward movement, crosses over the –DI line (which measures
downward movement). Sell signals are given when the –DI line crosses the +DI line. The signals
are valid when the ADXR line is suggesting the market is in trending mode.
For the purpose of this course, readers should understand how the ADXR, +DI and –DI lines are
used. Those interested in learning more about the indicator are directed to the Wilder text.
Explain how to use stochastics in depth.
The stochastic indicator produces two lines, the faster %K and the slower %D, which both
fluctuate between 0 and 100. Stochastics are used to generate buy and sell signals based on
crossovers, to identify overbought and oversold levels and to conduct divergence analysis.
Buy or sell signals are given when the %K crosses the %D. Buy signals are set up when, during
a market correction, prices decline to the point where the %K line falls under 20, which is
considered an oversold level. When the %K then crosses back over the %D line (from below)
the buy signal is generated (see Figure 7.12). The signal is even more effective when a bullish
divergence is evident, that is, when new lows in prices are not confirmed by the %K or %D line.
Because the stochastic is measuring a shift in market direction, protective stops should be placed
below the lows/highs of the bar where the shift occurred. Figure 7.12 shows several buy signals for
Barrick Gold generated when the %K crossed over the %D following a market correction which
saw the %K line fall under 20. Sell signals are the exact opposite, set up when the %K line climbs
over 80 (overbought).
Another way to use stochastics is as an overbought/oversold indicator. However, these terms can
be misleading in a trending environment when discussing the stochastic indicator. With typical
overbought levels at 80 or higher and typical oversold levels at 20 or lower, a reading of 80 just
tells us the security is closing within the top 20% of its high and low range for the period being
analyzed. Just because a market is “overbought” does not mean it should be sold; in fact, an
overbought condition, as defined by the stochastic indicator, means that the market is regularly closing strongly in a trending market, which is certainly not bearish. Oscillators can and will
remain for extended periods in overbought or oversold territory. Remember, they are designed to
work best in periods of sideways price action, not strongly trending markets. The best way to use
stochastics is as a buy signal after a price correction (decline) in a bull market or as a sell signal
after a rally in a bear market, when the indicators reach oversold or overbought levels and the
crossover occurs.
What are the overbought and oversold levels for RSI?
Similar to the stochastic, the RSI also has overbought and oversold levels. The standard ranges
are above 70 and below 30, which act as warning signals of overbought and oversold conditions
respectively. Some markets by their nature will rarely reach these extremes. A reading of 80 tells
us that the market is closing, on average, four times stronger on up days than it is closing weaker
on down days during the time period analyzed. A 14-day RSI reading of 80 is very strong. When
a market remains above or below 50 for extended periods of time, it is generally considered to be
trending (see Figure 7.13).
How can one use two moving averages?
Technical analysts will often use two moving averages, one shorter-term and one longer-term.
Buy and sell signals are given when the shorter-term average crosses the longer-term average
(see Figure 7.3). This method of using moving averages can be effective, since in essence the price
data is being smoothed twice, which reduces the chances of false signals. The key to using two
moving averages, as it is with using one, is to find the moving average length that works best for
the particular security or market being analyzed.
Why do shorter term moving averages increase the likelihood of getting whipsawed?
Short-term moving averages are more sensitive to daily price changes because they average prices over a shorter period. This means they react more quickly to recent price fluctuations, often resulting in frequent crossings over the stock price line. These frequent crossings can generate multiple trading signals in a short period, increasing the likelihood of entering or exiting trades prematurely or unnecessarily, which is often referred to as getting “whipsawed.”
Cover the concept of crossovers and divergences of the MACD indicator.
CROSSOVERS
The basic MACD signal is given on crossovers between the MACD line (the difference between
the 12- and 26-day moving averages) and the signal line (the smoothed moving average of the
MACD line). Buy signals are given when the MACD line crosses above the signal line; sell signals
are given when the MACD line crosses below the signal line.
DIVERGENCES
The concept of trend analysis and the making of higher highs and higher lows are at the root of
divergence analysis. The concept of confirmation also runs deeply throughout technical analysis,
and is very important in momentum analysis. Consider a rubber ball that has been dropped;
each successive bounce has less and less momentum. For confirmation of a strong uptrend, it is
important that the quality of momentum increases as the market moves higher. If a market is
rallying with less and less momentum, it is a sign that the strength of the market is changing.
Divergence analysis is a very powerful technique for identifying this change. While a divergence
signal is not enough in itself to buy/sell a security, it does flash warning signs that a change in
trend is possible. Figure 7.7 shows MACD divergences on a daily chart. This is a very good
indicator for tracking trend changes in assets with high volume, broad participation and normal
volatility, such as blue chip stocks, government bonds and stock indexes.
Cover the concept of ROC and cycles.
Combining several time periods is helpful in spotting when cycles of various time frames peak
and trough, and can add a very valuable piece to the analysis process. Though not specifically
recommended for trading, it can help establish the significance of a market extreme point.
Figure 7.11 shows a 3-, 6- and 12-month ROC for a stock. Note that the coincidence of the cycle
low periods identified a key longer-term turning point in the market (August 1993). The crucial
element in spotting key cycle low points is to ensure that the cycle is near a historical extreme for
all time frames.
What is relative volume?
RVOL is calculated by comparing the current trading volume of a stock to its average trading volume over a given period of time.
