Day Trading Simulator - Learn How to Trade | Tradingsim.com
TradingSim accelerates the steep learning curve of becoming a consistently profitable trader by allowing you to replay the market as if you were trading live today, for any day from the last 2 years – it’s really a trading time machine. Practice day trading or swing trading over 11,000 Nasdaq, NYSE and AMEX stocks without risking your shirt? Learn with the best stock simulator on the web.
As the number of online brokerages continues to increase at a steady pace and the competition gets fiercer, traders are often targeted with offers ranging from "commission free trading" to "as low as $4,99" brokerage fee advertisements.
For traders who are starting with a low capital, brokerage fee plays an important role. At the same time, traders who have been trading for a considerable amount of time need to also reevaluate their trading conditions to see if they are getting the best deal possible.
Brokerage fees, trading commissions, call it whatever you want. They exist because of the service that is provided by the brokerage.
When you buy or sell a product from a vendor, you will no doubt pay some commissions on the original price. In the world of financial investments such as stocks, bonds, futures, commissions play an important role and are unavoidable at any cost.
When you transact with your broker, you pay a fee to the broker for giving you this service. There is no way to avoid this, unless you get a seat directly at the trading pit, which is usually out of reach for the average retail investor.
Trading commissions can play a big role in determining your profit and loss. They can reduce your profits, and they can also increase your losses. The inclusion of trading fees is important as it impacts your profit and loss statement which has its own tax ramifications.
Trading fees are usually included into your trading as part of the total cost of the transaction. This is true not just when you trade a financial product but in almost every day purchases. Trading fees, depending on the jurisdiction and the local tax laws can be excluded from the final tax that one might have to pay.
For the average retail trader, understanding the trading costs upfront can be very beneficial not just in their trading but also in terms of the resulting taxes on the profits as well as in managing their trading capital.
Why do brokerages have different trading commissions?
One thing that traders might notice is that the trading fees or commissions vary from one brokerage to another. You will also find that the trading fee differs from one financial product to another. These differences in the trading fees of course contribute to the broader confusion, especially among new traders.
Different brokerages have different trading fees or commissions for a number of reasons.
For starters, brokerages that offer low commissions are the ones that enjoy a higher volume of transactions. Typically in the retail trading business, brokerages can enjoy lower transaction fees when they generate higher volume of business for the exchange.
You can also expect to see lower trading fees for brokerage whose only job is to execute or relay your orders to the main market. The moment the brokerage brings in additional services, you can expect to see the trading commissions and fees start to grow accordingly.
Secondly, the online brokerages don't just charge a trading commission fee, but also other hidden fees. These can be account maintenance fee, account inactivity fees, transaction fees on deposits and withdrawals and so on.
Different types of retail trading brokerages
The trading fee or commissions charged by a broker, depends on the type of business and the services that is provided.
Most of the online retail brokerage firms can be classified into one of the three categories.
Full service brokerage: A full service broker firm sits on the top of the ladder. These are firms that offer complete investment or managed funds services. Such brokerage firms tend to have full-fledged team of researchers and offer value added services such as giving trade recommendation to the clients as well as managing money for high net worth individuals.
Needless to say, such full service brokerage firms charge huge fees. Due to the nature of the clientele, the full service brokerage firms have a higher level of entry requirements to open an account with them.
On top of this restriction, these firms charge additional fees such as annual fees and levy a percentage of the transactions as trading commissions.
Online brokerage: The online brokerage service sits in the middle and is often seen as offering a mix of services that clients can pick and choose. Investors who are savvy about the markets can use an online brokerage firm only to relay their orders, while some might opt for even choosing for a full service type of recommendation.
An online brokerage firm typically manages their services and business completely via the Internet. Of course the brokerage firms need to be regulated no doubt but offers a better value for money on the service that is provided.
An online brokerage usually has additional fees such as account maintenance fees and so on on top of the transaction fees made per trade.
Discount brokerage: A discount brokerage firm is the cheapest of the three and is most affordable for retail traders. Although despite being advertised as cheap, traders should read the fine print.
Many discount brokerage firms will advertise the cheap transaction fees provided that the trader meets a monthly trading volume. The discount brokerage firms do not offer any other additional benefits and is purely for trading purposes only.
In most cases, the discount brokerage also does not charge any maintenance fee or other costs, but again this is dependent on the trading volumes. While it might seem cheaper, traders should opt for this only when they know that they can match the required trading volumes.
