1978, Welles Wilder published a book named New Concepts in Technical Trading Systems. In this book, he introduced four indicators to readers, including Average True Range, Relative Strength Index(RSI), Directional Movement Concept(ADX) and Parabolic SAR. Despite being developed many years ago, I am still surprised by their rigorous logics and practicality recent days.
1. Average True Range (ATR)
1.1 Calculation
parameter: period = 14
TR = max(current High - current Low, current High - previous Close, current Low - previous Close)
Current ATR = ([(Prior ATR)*13] + current ATR)/14
1.2 Features
ATR is not a directional indicator, it just measures volatility that reflects the degree of interest or disinterest in a move. A bullish reversal with an increase in ATR would show strong buying pressure and reinforce the reversal. A bearish support break with an increase in ATR would show strong selling pressure and reinforce the support break.
ATR is absolute, not relative, high priced securities generally have higher ATR values, low priced securities generally have lower ATR values.
1.3 Usage
Usage 1
as stop value
Usage 2
the width of BB < a, ATR > m, buy
the width of BB > b, ATR < n, sell
2. Relative Strength Index (RSI)
2.1 Calculation
parameter: period = 14
RSI = 100 - 100/(1+RS)
RS = Average Gain / Average Loss
First Average Gain = Sum of Gains over the past periods / 14
First Average Loss = Sum of Losses over the past periods / 14
Average Gain = [(pervious Average Gain)*13 + current Gain] / 14
Average Loss = [(pervious Average Loss)*13 + current Loss] / 14
2.2 Features
RSI is a momentum oscillator that measures the speed and change of price movements. It is relative, can be compared among different securities. RSI oscillates between zero and 100. Traditionally, it’s considered overbought when above 70 and oversold below 30.
Signals can also be generated by looking for divergences, failure swings and centerline crossovers. RSI can also be used to identify the general trend.
Divergence and Positive-negative Reversal
Divergences means that directional momentum does not confirm price. A bearish divergence occurs when the underlying security makes a higher high and RSI forms a lower high. A bullish divergence occurs when the underlying security makes a lower low and RSI forms a higher low.
A negative Reversal occurs when the underlying security makes a lower high and RSI forms a higher high.
A positive Reversal occurs when the underlying security makes a higher low and RSI forms a lower low.
Divergences are misleading in a strong trend.
Failure Swing
It’s like double or three bottom reversal at RSI.
It’s like double or three top reversal at RSI.
Trade ID
Support in Bull market: RSI between 40 to 50
Resistance in Bear market: RSI between 50-60
2.3 Usage
Usage 1
ADX < 30, oversold, buy
ADX < 30, overbought, sell
Usage 2
ADX > 70, RSI cross over 60, buy
ADX > 70, RSI cross below 40, sell
Usage 3
shorter RSI > longer RSI, shorter RSI < 30, buy
shorter RSI < longer RSI, shorter RSI >70, sell
3. Directional Movement (ADX)
3.1 Calculation
parameter: period = 14
1. Calculate True Range (TR), Plus Directional Movement (+DM), Minus Directional Movement (-DM)
2. Calculate the sum of TR, +DM, -DM of the period. (TR14, +DM14, -DM14)
3. 14-day Plus Directional Indicator (+DI14) = TR14/+DM14
4. 14-day Plus Directional Indicator (+DI14) = TR14/-DM14
5. DX = diff(+DI14, -DI14) / sum(+DI14, -DI14)
6. current ADX = ((previous ADX)*13 + current DX) / 14
3.2 Features
+DI, -DI determine the direction of the trend, ADX determine the strength of the trend.
ADX < 20, non-trending
20 < ADX < 50, trending
ADX > 50, strong trending
3.3 Usage
Usage 1
ADX > 20, +DI cross above -DI, buy
ADX > 20, -DI cross above +DI, sell
4. Parabolic SAR
4.1 Calculation
Rising SAR
parameter:(acceleration factor (AF): first AF, max AF, step)
EP: The highest high of the current uptrend
AF: starting at 0.02, increased by 0.02 each time the EP makes a new high, the maximum is 0.2
first SAR = low in period (eg. 4 ticks)
SAR(n) = SAR(n-1) + AF(n-1)*(EP(n-1) - SAR(n-1))
SAR = min[SAR(n), LL(n), LL(n-1)]
If close price is lower than SAR, trend becomes falling, start to calculate Falling SAR
Falling SAR
parameter:(acceleration factor (AF): first AF, max AF, step)
EP: the lowest low of the current uptrend
AF: starting at 0.02, increased by 0.02 each time the EP makes a new low, the maximum is 0.2
first SAR = high in period (eg. 4 ticks)
SAR(n) = SAR(n-1) + AF(n-1)*(EP(n-1) - SAR(n-1))
SAR = max[SAR(n), HH(n), HH(n-1)]
If close price is higher than SAR, trend becomes rising, start to calculate Falling SAR
4.2 Features
SAR stands for ‘stop and reverse’, it trails price as the trend extends over time. The indicator is below prices when prices are rising and above prices when prices are falling. It can protects profits.
AF:
Step Increments: SAR sensitivity can be decreased by decreasing the Step. SAR sensitivity can be increased by increasing the step. The indicator will reverse too often if the step is set too high. This will produce whipsaws and fail to capture the trend.
Maximum Step: lower max step = less sensitivity, higher max step = more sensitivity and more reversals.
The Parabolic SAR works best with trending securities, Each security should be evaluated based on its own characteristics.
4.3 Usage
Usage 1
ADX >30, falling SAR -> rising SAR, buy
ADX >30, rising SAR -> falling SAR, sell
Reference:
All example pictures are from CHARTSCHOOL.