WARNING: These indicators are by no way representative of what the I Know First algorithm actually does. This was created to give a perspective on simple mathematical models used to forecast and project price movements. 

Trend Indicators: Simple Moving Average (SMA) & Exponential Moving Average (EMA), Moving Average Convergence Divergence (MACD), and Parabolic Stop and Reverse (SAR).

Simple Moving Average (SMA) & Exponential Moving Average (EMA)

One of the most indicative and important elements any trader should be strongly aware of during any trade. The SMA is a simple average calculation of the closing price of any security for a given number of days. A short term SMA would use a relative small amount of days as input, while a long term SMA will use a larger sample of days.

The picture above demonstrates the difference between two moving averages. The “period = 30” average is indicative of the overall trend, while the “period = 7” average is indicative of the most current trend. Crossovers between the short (green) and long (red) SMA’s can be used as signals for buy and sell points.

The Exponential Moving Average (EMA) is the same as the SMA, except it applies more weight to recent forecasts. Because the recent trend is generally more informative, an investor will apply a stronger weight on the more recent data according to his preferred strategy.

The example above demonstrates the difference between a SMA and EMA. The dark blue EMA line will inevitably have sharper trend changes (quicker reaction to reversal in trend), while the light blue SMA line will have a flatter curves.

Moving Average Convergence Divergence (MACD)

The MACD is one of the most widely used indicators to reveal changes in the strength, direction, momentum, and duration of a trend in a stock’s price. The MACD is calculated by subtracting the 26-day exponential moving average (EMA) from the 12-day EMA as illustrated in the image below (bottom line is the MACD)

The signal line is a 9-day EMA of the MACD Line.  A bullish crossover occurs when the MACD turns up and crosses above the signal line. A bearish crossover occurs when the MACD turns down and crosses below the signal line. Crossovers can last a few days or a few weeks, it all depends on the strength of the move. Theoretically, you should buy when the MACD crosses above the signal line, and sell when the MACD crosses below the signal line

Although a great trading indicator, the MACD does have a couple disadvantages. Because the value of the MACD represents a price, it is not suitable for comparing securities. For that you can use the Percentage Price Oscillator (PPO) not discussed in this article. It is also a lagging indicator defined as “A measurable economic factor that changes after the economy has already begun to follow a particular pattern or trend”. Thus, as a metric of price trends, the MACD is less useful for stocks that are not trending.

Parabolic SAR

The parabolic SAR, which stands for “stop and reverse”, literally stops and reverses when the price trend reverses and breaks above or below the indicator. It is extremely valuable because it is one of the easiest methods available for strategically setting the position of a stop-loss order. Professional traders who short the market will often use this indicator to help determine the time to cover their short positions. This indicator proves to be extremely valuable in trending environments, but it can often lead to many false signals during periods of consolidation.

As can be seen from the image above, when the trend changed the stop loss fliped. Meaning for an uptrend the SAR acts as a stop when prices decrease and for a downtrend when prices increase. Calculating the SAR is rather complex; simply explained it checks to see if the extreme points (lowest and highest prices during day trades) has been crossed, then calculated an acceleration factor according to if it has been or not. There are many tools that make viewing the parabolic SAR very simple such as stockcharts.com, which offers it as an overlay to their charts.

Momentum Indicators: Stochastic Oscillator, Commodity Channel Index (CCI), and Relative Strength Index (RSI)

Stochastic Oscillator

This is a technical momentum indicator that compares a security’s closing price to its price range over a given time period.   The calculation goes as follows:

%K = 100[(C – L14)/(H14 – L14)]

Where C is the most recent closing price. L14 is the lowest price traded during the last 14 trading sessions, and H14 is the highest price traded during the same 14-day period. The result’s 3 day moving average, also known as %D is then the signal line. When the signal line crosses 80 the security is said to be overbought, and when it goes under 20 the security is said to be oversold.

Commodity Channel Index (CCI)

This indicator is used to identify a new trend or warn of extreme conditions. Identifying overbought and oversold levels can be difficult with the Commodity Channel Index (CCI), or any other momentum oscillator for that matter. Theoretically, there are no upside or downside limits. This makes an overbought or oversold assessment subjective. To calculate the CCI divide the Typical Price ((High + Low + Close)/3) minus the SMA (20 days) of the typical price by the constant 0.15 times the mean deviation.

CCI = (Typical Price  –  20-period SMA of TP) / (.015 x Mean Deviation)

There are four steps to calculating the Mean Deviation. First, subtract the most recent 20-period average of the typical price from each period’s typical price. Second, take the absolute values of these numbers. Third, sum the absolute values. Fourth, divide by the total number of periods (20). The Image below demonstrates the resulting CCI line.

This example of google uses a more extreme 200 CCI parameter line. When CCI re-enters below 200 it is indicated by a red line. When CCI crosses above -200 it is indicated by a green line. This indicator offers no price target or exit/stop strategy, it simply gives a direction and strength (should sound familiar to the I Know First signal indicator)

Relative Strength Index (RSI)

The RSI is another momentum oscillator.  Basically RSI measures how often the stock was “bought” or “sold”, and assumes the two will eventually balance out. If gains were 1’s and losses 0’s then an 1101010001000 line would be indicative of increased pressure for a “1” because the stock has been constantly losing. It is calculated by the formula “RSI = 100 – 100/(1 + RS)” Where RS is the average of x days’ up closes / Average of x days’ down closes.

The oscillator ranges from 0 to a 100. An asset is deemed to be overbought once the RSI approaches the 70 level and oversold once it approaches the 30 level.

I Know First Research is the analytic branch of I Know First, a financial startup company that specializes in quantitatively predicting the stock market. This article was written by Daniel Hai, one of our interns. We did not receive compensation for this article, and we have no business relationship with any company whose stock is mentioned in this article.