Such type of brokerages are ideal for day traders as they can trade in higher volumes, compared to traditional buy and hold investors whose trading volumes are comparatively lower.
What are the types of trading commissions and fees you can expect
A brokerage firm will typically have two types of fees that they will charge; trading fees and non-trading fees.
Types of trading fees (Fixed, percentage, tiered)
Trading fees, as the name suggests are associated with the trading aspect of the business. Here, the charges applied are of three types.
Fixed or flat fee: A fixed or flat fee charges you a flat rate every time you trade, be it trading just 1 share or 100 shares of the same stock. Under the fixed fee structure, you will have to pay for both buying and selling (opening the trade and closing the trade). So, if you see a fixed fee of $4.95, this means that you pay $4.95 for buying and you will pay $4.95 when you sell or close that trade.
Floating or percentage fee: Under this scheme, the brokerage will charge a percentage of the trading volume as commissions. This is typically applied to high end brokers. A typical floating fee would be in the form of the brokerage charging 0.5% on the value of the trade.
For example, if you bought 100 shares for a stock that is trading at $10, your value of the trade is $1000 (100 shares x $10). Thus, the brokerage’s trading fee at 0.5% will be $5.
From the above two examples you can see that the fees between the two types are nearly the same. But when you scale up your trading activity you can find a big difference.
Let’s take an example where a trader makes 5 trades during a month.
Example - Trading fees difference between flat and percentage based
In the above table you can see that the flat fee amounts to a total of $49.6 for all the transactions. On the other hand, the percentage based fee is significantly higher at $2,272.5. So at the first glance, one can see that the flat or fixed rate is better.
But look at row 2. Here, when a trade is made for just one share at $5, the flat fee comes to a total of $9.90. On the other hand, the percentage based fee charges just $2.50.
Tiered fee: A tiered fee is charged based on the number of trades a trade makes. Usually, under this model, the more number of trades a trade makes, the lower their costs become. For example, you might be charged $4.95 on the first 100 trades, $4.50 on the next 100 and so on.
Example of tired commission fees
Depending on the broker in question, the tiered rate is applied or adjusted on a monthly basis. In this scheme, traders can expect to see lower fee applied on all the trades. Contrary to the above example, if your monthly volume was 200, then you would be applied a total tiered fee of $4.50 on the all the 200 trades instead of being charged $4.95 on the first 100 and then $4.50 on the next 100.
Among the above, the tiered commission is probably the best choice for day traders who prefer to trade in the short term. On the other hand, traders with a buy and hold type of approach and who have a lower number of transactions will of course find the flat fee a better option.
Non trading fees include a number of charges and these fees basically depend on the broker. Some of the commonly applied non-trading fees include:
Account maintenance fee: This is usually charged once per quarter or a year
Account inactivity fee: These fees are charged when your account is dormant over a specified period of time
Data feed/Charting platform fee: If you opt for pricing data feed from the broker or a charting platform, you will be charged a fee on these services
Miscellaneous fees: Other miscellaneous fees include phone brokerage services, account statement requests and so on.
Understanding trading commissions
Understanding the costs associated with trading is no rocket science and traders who spend some time browsing through the brokerage’s website can quickly understand the full costs involved. Below are some key points that traders should bear in mind.
Trading commissions changes from one product to another
Do not expect uniform pricing. Trading fees changes depending on what you are trading. For example, a broker might charge you a flat rate of $4.95. This means that whether you buy 10 shares or 100, you pay a flat rate of $4.95 when you buy (and pay $4.95 when you sell those shares).
Example: You bought 100 shares in AAPL, at a rate of $100. Your transaction cost will be $4.95.
Your total cost will be 100 shares x $100 = $10,000 + $4.95
You now sell the 100 shares at $110. Your total profit will be 100 shares x $110 = $11,000 + $4.95
After deducting the fees ($9.90), your net profit will be $11,000 – $10,000 + $4.95 + $4.95 = $990.10
On the other hand, if you were trading options, you would be charged on average a few cents + a base rate. And finally for futures trading, the fees will be a fixed flat fee for 1 contract.
Example: The trading fee is $5/contract for trading the ES futures. So, when you buy 2 contracts, your fee increases to $10.
