The first of two articles on this topic appeared last week (Analytical Toolbox: Tools for Developing Your Outlook, Part 1 on January 8, 2009). Objective trend tools provide a view of the past, but keep you grounded as to what is actually happening in the markets versus what you may want to see. Such technical tools make use of objective techniques—i.e. moving average [MA], regression channel, and retracement areas—as well as subjective ones—i.e. support/resistance lines and trend lines—to help you form a rational opinion of current market conditions.

Trend tools can also be combined with other techniques to help you assess conditions going forward. By first identifying potential upside and downside targets, price action can be monitored near those areas. In addition to pure price action, traders and investors can note relative volume levels and momentum to assess the likelihood the specific support/resistance area will hold and the likelihood it will be violated. Adding these tools may help you formalize an outlook process for 2009.

Volume

Most technicians incorporate volume with price in their assessments, but it’s not a requirement (consider point-and-figure charts). Different approaches work for different people. If you’re in the “volume matters” camp, consider adding volumes bars with a moving average to assess relative conditions and a volume based indicator such as On Balance Volume or Accumulation/Distribution. Worden subscribers also have some nice proprietary tools available to them with Money Stream and Time Segmented Volume.

The most common application is to monitor volume as price a target area with these conclusions:

1. If volume is diminishing, chances favor the support or resistance area holding, and
2. If volume is increasing, chances favor a break of the support or resistance area.

On Balance Volume [OBV], developed by Joseph Granville, is a freely moving indicator (not range-bound) that is primarily used as confirming/diverging tool relative when compared to price. A downward trend in any time frame is considered suspect if it is accompanied by diminishing volume and/or a rising OBV. An advantage to freely moving oscillators is that they can continue to improve or deteriorate in extreme markets.

Momentum

I’m a fan of momentum tools and they likely have a place in your outlook as well. Two tools I regularly use include the Relative Strength Index [RSI] which is a range-bound oscillator that measures the price of an index or security against its own price x-periods ago. Applications include the identification of overbought/oversold regions and determination of confirming/diverging trends with price. After speaking with Andrew Cardwell and reviewing some of his work, I became that much more of a believer in the tool.

A second momentum indicator I use is the Moving Average Convergence-Divergence indicator which moves freely and combines lagging and leading measures. Its unique construction and the fact that it is not range-bound make MACD a nice complement to RSI, in my view.

Momentum tools can similarly be used to assess the likelihood price will breakthrough a specified support/resistance target. When price is trending upwards, momentum will help you answer, “Does price have enough strength in this direction to breakthrough this resistance area?” A lack of momentum will not prohibit such a move, while bullish momentum will not guarantee continued upward movement.

Remember that an outlook doesn’t provide you with a sure-fire roadmap to future prices; it is simply a collection of tools you can use to assess conditions and make an educated judgment about the movement in the future. It also identifies things to monitor that may change your view.

Other Tools to Consider

Volatility: Volatility is the range and speed in which prices move and can be measured on a relative basis with different tools. Examples include VIX, ATR, Bollinger Bands, etc.

Breadth: Breadth indicators generally take volume data a step further by breaking it into advancing and declining components. There are a variety of calculations that can be completed and indicators developed to view these statistics. It is not uncommon for these tools to work similar to sentiment measures, with extreme bullish readings having bearish implications and vice versa. Examples include TRIN, McClellan Oscillator, Advance/Decline Line, etc.

Sentiment: Sentiment measures attempt to assess extreme emotion in the market via trader/investors opinions and actions. Examples include VIX, Put-Call Ratios, investor polls, fund flows, etc.

Intermarket Analysis: It’s believed there are markets and sectors that lead others as the economy moves through different portion of the business cycle. John Murphy and Martin Pring are two noted technicians who focus a good deal on this discipline. One tool used by analysts includes Relative Ratios (a.k.a. Relative Strength Comparison) which divides one market or security by a comparison market or security. You can apply traditional TA techniques such as trend line construction and assessment on relative ratios. (ex.: Multiple chart views, sector analysis, relative ratios)

Putting it All Together

Identify the tools you consider to be primary for your outlook using the table that follows. Focus on those areas that suit your trading and/or investing style. For each primary tool, identify one or two synergistic techniques or tools (rather than redundant) you believe should be a part of your outlook.

Run through the list again noting potential secondary tools that you will incorporate later or will access in the event the outlook using your primary tools remains unclear. “Clarity” doesn’t mean you know which way the market is heading. It means you can identify where the market has been and you can generally provide a bullish case, a bearish case and a neutral case over different time horizons.

Closing Thoughts

What is the time horizon for the assets? Keep in mind …

1. If you’re performing a longer-term investment-oriented outlook you may want to complete that first, and separate from your shorter-term analysis. Remember that trends appearing on longer-term charts and indicators with slower settings (i.e. 200-day MA versus 20-day MA) are considered to represent stronger trends.
2. While a longer-term trend is considered stronger, short and intermediate-term trends can have some staying power in the markets too. Expect to see both bullish and bearish trends develop in the short-term and intermediate-term before the long-term trend changes. This means that even if you’re a longer term investor you may need to look at a relatively shorter view to get your bearings on what’s happening in the markets … especially if you’re exposed to media blasts of market activity.

Look back at your past performance and assess where price was relative to different MAs (and how the MAs lined up) during both your more successful periods and less successful ones. Consider whether you can identify objective price-MA positions that are best suited to your style. These observations may simply represent one piece of data for your outlook. Remember that “basic” tools are not equivalent to “substandard” tools. Sometimes going back to basics is just the thing you need to trade/invest on solid footing.

If you feel your analysis is missing a piece, consider looking through your tool’s Help content. You may also want to do this to add tools to explore and/or secondary tools to use periodically when you need to provide more clarity to an analysis. Be sure to give yourself a deadline for tool exploration so you actually get down to the business of monitoring conditions.

Before you start exploring the “want to know better” list, construct charts with your primary tools and start monitoring them. By now you likely know there is no Holy Grail combination that will guarantee the future direction of the market. So your job is to find the tools that aid in an objective assessment of current conditions and likely scenarios going forward. This is accomplished with an intentional approach.

Finally, don’t underestimate the importance of finding the approach that is bested suited to you so you can most effectively manage your emotions. Trader/investor psychology challenges are thriving in all of us.

More Information on the Tools I Use

Regression Channels
Gilbert Raff, Trading the Regression Channel, Stocks & Commodities, V 9:10 (403-408).

Momentum

RSI: Clare White, CMT, Analytical Toolbox: Cardwell Techniques with the RSI & Analytical Toolbox: Speaking with Andrew Cardwell Part 1 ” and Part II, Optionetics.com, July 2008.

MACD: Gerald Appel (2005), Technical Analysis: Power Tools for Active Investors, Upper Saddle River, NJ: Prentice-Hall, Inc.

Other

Robert Colby, CMT (2002). The Encyclopedia of Technical Indicators. New York, NY: The McGraw-Hill Companies.

To access other articles written by Clare White, please click here.

Clare White
Contributing Writer and Options Strategist
Optionetics.com ~ Your Options Education Site
Questions for Clare? Visit the Optionetics.com Discussion Board