Every investor believes in the strategy of buy-and-hold. The only topic of contention is how long the holding period should last. For every teenager who purchases an undervalued equity and retains it for 8 decades, collecting dividends along the way, there are dozens more speculators who want to get out of their positions in less than a week. Which not only requires a stock to appreciate quickly, but also to appreciate high enough to offset any transaction costs. Swing trading is for the investor who literally can’t wait for the weekend.
There’s an advantage to being small and nimble here. The chief investment officer at California State Teachers’ Retirement System ($188 billion in assets) can’t follow the technical indicators and move its money into a penny stock that he thinks is going to jump 20% in the short term. At least not if he wants a job in the long term. But a day trader with less downside and greater upside can.
Those technical indicators are the mathematical tools that can divine actionable information out of a stock chart that can seem arbitrary at times. In the hands of a sufficiently lucky speculator, the right technical indicators can spell an opportunity for profit. Here are just a few of the ones most commonly used by swing traders, in ascending order of complexity.
On-balance volume is supposed to uncover a relationship between price and number of shares traded. The theory is simple, and makes superficial sense. If far more units of a stock are trading than were before, but the price is staying the same, that’s an untenable position. There’s so much interest in the stock that its price ought to rise, or so the thinking goes. (This indicator disregards that for everyone buying a piece of said stock, someone else is selling.) To calculate on-balance volume, start at an arbitrary point. Say on Day 1, stock MNO is trading at $19 on volume of 100,000. The next day, the price rises, it doesn’t matter how much. But 150,000 shares change hands. On-balance volume is now 250,000. The next day the price falls as 160,000 shares are trading. Now the on-balance volume is 90,000. There isn’t much more to on-balance volume than that. It merely measures days of net advance and decline, weighing each day by the number of shares traded. Calculate on-balance volume for a period of years, and it’ll eventually gravitate toward the mean, which is why on-balance volume is used exclusively in the short-term.
And when it is used the short-term, the recommendations are simple. If prices rise while on-balance volume falls, buy. If prices fall while on-balance volume rises, sell. When the quantities move in tandem, do nothing. Case in point, here’s the on-balance volume data for AT&T (T) over a recent 10-day period:
Price and on-balance volume are diverging, at least at the end. The data say to unload your AT&T stock to capitalize on short-term profit potential.
Price rate of change looks at recent closing prices with respect to older ones. Take today’s closing price, call it $20. Subtract the closing price some number of days ago. 3 days? Sure, why not. Let’s say that was $16. Then divide the difference by that old closing price. Which would make the price rate of change .25. By looking at relative movements, rather than raw dollar figures, price rate of change should give a level of strength. The further away the quantity is from 0, the stronger the trend. Positive implies pressure to buy, negative implies pressure to sell.
And with AT&T over the last few days in the chart, price rate of change has decreased, however minimally. Therefore, you should sell. (Keep in mind that the chart expresses quantities as percentages. Fortunes have been won and lost by people putting the decimal point 2 places away from where it belongs):
A more elaborate technical indicator, the commodity channel index, measures excess deviation from the norm. The index involves some easy arithmetical manipulation. Start with the stock’s “typical price”, which is just the average of its high, low, and close over some period. MNO opens at $18, rises to $30, gets down to $18 again (or at least, no lower than $18) and closes at $27? That’s a typical price of $25.
Then, subtract MNO’s simple moving average over the same period. Which is just the average of its daily closing prices. Let’s assume we’re measuring this over a week. MNO closed at $19, $24, $29, $21 and $27 on each of the 5 days in question. Thus the simple moving average is $24.
The difference is $1.
Now calculate the mean absolute deviation. To do that, start with each period’s typical price. Compare each of to the average typical price, and in every case subtract the smaller from the larger. Divide by the number of periods – in this case, 5 days – and that’s the mean absolute deviation. Divide that into $1, multiply by a constant of 66 2/3, and you’re done. The result is a quantity that ought to tell you not only when prices are changing direction, but when they’re reaching maxima or minima, and how strongly. If the commodity channel index is >100, the data says to buy. If <-100, sell. The vast majority of the time, the commodity channel index will recommend neither buying nor selling.
Here’s the commodity channel index for AT&T over the same period:
Note that the data recommend you should buy, notwithstanding that 2 days earlier they gave the opposite recommendation. By ignoring absolute values <100, the commodity channel index only indicates selling or buying in rare circumstances. Especially with a blue-chip stock such as AT&T.
The Bottom Line
The perfect all-purpose technical indicator that unfailingly gives the right buy or sell recommendation has yet to be devised, and might be beyond human capacity. But analysts will keep striving to find it. In the meantime, on-balance volume, price rate of change, and the commodity channel index represent three comprehendible ways of analyzing price movements to make decisions.