Trading fees change not just from futures to stocks or options, but also within the market itself. For example, you will get two different pricings when you trade stocks above $10 and below $10. Likewise, in futures trading you will get different trading commissions when you trade index futures and different fees when you trade commodity futures.
Role of Fintech in lowering trading fees
Fintech Stock Trading firms disrupting traditional models of trading commissions -fees
With the advent of various Fintech firms, the trading landscape has become even more competitive. Firms such as equities.com for example have begun to offer a flat monthly fee of $29.95, with no commissions and no hidden fees.
Other examples include, Motif Investing which offers a flat rate of $9.95 to trade up to 30 stocks or even a monthly subscription based service that eliminates any fees or commissions on the trade.
Robinhood, which is another Fintech firm, charges absolutely no fees when you trade U.S. equities. With more and more such Fintech firms coming up, there is a very high likelihood that retail traders will soon be able to see lower if not no costs to trading in the near future.
In conclusion, trading costs are an important aspect of trading that retail traders need to focus on as it affects not just the capital that they trade with but also the bottom line profit or loss and the resulting taxes on the profits one makes.
In order to find out the best costs, traders need to focus on factors such as the number of trades they make per month and the type of markets that they trade which can then enable them to choose the right brokerage that offers traders the best conditions for trading fees.
Bonds and U.S. Treasuries are a unique asset class that finds its way into an investor's portfolio in most of the cases. Widely known as a good diversification, bonds often come to the rescue of one's portfolio when the stock markets go downhill.
Unless one follows a very aggressive investing strategy, bonds which are slower to move in comparison to the equities come with a certain level of safety as well, which gives the bonds and Treasuries the nick name as being a "safe haven" asset.
Despite the simplicity, there is a lot more to investing in a few treasuries or bonds than what it seems. The type of diversification you seek and the eventual protection or hedge you get as a result depends a lot on the type of bonds or treasuries that you own or invest in.
At the end of the day, each asset class is unique and all of them offer a different level of risk and the potential returns you can expect. This balance between the risk and the return will depend on what asset you choose.
The quilt chart below, courtesy of PIMCO gives a quick glimpse into the different types of sectors one can invest in with bonds and you can also see how the returns vary depending on the sector. The type of sector that you choose will depend on your expectations however.
Different bond sectors and their returns (Source - PIMCO)
Do you want to use Treasuries and bonds just to offset the losses from a bear market? Do you want to use this asset class as a way to earn steady income? The way you answer these questions will determine in which type of bond you will choose.
Are bonds and treasuries more risky than stocks?
Investing in bonds or treasuries is actually less risky than investing in stocks. This is because bonds come with the promise from the issuer to return the face value of the bond or the treasury after the term matures.
What this means for investors is that if they buy a treasury worth $1000 for a 10-year term, they can rest assured that they will get back the $1000 at the end of ten years. Between now and then, treasury investors also get paid what is called as a coupon rate which is the interest one gets for buying the bond or treasury.
Of course, if one factors inflation and other aspects, it can be a completely different story, but sticking to the main theme, treasuries and bonds offer some kind of security which is missing with stocks.
For example, if you invested $1000 in stocks, purchasing shares of one company or even diversified it into buying shares from three or more companies and held your investment for 10 years, chances that either you will make a very good return on your investment, or you could end up losing your investment if the company went bankrupt.
Therefore, in stocks, investors take a risk for which they are rewarded accordingly. Whereas with Treasuries and bonds, the risks are much lesser, thus the returns are also less.
What are Treasuries and Bonds?
Bonds can be issued by just about anyone; from sovereign nations to corporations and even local municipals. Although there is a saying that all bonds are risk free, the truth is that not all bonds or treasuries that you buy are risk free.
Another important distinction to make here is the terminology. While bonds and treasuries can be used interchangeably, the term treasuries are applied only to the longer dated bonds and ones that are issued by the U.S. Department of Treasury only.
Thus, while most bonds in general, such as sovereign, municipal and corporate bonds are at risk of a credit or an institutional default, the treasury bonds are not, as they are backed by the "full faith and credit" of the U.S. government.
This risk is also known as the default risk in bond market terminology, which determines the risk of a potential default from the issuer. Based on this default risk, the markets also price the bond yields (and prices) accordingly.
The 10-year yield on the Greek bonds shown below is one such example where the yields rallied to a whopping 36% in the height of the Greek debt crisis which put the country on a risk of a default on its bonds.
