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Technical indicators

Positioning


Momentum


Momentum measures the percentage change in a stock price over a certain period of time. For example: “S&P 500 fell 10% this week”


Momentum is a highly significant measure for market participants. It helps gauge the size of a move, and provides psychological benchmarks. For example, when the market falls 20% it is considered to be in a “bear market”.


Momentum is used to gauge entry points and the strength of a trend


Momentum is the measure of percentage change in price over a certain period of time, from a day to a year or more.


The chart below shows the trailing PE for SPX in the last 40 years.



Momentum is used to gauge whether the market is trending or conversely has reached overextended levels.


Stochastic Indicator


The KD Stochastic is a popular indicator in the oscillator family, which is one of the largest tools in the technical analysis toolkit. The Stochastic indicator tells you the position of a security within its recent range in % terms: 1% means it’s at the lowest 1% of the recent range, and 99% conversely that the security is the top of the price range of the last few days. The KD spread is the spread between a short stochastic (D is the 3 days stochastic) and a longer one (K is the 14 days one)


Oscillators are used to gauge bottoms/tops and inversions. The theory is that if the oscillator is close to the bottom of its range, then so is the stock and vice versa.


Realized Volatility


The realized volatility is a measure of the average size of the returns offered by a security in a determined period. For example, a stock that falls or rises 30% in a few days is considered very volatile, and conversely a Treasury bond that moves 1% at most on a given week has low volatility.


Volatility by its nature is a range-bound measure on the low side, it can never go below 0. This allows traders to distinguish regimes of low volatility.


The more appropriate name for this measure would be “standard deviation of returns” but financial jargon


Volatility is used in two different settings at least:

  • For security due diligence and structuring: stocks that have experienced a long spell of low volatility offer interesting opportunities ahead of catalysts that might make them more volatile. Usually, when realized volatility is low then so is the price of options

  • For portfolio construction and risk budgeting: realized volatility (and its sibling measure VaR) are used to construct portfolios with specific risk/volatility targets


Consecutive Days Move Counter Indicator


This indicator belongs broadly to the category of Technical Analysis Indicators, and is used to monitor extreme short-term rallies or drops in a simple way: it counts the number of consecutive days during which the stock moved in the same direction.


So if a stock rallied for three days the indicator will be set at 3, and conversely if a currency fell for six trading days in a row the indicator will be set at -6.


Like most oscillators, this is used mostly for 1d reversion plays: look at the S&P 500 example below, which shows that in the last 5 years SPX never managed to rally more than 5 days before falling. The implication is that, by monitoring these opportunities, one can play a reversion with a degree of confidence.



Sharpe Ratio


The Sharpe Ratio for a security is a measure of its return divided by its volatility. It normalizes the size of the move by comparing it to recent history, so that it’s easier for traders to gauge the significance of the move itself. When you hear in the media that “the market fell 2 standard deviations” they refer to the Sharpe Ratio of the security.


The indicator is an oscillator of sorts, allowing investors to answer questions like “What happened the last 10 times that S&P 500 fell 2 standard deviations?”. It is usually used as a mean reversion guide.


The indicator is named after Nobel prize-winner William F. Sharpe, who developed it in 1966. Originally the calculation subtracted the risk-free rate from the return calculation.


Surprise Move Indicator


The Surprise Move of a security is a modified version of the Sharpe Ratio: whereas the latter indicator measures the return of a security divided by the volatility of the security during the move, the Surprise Move divides the return of a security by the risk regime before the move took place.


This modification of the Sharpe Ratio allows the indicator to highlight how a relatively small move was quite large within the context of a pre-existing low-volatility environment, and conversely a large rebound was not so out of the ordinary, if seen under the light of a tumultuous high-vol regime that maybe came after a large drop.


The indicator is an oscillator of sorts, allowing investors to answer questions like “What happened the last 10 times that S&P 500 fell 2 standard deviations?”. It is usually used as a mean reversion guide.


MacD Indicator


The MACD is possibly one of the most well known Technical Indicators. The acronym means Moving Average Convergence Divergence and the indicator is calculated as the difference between a shorter and a longer moving averages.


Moving averages are used to gauge trends. The basic assumption is that a moving average helps identify a trend, and therefore when a short-term one diverges or converges to a longer term moving average, the trend is meant to continue or invert. Generally, when one moving average crosses the other traders assume the trend will invert.


MACDs are defined by the windows of the two moving averages, for example one can have 1 month vs. 3 months, 12 weeks vs. 24 weeks, and so on.


Possibly the most well known MACD combo is the 50 days vs. 200 days one, which gives rise to two colorfully named inversion events: the Golden Cross and the Death Cross. These are, respectively, the occurrence of the 50D average crossing above the 200D one, and the mirror event when the shorter average crosses below.


Seasonality Indicator


Financial indicator based on the assumption that security prices go through predictable changes within the same period of every year: a quarter, month, holiday period, peak period.This indicator is mostly used to predict movements in the price of commodities, such as soybeans.


On the equity side, the seasonality indicator is justified by fundamental reasons: earnings, tax season. Over the last few years, seasonal patterns in the stock market have been detected based on human behavior. For example, around Christmas, the market seems to rally upwards due to the holiday spirit and investment into the market, starting the year on a clean slate. Other patterns include liquidations at the end of each month to pay for month-end costs and fund managers selling losing positions to improve end of month performance metrics.


Investors can use this data to predict price movements in a specific period of time, based on an asset’s historical performance. However, investors should be aware of the macroeconomic environment as this can have an effect on price movements predicted by past performance.