Technical analysis can sound scary: The charts, the lines, the jargon.
But once you get a handle - just a handle, not a "cup and handle" - on some of the terms and ideas, it's not hard to grasp.
Here, I'll walk you through some of the words, tools and methods I use regularly in my columns and "Top Stocks" newsletters, so that you can more easily make sense of them.
First, the "indicators."
I use various indicators on a regular basis and I include them in my analysis. Each day of the week one of these indicators appears in the "Today's Indicator" section of the "Top Stocks" newsletter as follows. Here are the regulars and when you'll see them:
Weekend: Highs and Lows
Monday: Intermediate-term Oscillator
Tuesday: McClellan Summation Index
Wednesday: Volume Indicator
Thursday: Put/Call ratio
I also use Sentiment and the Daily Sentiment Index often. Sentiment is basically what it sounds like: How investors feel overall about the market -- are they feeling bullish or bearish? (For a companion piece I wrote on sentiment earlier, please see this link.)
In the entries below, I explain each of those indicators I use, as well as other tools:
Highs and Lows: The Hi-Lo Indicator
This indicator is based on the number of stocks making new highs and new lows over a period
of 52 weeks on each stock exchange, such as the New York Stock Exchange. I use the
statistics in different ways.
First, is the raw data: How many stocks are there making new highs or new lows?
If new highs are expanding -- meaning if we're seeing more stocks trade at higher prices --
that is bullish. If they are shrinking, that is bearish, especially if they are contracting
as the indexes are rising. What does that mean? It means fewer stocks are making new highs,
and yet a minority of the big stocks on an index are rising, which makes the entire index
go higher. It's out of whack.
If new lows are expanding that is bearish, too. That means more stocks are trading at lower
prices. But if the new lows are contracting as the indexes go lower then that is bullish.
That's the opposite of what we discussed in the above paragraph. It means the selling is
drying up and at the same time folks are finally selling the fan favorites (the big-cap
"safety" names) which had been pushing the index up.
The thinking here is that the major indexes are made up of many stocks but are heavily
influenced by the heavyweight stocks -- the biggest market capitalization ones, like Apple (AAPL) or Alphabet (GOOGL) -- so this is one way to view the breadth of the market. A narrow market tends to be an unhealthy market. I define a narrow market as one with contracting new highs. (Think of it like this: You don't want your army being fought by only generals, you want the troops in the fight as well.)
I also like to watch the 10-day moving average of new highs or new lows. If the moving
average of highs is rolling over, it's generally bearish and if the new lows are rising,
it's generally bearish. The inverse is what we use to see if there are bullish signs.
Finally, I use the Hi-Lo Indicator. It is a calculation based on the new highs and new lows. I like to use it by noting when this indicator gets under .20, that we're getting intermediate-term oversold. The overbought levels are not as easy to define, so I simply watch for when it peaks and rolls over. Remember, oversold just means that a stock or stocks has been selling at lower and lower prices and could be due for bounce; overbought is the opposite.
Overbought/Oversold Oscillator: Short-Term and Intermediate-Term
For short-term moves I start with the Overbought/Oversold Oscillator. There are many different versions of overbought and oversold that folks use, such as one called the Stochastics, another called the Moving Average Convergence Divergence (MACD) oscillator, and another, the Relative Strength Index. My Oscillator, however, is based on the 10-day moving average of the net of advancers minus decliners.
What does this mean? It means I look back 10 trading days ago, to see what sort of numbers we are dropping. If we are set to drop a long string of red (negative) numbers, then we are oversold. Conversely, if we are set to drop a long string of green/black (positive) numbers, then we are overbought.
For the intermediate-term, the 30-day moving average of the net of the advance/decline line
is what I use as an oscillator. The concept is the same as the short-term Overbought/Oversold Oscillator, only here we're encompassing something closer to six weeks in the market rather than two.
The McClellan Summation Index: Spotting the Market's 'Second Act'
First, I do not use the McClellan Oscillator, I use the Summation Index. The Summation Index is a complicated calculation, so rather than go through the math, just think of it as a very smooth version of the advance-decline line. Second, to understand the importance of this index, you must know what "breadth" is. It's just a measure of how "strong" the market is. Breadth is figured out by looking at how many stocks are advancing (upside volume) vs. how many are declining (downside volume) each day on the market.
