RateWatch #339 – Technical Trading
January 18, 2003 By Dick Lepre
dicklepre@rpm-mortgage.com
Technical Trading
If you listen to radio or TV reports of what the market is doing they sometimes say things like
"technical selling caused the Dow to drop 50 points." We sometimes make similar comments about the bond market. If you want to understand fully why interest rates have some of those strange days it would help to read this discussion of technical trading and keep it in the back or your mind. (Way in the back of your mind.) If you stay informed about the technical picture of the
30-year bond you can know when technical trading is likely to have an effect of the market and
interest rates and also become assessed of longer (month-to-month) trends.
Macroeconomics
Shortly after the Great Depression of 1929 people sought answers to the questions "why" and "how can we avoid this in the future." This human tragedy was blamed on lack of understanding of the economy. John Maynard Keynes (see: note 1) published in 1936 The General Theory of Employment, Interest and Money. The General Theory, as it is known, started modern
macroeconomics. Keynes was to economics what Freud was to psychology. You could agree or disagree with him but he "wrote the book." Keynes described "business cycles" and we still talk in those terms. Keynes' thinking was that economic fluctuations were caused by changes in savings and investments. Savings and investments getting out of whack are where the troubles begin. While the GT is a great attempt to explain the movement of the economy I think that the foremost reality about economics is that it involves the quasi-rational decisions of large numbers of people. Thus it does not always "make sense" but there is a method to its madness.
People's decisions in regard to buying and selling commodities (such as wheat or bonds) are based not only on external circumstances, such as weather or strikes but also on the "poker game" interplay of greed and the desire to anticipate the actions of the other players. The timing of many investment decisions is therefore based not an educated guesses as to what the economy is going to do, but on guessing what other people are going to guess the economy is going to do.
The movement of commodity prices is the result of the collective decisions of a large number of people. Some working together and some at odds. The movement of prices resembles the "random walk" of a drunk. When you first look at a drunk walking you might conclude that he is not walking toward any particular goal. If you follow him for a bit you will conclude that he is headed is some general direction, say, home. You can actually draw some conclusion about
how many steps the drunk will take in any one direction on the way home. Our statistical conclusions about the "path" of the drunk may be seriously affected by external circumstances. He may run into some friends and head to a new bar. He may be stopped by the police and have
his path very seriously altered, but when he is moving there is a measurable pattern to his
unpredictable steps. Bond prices and thus, interest rates, move in a similar manner. They have (usually) a particular long term goal but get there by a circuitous part, instead of running into other drunken friends they run into hard economic data and press releases. Instead of getting picked up by the police they get deterred by the Federal Reserve. The variations in the prices of commodities thus resemble statistical processes. Various mathematical models have been
developed to predict the price of commodities such as treasury bonds.
Technical Trading
It is these mathematical models that constitute the basis of "technical trading." Technical trading
is based on the analysis of certain data and the commitment to making decisions to buy or sell based on what the data is doing rather than listening to what analysts are saying. The "old school" Keynesian concept of the cyclic nature of markets coupled with late 20th century computer technology providing "real-time" decision making tools make technical trading popular.
I think that it is interesting that technical trading is self-actualizing. Even if is not inherently correct,
the fact that people believe in it and practice it is inclined to make it so. It is a psychosomatic
economic dynamic.
Technical traders make their decisions on one or a combination of several technical indicators. The technical indicators are derived from a constant charting of certain data, if one looks at the data
as graphs, the technical indicators say things like "sell when this line cross that line."
Following are some of the technical data that people watch.
Stochastic
When the price of a commodity is rising its closing price is close to the top of the range for the day. When the price is falling it is close to the bottom of the range for the day. A quantification of this is called the Stochastic Process. The calculated Stochastic variable is called %K
%K = 100[(C-L)/(H-L)] where,
C= Close, H = High, L = Low for the period in question
%K may vary from 0 to 100%, measuring the closing price as a percentage of the total range. Depending on the time frame desired, %K may represent this relationship for a selected number of minutes, hours, days, weeks months, years, or any other interval. One on-line technical treasury bond analyzer StoMaster (see Note 2) presents this data as cycles of 60 minutes, 100 minutes, daily, weekly and monthly. This is useful for very serious technical traders. The Stochastic variable %D is simply a moving average of %K and will, therefore, describe the movements of %K on a smooth lagged basis. A buy/sell Stochastic indicator occurs when the graph of %K crosses the graph of %D.
Moving Average
The moving average is the average of the previous n-days closing price. For example, a 10-day simple moving average is the average of the closing prices for the last 10 days. The effect of a moving average is to slow down the price movement so that the longer term trend becomes smoother and therefore more obvious. The longer the period of the moving average, the
smoother the price movement. The technical indicator derived from moving average is Price Cross. When a line tracking prices crosses the line of the Moving Average a "cross" occurs and there is an indication to buy or sell.
Momentum
Momentum is simply the difference in closing price over a period of time. Momentum is defined as the current closing price minus the closing price of n days ago. Momentum describes how fast the market has been moving. (If you studied Physics you might prefer the term "velocity" but someone got this one wrong.) Momentum is plotted above and below a "zero line" and a technical indication occurs when it crosses the axis.
Directional Indicators
The +DI is the difference between the high of today and the highest high of the past n- days.
The -DI is the difference between the low of today and the lowest low of the past n- days. ADX is the directional movement divided by therange over the period. The +DI attempts to define the strength of an issue's positive price movement while the - DI, or Minus Directional Index tries to determine the strength of the issue's downward movement. I think of it as indication "just how bullish are the bulls?" vs. "just how bearish are the bears?"
Generally, if the +DI is greater than -DI and ADX is equal to or greater than 25, then the trend
is considered bullish. Conversely, if the +DI is less than -DI and ADX is equal to or greater than
25, then the trend is considered bearish.
Relative Strength Index
The Relative Strength Index (RSI) is a popular overbought/oversold indicator. RSI is an internal
strength index which is adjusted on a daily basis by the amount by which the market rose or fell. A high RSI occurs when the market has been rallying sharply and a low RSI occurs when the market has been selling off sharply. The RSI is expressed as a percentage, and ranges from zero to 100%. The calculation of RSI may be obtained from Equity Analytics, Ltd. (see note 4) at http://www.e-analytics.com/rsi.htm One characteristic of the RSI is that it moves slower when it is far from the extremes of very overbought or oversold. RSI treats price as if it were a rubber band. It can be stretched so far and then it snaps back very quickly when the market reverses and
returns to a "neutral level" relatively quickly and starts a new trend. It "freshens" quickly.
An RSI of about 75 indicates "sell" an RSI of about 25 indicates "buy."
Notes:
1) http://william-king.www.drexel.edu/top/prin/txt/Intro/Keynes.html a biography of Keynes
2) http://www.stomaster.com StoMaster An incredibly detailed look at the technical analysis of the 30-year bond. In addition to learning about the 30-year Treasury bond you will expand your vocabulary.
3) http://www.barchart.com MRI, a subscription based service with technical data on more commodities than I ever knew existed.