Greece 10-year bond yields (36% interest demanded by bond investors)
This seemingly simple aspect is what makes Treasuries stand out among all the types of bonds.
As mentioned earlier in this article, that the level of diversification one needs will depend on the type of bonds or treasuries that one invests it, it is exactly the point that the diversification will change when one invests in a corporate bond versus a 10-year treasury note.
Why invest in bonds or treasuries at all?
Given the fact that Treasuries in particular are backed by the full faith and credit of the U.S. government, the returns one can expect from these assets are very less.
Thus, a common question that is asked is why bother investing in treasuries when they yield very little. The fact is that with the stock markets which are relatively riskier than bonds, the returns are also higher.
This increases the risk of market corrections that can at times come unannounced. Therefore, investors need to look at diversifying their portfolio with an asset class that could offset a bear market in the equities.
This is where the relatively low yielding treasuries come into play as they can help to balance out the losses one might incur during a bear market.
How can treasuries help you to offset losses from a bear market?
With bonds and treasuries, there are two variables in play. The price of the bond or the treasury itself, known as the face value and the coupon rate or the yield which is the interest earned every year for buying the bond or the treasury.
The bond prices and the yields therefore have an inverse relationship.
Because bonds are safe haven assets, investors tend to sell bonds and invest their money in the riskier stock markets which can give higher rate of returns. Therefore when the bonds or treasuries are sold, the prices fall, making the yields more attractive.
Similarly, when the equities are in a bear market, investors tend to sell the stocks and purchase bonds and treasuries. In this scenario, as demand for treasuries or bonds increases, the yields fall.
You can now see that when stocks rally (equities are in a bull market), bond prices fall and when stocks are in a bear market, the bonds and treasuries prices rise.
Is buying treasury ETFs same as buying Treasuries?
An important distinction to make here is that buying Treasury ETFs is not the same as buying Treasuries. The Treasury ETFs are structured in a way that the fund tracks an index of bonds and replicates those returns. Despite the fact that the Treasury ETFs tracks the said portfolio of treasury bonds, they trade on a stock exchange giving them a similarity to trading equities.
One of the biggest differing factors trading a Treasury ETF is that they do not expire or mature. While individual bonds or treasuries have a fixed period maturity, treasury ETFs do not as they have a constant maturity. This constant maturity is based on the weighted average of all the maturities in the bonds that the treasury ETF tracks.
At any point in time, a treasury ETF will have bonds or treasuries that are expiring or reaching maturity. Therefore, treasury ETFs constantly rebalance by purchasing new bonds or treasuries.
While treasury ETFs might be a good way to offset the market decline, they also come with the additional benefit of paying out a fixed income. In most cases, treasury ETFs pay out fixed monthly income due to the nature of the bonds and treasuries that they track.
What are some of the most popular Treasury ETFs?
Among the different Treasury ETFs here are the top three, based on factors such as the assets under management (AUM) and the expense ratio.
1. iShares 1-3 Year Treasury Bond ETF (SHY)
SHY - 5-yr Returns - 0.23 percent
The iShares, 3-7 Year Treasury Bond ETF, (SHY) focuses on the short term Treasuries and has an expense ratio of 0.15% with total assets under management worth $11.044 million. Among the different types of treasury ETFs, the SHY is the most popular due to the short term maturity curve.
The SHY focuses on treasury with less than three years to maturity and therefore offers a balanced risk between interest rate risk and credit risk. SHY is considered to be a safe haven given that the returns are relatively low.
2. iShares 3-7 Year Treasury Bond ETF (IEI)
IEI - 5-yr Returns - 1.05 percent
The iShares 3-7 Year Treasury Bond ETF, IEI has an expense ratio of 0.15% with assets under management worth $6.650 million. The IEI ETF allows investors exposure to the three - seven year maturing Treasuries with little risk of interest rate hike. The IEI also delivers higher returns and overall offers a good cost perspective for investors.
3. iShares 20+ Year Treasury Bond ETF (TLT)
TLT - 5-yr Returns - 0.03 percent
The iShares 20+ Year Treasury Bond ETF, TLT has an expense ratio of 0.15% with over $6.313 million assets under management. TLT is ideal for investors who want exposure to the longer date Treasuries. TLT is also cost efficient and comes with good liquidity and has full exposure to the U.S. Federal debt.
