In a previous article, Discovering the Force Index, we touched briefly on the force index and its use in conjunction with a moving average. The system can be used on either a short-term or a longer-term basis to gain a rather precise picture of the force, or the power of the bulls and the bears, in the market. Here, we look at the trading rules for using the force index in both a short-term and an intermediate-term perspective. (See also: Moving Average Envelopes: Refining a Popular Trading Tool.)
Short-Term Force Index
The two-day exponential moving average (EMA) plotted on a histogram gives the shortest-term indication of the force of the bulls or the bears. When the two-day EMA exceeds the centerline, the bulls are stronger. When it is below the centerline, the bears are shown to be stronger. (See also: Analyzing Chart Patterns.)
When used in conjunction with other trend-following indicators, the effectiveness of the two-day EMA can be enhanced even more. By using any other trend-following indicator to identify an uptrend, you can pinpoint the best buying points at the very moments that the two-day EMA of force index declines. When another trend indicator shows a downtrend, a two-day EMA of force index will identify the precise areas at which shorting is the appropriate trading decision.
To identify a short-term bottom in a market uptrend, wait until the two-day EMA of force index turns negative. You will then be buying when a longer-term uptrend is experiencing a temporary pullback. More specifically, place your buy order above the high price of the day when the two-day EMA of force index turns negative during an uptrend. You are then protected from a decline in prices as your order will not be executed if prices decline; however, if, as expected, the uptrend resumes, your long order will be filled in a strong bull uptrend. (See also: Why a Falling Stock Is Not Always a Bargain.)
If you lower your buy order to within one tick of the high, you can place a protective stop below the low of the day (or the previous day's low if it was the lower price) once your buy stop is triggered. This tightens your stop so that you are able to exit the trade early if the trend is weak.
In the case where a two-day EMA of force index turns positive in a market downtrend, the preferred strategy is to sells short. This is a quick opportunity provided by market bullishness, allowing you to place an order to sell short just below the low of the latest price bar. If the quick dose of bullishness is sustained longer than anticipated, you can raise your sell order every day to stay within a tick of the latest low. Then, when prices slide, your short trade is executed, and you can place a protective stop above the high of the latest price bar (or the previous bar if that was the higher price). You can then move your stop to break even as soon as possible.
You can also use the two-day EMA of force index to add to your long and short positions: You can add to long positions in an uptrend every time the force index turns negative, and supplement your shorts when the force index turns positive. On a longer-term basis, when the two-day EMA of force index falls to its lowest level in a longer period of time (a month, for example), the bears have exceptional strength, and prices will likely fall even lower. Alternatively, when a two-day EMA of force index rallies to its highest level in a month, bulls are exhibiting strength, and prices are likely to rise higher. (See also: Short Selling Risk Can Be Similar to Buying Long.)
In deciding when to close out either a long or a short position, the two-day EMA of force index is a crucial tool. If a short-term trader buys when the two-day EMA of force index is negative, he or she should sell when it turns positive. If the trader goes short when the indicator is positive, he or she should cover when it turns negative. A longer-term trader should exit his or her position only if the trend changes, or if there is a divergence between the two-day EMA of force index and the larger trend.
Divergences are also crucially important when trading on the basis of force index. Bullish divergences occur when prices fall to a new low while the force index makes a shallower bottom. Bullish divergences between the two-day EMA of force index and the price are strong buy signals. Strong sell signals are issued by bearish divergences between the two-day EMA of force index and the price. When prices rally to a new high while force index hits a lower second top, a bearish divergence is realized.
Intermediate-Term Force Index
Instead of relying exclusively on the two-day EMA of force index, we can identify longer-term changes in the strength of bulls and bears by using a 13-day EMA of force index. Like the two-day EMA of force index, the 13-day figure indicates bulls are in control when it is above its centerline. When it is below the centerline, bears are stronger. When the indicator remains at or near its centerline, the market is said to be "trend-less:" the force index or other trend-following trading indicators will not give accurate trading information.
When a 13-day EMA of force index reaches a new high, an uptrend is confirmed. This essentially means that the rally has strength and prices will jump on heavy volume. As the uptrend becomes long in the tooth, prices either rise more slowly than before, or volume becomes progressively thinner. The 13-day EMA of force index then displays lower and lower tops, eventually dropping below its centerline. This important trend is the final indication that the bullish trend has run its course.
A brand-new high in a 13-day EMA of force index histogram indicates the likelihood of a sustained rally. A bearish divergence between the 13-day EMA of force index and price is a strong indication to sell short. If prices reach a new high but the 13-day EMA of force index hits a lower peak, the bulls are losing control, and the bears are ready to step in and take over.
The continuance of a downtrend is typically indicated by the 13-day EMA of force index broaching a new low. If, by contrast, prices fall to a new low but the 13-day EMA of force index traces a shallower low, bears are losing their power. This is a bullish divergence, and it is a strong buy signal.
The Bottom Line
When a downtrend begins, prices usually drop initially on heavy volume. When the 13-day EMA of force index falls to new lows, the decline is confirmed. When the downtrend begins to lose strength, either prices fall more slowly or volume gradually declines. The 13-day EMA of force index then reaches ever-shallower bottoms, finally rallying above its centerline: the bear has been beaten, and a bullish reversal is nigh.