So in the previous few installments, I tried to cover as many basics that I could think of, if I do recall anything from this point forward, I will add it as I go. Hopefully too many don’t mind.

Getting back to the stock market, there are “indicators” that different people use or discuss when talking about market movements. Today I will briefly introduce a few and then proceed to go into to next week in depth. Warning, there may be math involved! So drink some coffee before proceeding!!

What is an “indicator”?
Basically speaking, an indicator is also referred to a “technical indicator”. Its purpose it to expose “overbought” or “oversold” situations in a market security where an investor has the best opportunity to make a profit.

Commonly, many new investor will either rely on a single indicator or swear by their calculations to be true. Both are false thinking. If you are using only one technical indicator, its only giving you a small accuracy of hitting the target entry points on the market, and at the same time, only using an indicator to predict a point to enter a stock is bad also.

Why? Well without other research, you might be putting all your calculations into a stock, getting an entry point and failing to listen to the news about company X and its lawsuit or bad product. Does that make sense? A well rounded investor is a well informed investor.

Use indicators as a tool along with all other sources. One cannot give you an advantage over another. If indicators were 100% accurate and true, every single person on the stock market would be a multi-billionaire.

by tziralis

Okay now the indicators:

ARMS Index (or TRIN)

Created in 1967, the ARMS Index is a market strength indicator, which attempts to analyze the relationship between the number of advancing and declining issues and the advancing and declining volume. The ARMS Index is calculated by the following formula:

(Number of Advances / Number of Decliners) / (Advancing Volume / Declining Volume)

An ARMS Index reading of 1 means that the market is in balance, while a reading below 1 means more volume is moving into advancing stocks (bullish) and opposite if the reading is above 1. The ARMS Index can also be used as an oversold/overbought indicator when incorporated by a simple moving average – such as using a 10-day or a 21-day moving average. Some do prefer to have a larger moving average as I have heard 52-day one common number.

Advance/Decline Line

The Advance/Decline has been one of the most popular tools in measuring the depth of the overall market. It is a total sum of the daily differences between the number of stocks advancing and the number of stocks declining – simply, how many stocks made money, how many lost. Plotting this indicator on an intermediate term or long term basis is a great way to gauge the strength of the broad market. Some traders feel that cap-weighted indices such as the NASDAQ or S&P 500 cannot have a sustained advance if they rise without the A/D line confirming (commonly called a “divergence”). There have been numerous times in the past when the A/D line has acted as a precursor of a significant stock market top – one recent example of this is the topping out of the NYSE A/D line in April 1998 – nearly a whole two years before a corresponding top in the major indices such as the DJIA, the NASDAQ Composite, and S&P 500.

McClellan Summation Index

The level of the McClellan Summation Index is obtained by summing up the daily values of the McClellan Oscillator. A market is termed “neutral” at the +1000 level; during a normal bull market, the Summation Index usually swings in between a range of 0 and + 2000. The significance of the Summation Index comes into play when the reading is outside the range of 0 and + 2000 – indicating an unusual situation in the stock market. For example, a bear market typically end with the Summation Index below – 1200. Long-term investors can typically buy stocks at such a level and expect to make returns over the long haul. A strong rise from such an oversold level would further confirm the beginning of a new bull market.

Percentage Price Oscillator (PPO)

The PPO is obtained by subtracting the longer-term moving average of prices from the short-term moving average and then dividing the result by the longer-term moving average. Most uses a 6-week exponential moving average for the shorter-term and a 12-week exponential moving average for the longer-term average (a 12-day and a 26-day on the daily charts). Momentum is positive while the shorter-term is above the longer-term average (or negative when opposite), but the PPO can also be used as an overbought or oversold indicator. The weekly formula is as follows:

(6-week EMA – 12-week EMA) / 12-week EMA

VIX

The VIX is calculated from the prices of ALL near-term at-the-money call and out-of-the-money call and put options traded on the S&P 500. Options that are in the money are not included. The VIX is a measure of fear and optimism among option writers and buyers. When a large number of traders become fearful (when they want to buy a large number of put options, say, to hedge their long positions in stocks) then the VIX rises. When the opposite happens, the VIX falls. The VIX is sometimes used as a contrarian indicator (especially at extremes) and therefore can be used as a measurement of how oversold or overbought the market is.

Daily High-Low Differential Ratio

The Daily High-Low Differential Ratio is a momentum/overbought-oversold indicator that this has proved to be reliable in the past. This is calculated by taking the difference between the daily number of new 52-week highs and the daily number of new 52-week lows and dividing the result by the total number of shares (in either the NYSE or Nasdaq Composite) traded during that day. The formula is as follows:

Daily High-Low Differential Ratio = (Number of New 52-week Highs – Number of New 52-week Lows) / Total Number of Issues Traded During the Day

A reading of 10% is typically indicative of a highly overbought situation. Extremely oversold readings have gotten to be as low as (20%). Note that calculating this indicator as a ratio is highly important since this allows readings to be compared over time as the number of issues traded in the United States has fluctuated greatly over the years.

McClellan Oscillator

The formula for the McClellan Oscillator is:

10% Trend – 5% Trend, where

the 10% Trend = the exponential moving average (EMA) of the daily number of advancing stocks minus number of declining stocks with a 10% smoothing constant (or the 19-day EMA), and;

the 5% Trend = the EMA of the daily number of advancing stocks minus number of declining stocks with a 10% smoothing constant (or the 39-day EMA).

Most utilize the McClellan Oscillator for two reasons. First, when the Oscillator is positive then it means there is new money coming into the market. Second, when the Oscillator is in extreme territory, it can be used to indicate an overbought or oversold situation.

Well that is a lot of information for today to digest. Next week I will continue further.

Add these tools to your war chest when playing on the stock market for a strong success rate.

Happy Investing!

Aman, MBA

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