While there are many more different types of Treasury ETFs the above three offers investors a choice into gaining exposure on the different maturity treasuries which can in return offer a varied level of protection against a declining stock market, while also ensuring that the credit and interest rate risks are properly balanced.
How to use Treasuries in a bear market
Investors who want protection against their portfolio exposure to the equity markets will find that investing in treasuries is a good option. However, this asset allocation needs to be done from the start and not just before one begins to smell a bear market.
There are many different ways to invest in Treasuries. The simplest method is to purchase the Treasuries directly. However, buying or selling can be a bit slow, which brings us to the next alternative, which is to look at the Treasury ETFs. Other examples can also include purchasing Treasury futures as well.
The main benefit of purchasing treasury ETFs is the fact that the markets are liquid enough for traders to enter and exit the market whenever they please. Furthermore, buying and selling treasury ETFs are somewhat similar to buying and selling stocks or equity based ETFs.
In conclusion, treasury ETFs allow traders an easy way to allocate their trading capital. Given the way the Treasury ETFs are structured, investors can easily buy and sell such ETFs as if they were buying and selling stock.
Treasury ETFs gives trader the convenience of price discovery, liquidity and the additional advantage of paying fixed income besides serving as a good hedging tool against a declining stock market. While Treasury or bond ETFs has some strong advantages, there are some factors to bear in mind as well.
Unlike buying treasuries directly where the face value is guaranteed, with Treasury ETFs this is not the case. In other words, when you buy Treasury ETFs there is no guarantee that you will get back your investment amount.
This is because Treasury ETFs are a proxy. Furthermore the fact that there is bon maturity with Treasury ETFs means that investors do not get the same level of protection as someone who directly purchases the Treasuries or the bonds.
Last but not the least, while Treasury ETFs might be a good bet against falling markets, they do suffer under higher interest rate regime which can pull down the value of bonds.
Despite the shortcomings, Treasury ETFs are a good way for investors to build a diversified portfolio that can easily protect their investments against uncertain market conditions. While buying bonds and treasuries outright is a good investment in itself, as far as stock market investors as concerned, Treasury ETFs are a great place to start hedging the risks.
Compound returns or compounding is probably one of the most powerful concepts in the world of financial investing. Compounding is often dubbed as the eighth wonder of the world, at least as far as the investment world is concerned.
Compound interest as it is called mathematically is deceptively simple, to the point that Albert Einstein called it the greatest discovery of all time in mathematics. Einstein further went on to say that the people who understand compound interest can earn it, while the ones who do not understand end up paying it.
There are basically three variables or inputs that one needs to be concerned with when it comes to compounding and these three variables are of course the most important when it comes to determining your returns.
Despite being praised by mathematicians and the financial community at large, interest on loans was largely shunned by many of the world’s largest cultures and religions. Referred to as usury, which is the act of lending at interest or excessive interest; the concept of interest (and thus by definition simple and compound interest) managed to survive the age of time.
Today, compound interest and financial investments go hand in hand and is often used as the one of the most widely used metrics in the world of investing. While compounding can clearly magnify the returns on an investment, it can also equally magnify the liabilities when you take out a loan that is based on the compound interest.
Understanding simple and compound interest
When talking about compound interest, it is always best to understand simple interest in order to truly realize the power of compounding.
So what is simple interest?
Simple interest is where you get a percentage (or the interest) on your investment paid to you after a fixed period of time, usually one year.
Compound interest on the other hand reinvests the interest received at the end of every year or a certain period and increases your capital which in turn increases the interest you earn the following year.
For example, if you invested $1000 into a one year fixed deposit with an annual interest rate of 5%. At the end of the one year, you would have $1050, where $50 is the interest earned.
This $50 is nothing but 5% of the investment of $1000 that you made. This is simple interest at work.
Now, if you had the same option as above, but opted for a 2 year fixed deposit term, let's see two ways you can make money.
In the first option, you invest $1000 at 5% annual interest rate. Therefore, at the end of the first year you make $50 on your investment. Now you invest back the capital of $1000 and by the end of second year, you again make $50.
Therefore, with simple interest, you make a total profit of $100 in the two year period.
Taking the same example, let's see how returns are different when you opt for compound interest.
At the end of the first year, you make $50 interest. But instead of withdrawing this interest, you reinvest it back for the second year along with your initial investment of $1000.
