As advisors, one of our greatest challenges these days is to generate good risk adjusted returns for our clients. If you are a proponent of the Efficient Market Hypothesis (EMH), you adhere to the belief that all known and relevant information is already priced into the market and as a result, you are probably an advocate of passive or index investing. If so, technical analysis, which is discounted by the EMH, would not be a part of your investing DNA. However, if you are unsure or believe that the EMH is just what is says, a hypothesis and not fact, then technical analysis might be a tool you utilize.
For many advisors, technical analysis is either an amazing technique with predictive value or a mysterious black box of confusion. Whatever your particular belief, in the next two posts we'll discuss ten of the most widely used technical indicators. Before we discuss the first five, I should mention that next week, when we conclude with the remaining five, I'll include a link to a great website which will provide detailed information on each indicator in the event you'd like to dig deeper into the subject.
1. Accumulation/Distribution Line
This was developed by Marc Chaikin and is a volume-based indicator which measures the flow of money into and out of an investment. It was originally called the Cumulative Money Flow Line. As we all know, when excess money flows into an investment, it tends to push its price higher. Therefore, this indicator will help assess whether a specific investment is experiencing positive or negative net cash flows.
2. Average Directional Index (ADX)
This was created by Welles Wilder, a Mechanical Engineer who also created the Relative Strength Index (RSI), Average True Range (ATR), and Parabolic SAR (SAR). The ADX is designed to measure trend strength without regard to direction. Originally designed for commodities, it is also very useful for stocks and market indexes. In fact, I also use it with mutual funds and ETFs.
3. Relative Strength Index (RSI)
This indicator helps to determine if an investment is overbought or oversold. As mentioned, it was developed by Welles Wilder.
4. Average True Range (ATR)
This is another indicator from Welles Wilder which measures volatility rather than price direction. Hence, it is useful when seeking investments with low or high volatility.
5. Parabolic SAR (PSAR)
This is the final indicator we'll discuss in this post. The PSAR, also from Welles Wilder, is designed to determine good entry and exit points in an investment. Like all of Mr. Wilders’ indicators, this is has stood the test of time and is utilized by a large number of proponents of technical analysis.
Next week we'll explore the remaining five indicators and I'll provide a link to a website with some great information for all 10 in the event you'd like to learn more. I should mention that no single indicator should be used in a vacuum. For example, to determine if a trend is in place, it's best to use two or three trend indicators.
Have a great week and thanks for reading!