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5 Common Indicators and Some Alternative Uses

Key Points
  • Even the most common indicators can have uncommon, though helpful, uses.

  • Knowing how to maximally utilize indicators can open new trading possibilities.

When it comes to analyzing the action of stocks and other securities, there is no shortage of technical indicators available for traders to analyze. And while most have a certain “standard” form of interpretation associated with them, sometimes it pays to look at standard indicators in alternative ways. Let’s consider five.

 1. 200-day moving average

In its simplest form, the goal of investing is to own an asset when it is rising in price and to not own an asset when it is declining in price. One tool that can help in achieving this goal is the 200-day simple moving average. This particular trend-following indicator is calculated by summing up the closing price for the most recent 200 trading days and dividing by 200.

 Standard interpretation

Investors use moving averages as timing tools to buy when the price moves above the moving average and sell when the price moves below the moving average. This approach can be very effective during major uptrends when a stock will spend most of its time above the moving average. Likewise, during a major decline a stock will spend most of its time below the moving average. The problem is that when price is close to the moving average it can move above and below the moving average frequently. This can result in “whipsaws”, when an investor buys and sells repeatedly, sometimes at a loss and sometimes at a profit.

 Alternative methodology

An alternative approach is using a moving average as a perspective indicator to tell you the direction in which to trade, rather than as a specific buy or sell signal. In this manner, a moving average is used as one factor in a multi-factor approach. When price is above the moving average, the trader will look for some other factor to “trigger” an actual trading signal to buy. When price is below, the moving average the investor will typically avoid that stock completely.

Figure 1: Ticker IBM with simple 200-day moving average

Source: StreetSmart Edge®

2. Ichimoku Cloud

 The Ichimoku Cloud is a technical indicator that attempts to define support and resistance levels as well as trend direction and momentum. While the calculations are slightly more involved, the Ichimoku Cloud is based on the average of the high and low over a given period. The cloud consists of two lines which can be thought of as a bullish line and a bearish line, both of which are plotted on a price chart. When the bullish line is above the bearish line, the space between the two lines is filled in with green to indicate a positive situation. When the bullish line is below the bearish line, the space between the two lines is filled in with red to indicate a negative situation.

 Standard interpretation

Standard interpretation suggests that price action is bullish if the current price is above a green cloud and that price action is bearish if price is below a red cloud. As with moving averages, this approach can be very effective during a strong trend. However, in a choppier market, price whipsaws can generate very uneven results.

 Alternative methodology

For traders focused on riding shorter-term trends, one alternative is to add a 50-day simple moving average to the mix. A trader might consider focusing on the bullish side if price is above the 50-day simple moving average and the 50-day simple moving average is above a green Ichimoku Cloud. On the other hand, a trader might consider focusing on the bearish side if price is below the 50-day simple moving average and the 50-day simple moving average is below a red Ichimoku Cloud.

 This configuration is not intended to generate specific buy and sell signals, but rather to identifying potentially strongly trending securities.

Figure 2:  Ichimoku Cloud with 50-day simple moving average – Ticker GS

Source: StreetSmart Edge®

3. Bollinger Band® and Bollinger Bandwidth

Bollinger Bands were developed by technical analyst John Bollinger in the 1980’s and simply measure the width between the upper and lower bands. The bands are calculated by first taking a moving average of price and then adding and subtracting the standard deviation of price movements of that moving average over the same period.

 Standard interpretation

Standard interpretation suggests that a price movement is potentially overextended if the price tags either the upper or lower Bollinger Band, and that a reversal back inside the bands is likely. According to this interpretation, a tag of the lower band suggests a bullish opportunity and a tag of the upper band suggests a bearish opportunity. Standard interpretation suggests that periods of quiet and calm are highlighted by a narrowing of the bandwidth and that narrow bandwidth may highlight securities about to move from a period of relative quiet to a strongly trending mode.

 Alternative methodology

One alternative way to use a combination of these two technical indicators is to consider looking for Bollinger Bands width to move from below to above its own 20-day moving average. Using this alternative method, a touch of the upper band suggests a possible bullish upside breakout and a touch of the lower band suggest a possible bearish breakout.

Figure 3: Bollinger Bandwidth and Bollinger Bands – Ticker ZOP

Source: StreetSmart Edge®

4. IV puts

“IV Puts” measures the implied volatility of put options for the security being analyzed. Put implied volatility is calculated by an option pricing model and essentially indicates whether there is a lot of time premium built into put option prices for that security. The higher the implied volatility, the more time premium built in and vice versa. In periods of extreme volatility, IV Puts will often spike as concerned traders rush to buy put options, thus sharply increasing demand for put options.

Standard interpretation

Standard interpretation of IV Puts suggests that sharp increases may be indicative of a buying opportunity as short-term traders panic and potentially push price to an oversold level.

Alternative methodology

There is some truth to the standard interpretation. The problem is that not every IV Puts spike will result in a terrific buying opportunity. This is especially true when a security is in the midst of a long-term price decline. Therefore, one potentially useful alternative is to pay attention to spikes in IV Puts only when the price of the security in question is above its 200-day moving average and when price has experienced at least a short-term pullback.

The goal here is to attempt to identify pullbacks and buying opportunities within the context of a longer-term uptrend.

Figure 4: IV puts combined with 200-day moving average – Ticker CSCO

Source: StreetSmart Edge®

5. Relative Strength Index

The Relative Strength Index (RSI) was developed by J. Welles Wilder and is designed to identify overbought and oversold situations. The index looks at the daily changes in price over a specific number of trading days and accumulates the total gains and total losses, essentially dividing the total gains by the total gains plus the total losses. The index can range from 0 to 100 with 50 considered neutral.

Standard interpretation

The standard day window for RSI is 14 days. The theory is that the higher the index rises, the more overbought the security in question is, and the lower the index falls, the more oversold it is. According to standard interpretation, a reading of 70 or above suggests an overbought situation, and a reading of 30 or lower suggests an oversold situation.

Alternative methodology

One alternative is to use a much shorter day window of 2, 3, or 4 days instead of 14 days. Shorter windows make the indicator much more volatile but also much more responsive to short-term movements. There is no one best way to use this information, but let’s consider one example to illustrate the possibilities. A trader might consider a 4-day RSI reading below, for example, 32 as an overbought signal if the price of the security is above the 200-day moving average. In other words, this approach attempts to identify potential buying opportunities within the context of a longer-term uptrend.

Another potential use for shorter-term traders might be to use, for example, a 4-day RSI reading above a particular level (65 or higher) as a profit-taking opportunity if their goal is to sell into strength.

Figure 5: Ticker NFLX with 200-day simple moving average and 4-day RSI

Source: StreetSmart Edge®

Next Steps

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Past performance is no guarantee of future results.

There is no guarantee that execution of a stop order will be at or near the stop price.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Schwab does not recommend the use of technical analysis as a sole means of investment research

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