###### Application of Probability Rules

Probability rules are the concepts and facts that must be taken into account... **Read More**

Technical analysis indicators are measures used to predict changes in the price of a security price based on price, market sentiment, or flow of funds. In essence, they try to establish how potential changes in market forces (supply and demand) might impact the price of a security. We can categorize technical analysis indicators into 4 groups. These are:

- price-based indicators;
- momentum oscillators;
- sentiment indicators; and
- flow-of-funds indicators

Price-based technical analysis indicators combine information relating to both the current and the past price history. Under this category, we have simple indicators such as the moving average and other complex ones such as stochastic oscillators.

A moving average refers to the closing price of a security averaged over a specified number of periods. In other words, a moving average is the mean of the last *n* closing prices. They are particularly useful because they smooth out price fluctuations occurring in the short term, hence giving analysts a clearer idea of the trend exhibited by the market. The simple moving average places equal weights on both past and current prices. An exponential moving average, on the other hand, gives less weight to past/older prices and more weight to recent prices.

A widely accepted value of *n* when coming up with the moving average for a period of one month is 20 days. A 3-month moving average may comprise 60 days.

Bollinger Bands, named after John Bollinger, are technical analysis indicators that are based on the standard deviation of closing prices recorded over the last *n* periods. They appear in the form of a higher line that represents the moving average plus a set number of standard deviations from the mean price. Aside from this, there is an additional lower line that represents the moving average less the same number of standard deviations added to the higher line.

The range between the higher and lower bands indicates the volatility of the security under analysis. Bollinger bands help technicians to identify extreme price pavements screened against recent standards set by the market. Prices above the higher line may indicate oversubscription (overbuying). Prices below the lower line may indicate an oversold market. A strategy that yields optimum returns may entail buying when the price is at the lower band and selling when it’s at the higher band.

Momentum oscillators, also called rate of change oscillators, are computed by taking the most recent closing price, subtracting the closing price recorded on a specified trading day in the past, and finally multiplying the result by a factor of 100:

$$ M = (V – Vx)100 $$

Where:

M = momentum oscillator

V = most recent closing price

Vx = closing price as at a specified date in the past, say 10 days ago

It’s common to find market participants buying when the oscillator shifts from negative to positive during an uptrend. Alternatively, they may sell when the oscillator shifts from positive to negative during a downtrend.

Other types of oscillators regularly used by analysts include the relative strength index, moving average convergence/divergence oscillators, and the stochastic oscillators.

Sentiment indicators comprise a range of periodic polls conducted with the aim of sampling the sentiments of individual investors or investment professionals about the equity market. Some of the widely used polls include:

- Market Vane Bullish Consensus
- Investment Intelligence Advisors Sentiment
- Daily Sentiment Index

The responses gathered from investors and professionals are compiled and used to establish the relationships between sentiments and prices. Analysts can use such relationships to forecast future price movements.

Flow-of-funds indicators measure the movement of money into or out of rising and declining stocks. One of the most useful indicators under this category is the **Arms Index**, calculated as:

$$ \text{Arms Index} =\cfrac { \left\{ { \frac { \text{Number of advancing issues} }{ {\text {number of declining issues} } } } \right\} }{ \left\{ \frac { \text{volume of advancing issues} }{ { \text{volume of declining issues} } } \right\} } $$

**How do You Interpret the Result?**

First, a value close to 1.0 indicates a balanced market, meaning that more money is being channeled into rising stocks than into declining stocks. Furthermore, a value above 1.0 indicates more volume in declining stocks. Lastly, an index of less than 1.0 indicates trading in rising stocks is the most common activity at a particular point in time.

Other flow-of-funds indicators regularly used by market analysts include the *margin of debt, IPO’s (Initial Public Offerings)* and *the mutual fund cash position.*

*Reading 56 LOS 56e:*

*Describe common technical analysis indicators (price-based, momentum oscillators, sentiment, and flow of funds),*