Do Technical Indicators apply to all stocks?

Many people have asked me how to find out which indicator to use on which stock and why don't some stocks follow the basics of technical analysis while others follow it so neatly.

Well, the answer is hidden in basics of how technical anaysis have been founded and the fundamentals of prabibility and statistics. Often, many traders forget these fundamentals that define the very basics of any forecasting methodology including stock trading.

In this article, I've tried to show, one of the way to filter out stocks that will most probably follow the basics of technical analysis. The article is fairly mathematical in nature and I expect that you already know basic statistics concepts like Std. Deviation, mean, averages and technicals used in trading like Fibonacci, etc.

So, in this article, I'm focusing on "3 Month Avg. Volume" as our filter. The reason is that more is the volume of shares of a particular stock, higher will be the probability that the stocks is traded by more number of people, and hence it's not biased by only a few set of people. Technical indicators are often thrashed and bruised when only a few set of people are manipulating the stock price. So the whole idea is to find only those stocks that have enough number of shares in the market. But the questions is "how enough is enough?".

To find this, I analyzed all the 8000+ stocks traded in the US markets and can be found at http://finance.yahoo.com.

The first thing to find was the "distribution" of the 3 month avg volume of the stocks so that I can find out what's the type of statistical tool I should use to further analyze the stocks.

And here are the results:
Std Dev = 3,474,398.44
Avg = 905,364.23
Mean = 57,043,505.88

From this it is clear that the stocks are spread in a very large band and it's very difficult to prove that most of the stocks are in/around the avg (because avg and mean have a lot of difference).

To prove this, I plotted a histogram of the stocks and here are the results:
11 to 5,704,361 = 7981
5,746,440 to 11,450,789 = 112
11,542,300 to 17,246,649 = 44
18,230,600 to 23,934,949 = 14
24,889,500 to 30,593,849 = 8
34,054,600 to 39,758,949 = 10
67,585,400 to 73,289,749 = 4

This gives a hint that we should be focusing on the below 5M range and dig deeper into that range to find out that "cut off" of the 3 month avg. volume.

So, I started plotting the percentile chart to find out how many stocks have above n 3m avg. vol.
Here are the results:
90% ptl = 9,510
80% ptl = 24,160
70% ptl = 54,002
60% ptl = 106,053
50% ptl = 187,646
40% ptl = 310,041
30% ptl = 499,732
20% ptl = 845,622
10% ptl = 1,863,100

From this we see that 90% of the stocks have 3M avg. volume more than 9,510, 80% have more than 24,160, and so on.

This analysis along with the histogram clearly shows that if we are concentrating on stocks above 1.8M range, we are really focusing on a very small number of stocks (only 10%) and if we are focusing on above 54K range, then we are looking at 70% of the market.

I meshed this analysis with the Fibonacci magic numbers in "two dimensions". First, I used the 38.2% Fibonacci ratio and hence used the 40% percentile, which suggests that we should be focusing on stocks above 310,041 range.

Then I padded it with a risk factor, adding the second dimension, to say that instead of using the 40%, I'll use the 30% percentile, because for one, it's safer than the 40% range anyways, and secondly, the 30% number is 499,732, which is incidently the 50% Fibonacci ratio of the avg. (1M).

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Hence, for US stocks, there are better chances of your technical analysis to work properly on stocks that have 3 month avg. volume more than 500K
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Hope this analysis helped you! Feel free to drop in your comments!

cheers and Happy Trading!
GT

Too many Technical Indicators?

When it comes to trading, more tools and techniques might not necessarily give you edge over the market. Instead, what you really need to know is what tool to use when. Although there's tonnes and tonnes of information available about all sorts of techincal and fundamental stock forecasting techniques, unfortunately there's very little information available on the internet on what indicator and tool to use when.

Here I intend to start a series of blogs to educate people on what indicator to use when. Most of the information that I am providing here is based on my understanding of various technical indicators. To understand what indicator to use when, one really need to go through the detailed mathematics that is involved in plotting the indicators. We will try to keep mathematics as far as possible because there's a lot of it already available on the internet. Instead we will try to focus on the essence behind the mathematics.

In this first article of this series, I will cover SMA.

In the next articles I will cover other indicators like EMA, RSI, MACD, ADX, Ichimoku, etc.


Simple Moving Average (SMA)

SMA is one of the most basic stastical tools. Note that I am not calling SMA as a "forecasting" tool. Instead I am calling it a "stastical" tool. The reason is that since there's a very suttle difference between both the terms because one is not really meaningful or useful without the other, at least in the practical world; people, and especially traders, tend to forget this suttle difference and start treating the indicators as "forecasted results". However, in reality they could be just "statistical results".

It's important to keep in mind that all the indicators like SMA, EMA, RSI, etc. are "statistical indicators". In order to "forecast", traders use these indicators and put their own human intelligence and logic to "forecast".

So, in essense, more indicators won't give you a surity of winning trades! However, if you know many indicators, and you know which indicators to use in which situations, you can possibly "forecast" better; and that would lead to winning trades.

So, let's come back to the main theme of this blog series; i.e. the indicators.

SMA, Simple Moving Average is computed by taking average of past data. Let's say if you have a series of numbers like:

1, 3, 2, 4, 6, 7, 4, 1, 1, 3, 4, 4, 5, 2, 5

And we want to find SMA(5), which means we will calculate simple moving average of last 5 periods, then the first SMA would be calculated as:

(1+3+2+4+6)/5 = 3.2

Second SMA would be calculated as:

(3+2+4+6+7)/5 = 4.4

And so on.

The idea behind SMA is that it gives an overall average of the movement of stock prices so that you can have an idea of the overall trend. Note that the values calculated by SMA are "not" forecasts. Instead they are just averaged out numbers of the past n periods so that you know what's the overall trend.

Note that first, in this series of articles, I'll first cover about each indicator and then go deeper into each indicator and then into discussions as to when to use what indicator and how... So hang in there and keep on reading. It's going to be a bit long journey. But if you really want to make money in trading, "no one time 5 page article will help you do that". So stop wasting time looking for such "strategies" and instead spend some time going through this series of articles.

Sorry for being blunt, but that's how trading is - cold hard - you eat or get eaten...

So coming back to SMA...

Above, we first understood what SMA is. Let's see how to use it to find "overall trend".

Above is a one year chart of Sun Microsystems (SUNW). This is a "Candle Chart" with a 15 period SMA (also written as SMA(15)) plotted as a red line. Note that the stock moves up and down with small triangular formations, but SMA helps finding the overall trend. Once we know the trend, we can find the "channel" in which the trade is moving and then if the trend is up, then enter into the trade at the bottom of the channel and take profit at the top. For people who don't know these terms like "channel", etc., hang in there and things will be more clear in the coming articles.

Also, in trading, since the stock quote is given in generally 4 figures (open, close, high and low), generally, the SMA line is plotted using the "open" values. This is because, traditionally stocks have been traded on the "long" side. In other words, traditionally people used to only buy stocks and hope for them to grow. There was no concept of "shorting" trades, because that requires margins and all, in which we'll go later. So, if the stock is growing, then plotting the "open" values gives you more room for making profit because overall on an average the stock would open at some price and grow each day (on average), so plotting on open values makes sense. This also gives you a hint on what price the stock will open next morning.

That's it for now. Hope you'll be able to digest this information. Feel free to send in your comments or questions and I'll be happy to answer as many I can and also include as many answers as possible in the coming tutorials in this series.