Now, think of the McClellan Summation Index as a breadth calculation -- in that it takes a lot of up days to turn it up and a lot of weakness to send it south. I use it to determine the direction of the majority of stocks.
Also, know that this indicator moves slowly and rarely swings, offering it some level of consistency.
If the index is rising, we want to be on the bull-side of the market. If it's falling, we should be looking for shorts, not longs. I also calculate "what-ifs" based on the McClellan Summation Index to determine what it will take to "turn" this indicator from up to down or down to up.
Each day I calculate what it will take to turn it from up to down or down to up. This serves two purposes. The first is obvious: knowing how close we are to a turn. The second is because when it requires an extreme reading, the market tends to be overbought or oversold on a short-term basis.
The parameters I use are: When the market gets to the point where it requires more than +/-4,000 issues to turn, we are overbought or oversold.
If we get over +4,000 we are oversold. That means if it will take more than a net differential of +4,000 advancers minus decliners on the NYSE to halt the decline in the Summation Index we are oversold. There are approximately 3,000 issues that trade daily on the NYSE, so what +4,000 is telling us is that we'd need at least two days where breadth was extraordinarily positive just to halt the decline in the Summation Index, so I consider that a market that is oversold.
With about 3,000 issues that trade daily on the NYSE, that +4,000 is telling us that we'd need at least two days where breadth was extraordinarily positive just to halt the decline in the Summation Index.
For an overbought market I also use 4,000 only it would be a net negative number -- for all the same reasons. I should also note that that extreme reading over or under plus or minus 4,000 is rarely the exact low or high in the market. Often we get a bounce/pullback and then sell off again (or rally again) to get that "what if" to a lower high/higher low. It's a two step process: either up/down in the case of oversold or down then up in the case of overbought.
The key is always how the market acts on that second move. In the case of an uptrend, how well does it rally after the first pullback? In the case of a decline, how strong is the renewed decline after an oversold bounce? If the Summation Index changes direction, then it is likely the market will do so soon after. If the Summation Index stays steady in the initial direction, then chances are the trend continues.
The Volume Indicator: Spotting Highs and Lows
This helps you spot the difference between highs and lows on the market, as another aspect of market breadth is volume.
I follow many aspects of volume, but here's the intermediate-term indicator I watch most closely: The upside volume as a percentage of total volume on the NYSE plotted on a 30-day moving average. When this indicator gets down to the low 40% area, the market tends to be closer to a bottom than a top. At that point start focusing on when the oscillator will next be oversold.
In bull markets, it tends to get oversold in the mid- to upper 40% range and overbought in the mid-to- upper 50s. In bear markets - even the worst ones we've seen - it tends to get oversold either side of 40% (call it 37%-42%) and overbought in the mid-to upper 50s.
The Put/Call Ratio: How Do I 'Put' This?
Folks who are bearish tend to buy puts and folks who are bullish tend to buy calls. So a low put/call ratio means there are too many call buyers vs. put buyers, and is considered bearish. (Remember, in options trading, a "call" allows the trader the right to buy a stock and a "put" allows the trader the ability to sell it.)
Because you cannot judge a whole market on a one-day reading, though, I will tend to smooth this indicator out and plot it on a 10-day moving average.
When there is a one-day reading that is relatively high or relatively low, however, I find it worth commenting on, because it can often show enough of a change in sentiment to provide us with a short-term move in the market. (Are you listening, day traders?) Here is an explanation of the various put/call ratios that I often watch:
Total Put/Call Ratio: If I use the term put/call ratio I am referring to the total. The total is a reference to the CBOE Options Exchange's reading, where the exchange combines all the puts and calls that were traded that day on the exchange.
A high reading (over 1.0) says that folks are buying more puts than calls. A reading over 1.10, I would consider commenting on.
A low reading (under .70) is one I take to mean that folks are buying too many calls relative to puts. I might comment on a reading in the .70s, but would definitely comment on one under .70 .
