Russian novelist Leo Tolstoy noted that “happy families are all alike; every unhappy family is unhappy in its own way” in his novel Anna Karenina. I’ve noticed a similar pattern among investors. Successful investors are all alike in some ways while unsuccessful investors all seem to chart their own course away from success. It seems safe to say that successful investors tend to be happy with their results while unsuccessful investors will tend to be unhappy, each in their own way.
Among the attributes successful investors share, one of the ways they are alike, is that they understand their objective and they take actions that are in line with their objective. You may be thinking the objective of investing is simply to make money but it really is not that simple. Each investor needs to define their goal in terms of timeframe, risk tolerance and trading style. Successful investors tend to do this quite well. Unsuccessful investors tend to skip over this step.
Let’s look at two types of goals in the stock market, one for long-term investors and one for short-term investors. Both want to make money but the steps required to make money are different for each. That difference has been proven mathematically. In the long term, stock prices have a tendency to trend. This can be seen in the chart below.
On the left, we can see that the Dow Jones Industrials Average trended up since 2009. On the right, we see that Transocean has trended down over most of that time. These are trends that have lasted for years.
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On the other hand, the next chart shows that stocks don’t necessarily show strong trends in the short run.
This is a one-minute chart of iShares Russell 2000 Index ETF and shows a pattern that is called mean reversion in mathematical terms. Mean reversion describes the tendency of prices to move back and forth (revert) around a central point (the mean).
The charts shown above are extreme examples but the general tendencies shown exist to some degree in almost all charts. On a consistent basis, we see prices exhibit mean reversion behavior in the short term and trend in the long term. Given that prices behave in different ways in different time frames, it makes sense investors need different tools to profit in different time frames.
Technical indicators are often classified as trend following or oscillators. Trend following indicators work well in the long term whole oscillators can be best for the short term.
Trend following indicators include moving averages. MACD or on balance volume (OBV) among others.
A moving average is designed to show the direction of the trend. It smooths the price data, taking the short-term mean reversions out of the picture. It’s simple to apply a moving average. When prices are above the moving average, the trend is up. A down trend is defined as those periods of time when prices are below the moving average.
MACD, or the moving average convergence-divergence indicator, is designed to measure the direction and the strength of the trend. It is commonly displayed as a histogram, a style of a bar chart, as shown below.
When the MACD indicator is above zero, shown as green in the chart above, the indicator is bullish and the trend is up. Down trends are defined as those periods when the indicator is negative, shown as red in the chart above.
On balance volume, or OBV, combines price and volume. The idea behind this indicator is that volume should move in the same direction as price. To calculate OBV, the days volume is added to the previous day’s value of the indicator if prices close up and subtracted from the previous day’s value of the indicator if the close is down. OBV is shown in the next chart. This is a weekly chart because OBV is designed to identify the direction of the long-term trend.
The red lines indicate a divergence, a time when prices were rising slightly while the indicator was declining. Divergences are always expected to resolve in the direction the indicator is moving. In this case, the indicator was falling and the prices inching up. OBV was warning of a decline in price which came fairly quickly.
The blue arrows highlight a time when the indicator was in sync with the price action. The trend in both was up and the result was a strong price move, the kind of trend investors want to benefit from.
For the short term, investors should consider using oscillators, a group of indicators that include the relative strength index (RSI) or the AROON indicator.
RSI is calculated as a single line that moves between 0 and 100. Readings below 30 are usually considered to be oversold, meaning the stock price has fallen a relatively large amount in a short amount of time. Traders could wait for the indicator to move back above 30 before buying. This would indicate the short-term decline has most likely ended and a new up trend is potentially underway.
RSI can also be used to generate sell signals. This requires waiting for the indicator to rise above 70, indicating an overbought condition exists where the stock price has gone up too much in a short amount of time and is expected to pull back. The sell signal comes when RSI falls back below 70, indicating the up trend is most likely over and a new down trend may have started.
The AROON indicator is a series of two lines as shown in the chart below.
Each line measures the relationship of the high or low to the recent market action. In the chart above, the green line is based on the highs and the red line is calculated using data for the lows over the past 14 days. Buy signals are given when AROONup, shown as the green line, crosses above the AROONdown line, shown in red. As the chart shows, the indicator can provide timely buy and sell signals and can identify trends that last for several weeks. When using AROON, it’s important to remember that the indicator when the AROONup line is above the AROONdown line. The direction the lines are moving does not matter for the signal.
It’s possible to use a longer time frame in the calculation of RSI, AROON or other oscillators. This would make the indicators suitable for long-term signals. Likewise, a very short time frame could be used with a moving average or other trend following indicator to create a mean reversion indicator.
The best indicator to use is the one that matches your time frame. If you are a long-term investor, using short-term indicators will create frustrations because there will be more buy and sell signals than you want. Oscillators will usually generate a significant number of trading signals. This will result in short holding periods and generally small gains. The goal of a short-term trader is usually to capture a small gain in a short amount of time. A long-term trader will generally pursue larger gains and holding periods measured in months or years.
Indicator selection is just one component of defining your objectives in pursuit of investment success. It will also be important to be sure your style matches your personality and that you have the time required to implement your strategy. We will talk more about investment styles and strategies in future blog posts.