So for the second year, you have invested $1050. Now, at 5% annual interest rate, your investment would be $1102.5. Here $1000 was your initial investment and your profits were $102.5.
When you compare the simple interest and the compound interest, you can see that with compounding you made an additional $2.50. As the number of years grows at the same annual interest rate, but with compounded returns, you can expect your returns to also increase significantly as compared to simple interest.
Simple Interest vs Compound Interest
The above picture gives a visual explanation between the simple interest and the compound interest. The above example shows that while the interest rate of 10% was applied to both, with simple interest, the $10 interest was paid every year.
On the other hand, with compound interest, the interest from the previous year is added back to the capital, thus increasing the interest for the next year. By compounding at the same 10% interest, you can see that by year 3, compound interest had an interest if $12.10 instead of $10 when the investment started.
What is compounding?
Compounding is simply a process of making more returns on an investment by re-investing the earnings on the investment. In other words, compound interest is when the interest that is accrued beings to accrue interest on itself.
It might seem complicated to understand but very simple in concept. For compound interest to work, there three things required, which are the reinvestment of the earnings and the period of time and the third variable which is the rate of return.
Compound interest helps investors or savers to grow their investments exponentially and is particularly advantageous to young investors as time is the greatest variable that works in their favor.
Mathematically, compound interest or the compounded return is the rate of return expressed as a percentage. The compound interest reflects the cumulative effect a series of profits or losses have on the original investment amount over a period of time.
The compound interest, which is reported as a percentage refers to the annualized rate of return at which the invested capital has compounded over the period of time.
The formula for annual compound interest is as follows:
Annual compound interest = the future value of the investment including interest
P = Principal amount (initial deposit or initial investment)
r = annual interest rate in decimal (ex: 5% annual interest rate will be expressed as 5/100 or 0.05)
n = the number of times the interest is compounded every year
t = the number of years or duration of the investment
A simpler version of the above formula is also read as:
In this example the interest is compounded once per period.
For example, if you had an amount of $1000 in a fixed deposit account that has an annual interest rate of 5% compounded yearly, then the value of the investment after a period of 5 years would be calculated as:
P = 1000
r = 5% or 5/100 = 0.05
n = 1
t = 5
1000 (1 + 0.05/1)^(1 * 5)
1000 x 1.276281 = 1276.28
This value of $1276.28 can also be reached via the simpler formula where the interest is compounded once per period only.
Compound interest, when expressed in annualized terms is referred as the Compound Annual Growth Rate or CAGR for short.
The CAGR represents the annual growth rate of the investment over a period of time. CAGR is derived by dividing the value of the investment at the end of the period by the value of the investment at the start.
The result is raised to the power of one divided by the period of time and the resulting amount is subtracted by one.
Mathematically, CAGR is calculated as:
Fi = Final value of investment
Oi = Original value of investment
t = period of time
If we go back to the example from the previous section, we can calculate the CAGR.
Original value of investment was $1000; Final value of investment was $1276.28; Period was 5 years
Therefore, CAGR would be [(1276.28/1000)^(1/5)] -1
= [1.27628^0.2] – 1
= 1.05 – 1
= 0.05 or 5%
Therefore, the compounded annual growth rate or CAGR for the investment over the 5 year period is 5%.
Understanding the power of compounding
The best way to understand the power of compounding is by means of an example shown below.
Compound interest examples with two variations
The left side of the table shows an initial investment of $1000 made into a fund that gives a 1% annual return. The interest from the first year's investment is reinvested back into the second year and so on.
As you can see in the above table over a period of time, the interest accrued in the earlier years also starts to contribute to the capital thus exponentially increasing the returns by the end of the 5-year term.
On the right side of the table, the same example is shown but with the investor adding an steady $1000 every year. Taking the compounding factor into question, this time the returns generated are even higher.
What the above table illustrates is two key points, which is time and the amount of investment that is made, which when compounded can greatly increase the returns.
What are the benefits of compounding in finance and investing?
Interest rates play a major role for any type of investing. After all, the interest rates set the central bank become the benchmark for just about anything, from investments to debt. Therefore, it is safe to assume that interest rates are central to investing.
The accumulation of investing is a major concern, both for lenders and investors at the same time. Interest can play a dual role as it can be beneficial to one's investment but at the same time it can also end up eating into one's investments.
