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A study is an indicator that "oscillates" above and below a centerline or between set levels. Most studies can remain at extreme levels (overbought or oversold) for extended periods but do not trend for a sustained period. By contrast, a cumulative indicator like On-Balance-Volume (OBV) does trend.
There are many types of studies, some of which belong to more than one category. The breakdown of study types begins with two types:
Centered studies fluctuate above and below a center line, typically zero. Centered studies help identify the strength and direction of a move. A centered study's momentum is bullish when its line is above zero and rising, and bearish when it is below zero and falling. MACD is a centered study.
MACD is the difference between the two exponential moving averages, one shorter than the other. The farther one moving average moves away from the other, the greater the momentum. MACD is unique in that uses two lagging indicators to create a leading indicator. Moving averages are lagging indicators. Plotting the differences between the moving averages over time renders the rate-of-change. This rate-of-change calculation makes MACD a leading indicator.
The Moving Average Oscillator is another centered study.
Banded studies fluctuate between two values, typically 0 and 100. Within this range are overbought and oversold levels. The lower band represents oversold readings and the upper band represents overbought readings. These levels vary from study to study. For example, for RSI, the overbought and oversold levels are traditionally considered to be 70 and 30, respectively. Similarly, the Slow Stochastic uses 80 as the overbought level and 20 as oversold. Even though these levels were defined by the Wilder and Lane, many have adopted alternate levels to better suit particular instrument types.
Some banded studies are not bound by upper and lower limits. The RSI and Slow Stochastic are range-bound. Neither can generate a value less than 0, nor greater than 100. By contrast, the Commodity Channel Index (CCI) is a banded study that is not range bound.
Study Signals
Studies generate buy and sell signals in a variety of ways. Some studies generate early signals, while others generate signals after a trend has commenced. Some studies can foretell impending change. Given this signal variety, it is important to develop a system of confirmation. All indicators are designed to measure a specific characteristic of an instrument price or volume. Volume analysis, Trend analysis, Candlestick patterns, and support/resistance levels are all candidates for confirmation. Combine the analyses that best suit your needs.
Divergence is a key concept in reading centered studies. Divergence can signal trend change, or give a buy or sell signal. Divergence is either positive and negative. Positive divergence occurs when an study's values increase as the subject instrument's prices decrease. A negative divergence occurs when an indicator declines and the subject instrument advances.
Banded studies are designed to identify overbought and oversold extremes. Since banded studies fluctuate between extremes, they are best used to evaluate instruments that are not trending. In a strong trend, invalid signals may result.
To use a banded studies, you must know the proper values for the upper and lower bands. Given traditional settings, when RSI is below 30 or the Slow Stochastic is below 20, an oversold condition exists, and when RSI is above 70 and the Slow Stochastic is above 80, an overbought condition exists. Overbought/oversold identification should signal you to look for confirmation in other indicators.
Another way to identify signals using a banded study is to note when the upper and lower bands are crossed. If an instrument is overbought and moves back down below the upper band, a sell signal is generated. If an instrument is oversold and moves above the lower band, a buy signal is generated.
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