Equity Put/Call Ratio: This is for individual stocks only. ETFs, indexes, and others do not end up in this category. A higher reading (over .80) or a low reading (under .50) are worth commenting on in my view.
ETF Put/Call Ratio: This is for ETFs and does not include individual stocks. A high reading would be over 1.50 and a low reading is under 1.0. I might not comment on either but I will comment on it if it occurs on consecutive days.
Index Put/Call Ratio: This has moved around over the years and so I will not provide levels, but too many readings under 1.0 and I will feel the need to comment.
VIX Put/Call Ratio: This one is the most difficult to explain, because one must think of the total put/call ratio and flip it around. In other words, here a high reading is bearish and a low one is bullish. If there are too many puts bought on the Volatility Index, or VIX, folks are leaning market bullish, not market bearish.
Why? They are looking for the VIX to fall. I tend to use .20 on the low end and over 1.0 on the high end. With the advent of these new one day VIX options that might change, but we don't know yet.
As I wrap up these ratios, know that I use various moving averages for each of the sub-categories. For the total put/call ratio, my favorite is the 10-day moving average. Peaks in the moving average tend to come as the market is making a low/getting oversold. It tells us folks can't possibly get more bearish than they are.
Troughs in the moving average often mean folks are getting too bullish or giddy or complacent. And when that moving average turns up, it means they can't get more enthusiastic about the market.
For the equity-only I also use the 10-day moving average. I also like to look at the 30-day moving average for the same reasons.
For the exchange-traded fund ratio, I use a 21-day moving average as I find that one more useful. Same with the Index ratio.
The VIX ratio has tended to be useful with a 21-day moving average, but here, when it is turning up we tend to see a rise in volatility coming our way. A peak in the moving average is usually bullish as it means there are persistent bets that volatility will fall. This is difficult to understand, but the way I view it is most folks who trade volatility options are pros (as opposed to say, equity options) and when they get persistent in their bets, we want to be on their side. It is not contrarian.
Sentiment: Emotions on the Market
Sentiment in markets is something I spend quite a bit of time on. Anecdotal evidence is great, but the sentiment is the best.
Here the indicators I use: Investors Intelligence (II) and the American Association of Individual Investors (AAII).
The Investors Intelligence survey is released on Wednesdays. It's intermediate-term in nature; it's relatively stable. The American Association of Individual Investors (AAII) survey, which jumps around a lot, is released on Thursday but the voting ends on Tuesday.
We want the two to confirm each other.
The two surveys are contrarian indicators: Too many bulls warns us to be cautious. Too many bulls for the Investors Intelligence is around 60%. Too few bulls is under 40%. Low 40s, however, can be "enough" - depending on how far along we are in a decline.
These days, readings over 30% lean "too bearish."
For AAII, too many bulls is usually over 50% and too many bears is over 40%. Because voting ends on Tuesday, if the market is down heading into Tuesday, this survey usually reports "too many bears" on Thursday. It tends to represent older investors.
Daily Sentiment Index (DSI)
I have taken to this index in the last few years as I find it quite useful. The main reasons I find it useful is because it is a (relatively) expensive piece of research, mostly used by commodity traders, therefore it is not widely disseminated the same way many other sentiment indicators are. The less widely used, the more likely it is to be helpful.
It works on a scale of 0 to 100. Extremes are under 10 and over 90. Often it can get to say, 80 and never make it to 90 or it can get to 80 and spend ages sitting between 80 and 90, which means by the time it does get to 90, it really is extreme.
My parameters are as follows: Single-digits readings are extreme. Buy whatever the underlying asset is.
Over 90 is extreme. So, see whatever the underlying asset is.
Between 10 and 20 is a sort of yellow zone of various gradings. From 10 to 15 is bright yellow and possibly flashing while 15-20 is more muted. Between 20 and 80 is neutral.
Between 80 and 90 is a yellow zone of various gradings. From 80 to 85 is a muted yellow while 85-90 is bright and maybe even flashing yellow.
I hope you find these explanations useful as you dive into the technical tools I rely on most for my columns and letters. Please feel free to reach out with questions.