Compounding can play a big role in certain types of investments where the investor gets regular payouts such as dividends or interest on bonds that are held. When done correctly, such type of investments through the power of compounding can help investors to quickly scale up their investments.
As a rough comparison, if you invested $10,000 in a dividend paying stock with an average annual return of 12% which includes both the appreciation of the stock price and the dividend payments, the result would be $96,462 at the end of 20 years.
dividend investing vs non-dividend investing
On the same note, if you invested $10,000 in a non-dividend paying stock with the same annual return, it would have given a total return of $56,044, close to half of the amount one would have earned if they had invested in a dividend paying stock.
The above chart compares both the values. As you can see, the power of compounding clearly stands out in certain cases of investments.
What investments are best for utilizing compounded returns?
Besides dividends, a classic case of compounding the returns is applicable with bank deposits such as on savings accounts or fixed term deposit accounts and as well as certificates of deposits.
For investors who are holding bonds, the annual or bi-annual interest payments can be reinvested in purchasing other bonds or reinvesting the money into other forms of investments. There are also some specific types of bonds such as the zero coupon bonds which automatically include compounded returns.
Here, the only trade off is that you do not get the interest payments but you receive the face value of the bond and additionally the compounded interest at maturity.
Even for regular stock investors who do not necessarily focus on dividend paying stocks, the annual rate of return can be used to calculate how one can compound their profits over a period of time.
As shown in this article, compound interest is something that investors need to take time to thoroughly understand as it helps not just from an investing point of view but also helps to understand when one is taking out any loan, be it a short term personal loan or a mortgage loan.
When one understands the true power of compounding it can help investors to pick the right investing instruments and also have a firm plan through which they can expect to increase their returns significantly over a period of time.
However, as with most things, one of the key aspects to successful investing with compounding is the time itself. Compounding can be very powerful when an investor starts young as it can help them to build a significant amount of returns by the time one reaches retirement or a certain goal in life.
The key to compounding is of course saving and reinvesting the profits made from the investment in question. Thus, for those investors who have started investing at a later stage, it would be difficult to truly take advantage of the power of compounding.
Arms Index is a volume based technical indicator used by technical analysts for forecasting price. The indicator is a useful tool designed to trade stocks. The Arms Index was developed by Richard Arms in the 1960’s but it also commonly referred to as the TRIN, which stands for Trading Index.
The TRIN or Arms index determines the strength of the market by taking into account the relationship between the advance and decline indicator and the respective volume. The Arms index simply measures the intraday strength of the market and is ideally used for the short term markets, thus making the Arms index or TRIN as a perfect tool to day trade stocks more than any other market.
Stock market day traders have been using the Arms index or TRIN to trade the broader market as well as trading individual stocks based on the signals from the Arms index. In theory the principle being that when there is broad stock market strength, most stocks also move in the same direction.
In this article, you will learn about the Arms Index or the TRIN indicator and how you can day trade stocks using the Arms index.
What is the Arms Index (TRIN)?
The Arms Index or TRIN is a technical analysis tool. It compares the advancing and declining stocks and compares their respective volumes. This helps traders to identify the overall sentiment in the markets.
The Arms Index achieves this by comparing the relationship between the supply and demand. In the short term, such as day trading the Arms Index is ideal to predict the future price movements of the stock thus making it a valuable tool among stock market day traders
The Arms index doesn’t just show the overall market sentiment. The indicator can also offer dynamic views of the overall movements in the values of the stock exchanges as well, such as the NYSE and the NASDAQ exchanges for example. This is achieved by comparing the strength and breadth of the market movements in the respective exchanges.
For all the complexity involved, the Arms Index or the TRIN indicator is very simple. This technical analysis indicator fluctuates around the zero-line with a value of 1.0. Depending on where the TRIN indicator is relative to the zero-line, the market can be viewed as being either overbought or oversold.
In a way, the TRIN indicator or the Arms index works similar to just about any oscillator that moves around fixed values and signals the overbought and oversold conditions.
One of the most important aspect of the TRIN indicator or the Arms index is that it not only shows how many stocks are advancing and declining but also supports this data by showing the respective volume which brings additional confidence to the signals.
When the broader market strength or weakness is supported by the respective volume, it can offer some deep insights into the markets for the day trader.
Below is an example of the TRIN indicator or the Arms index applied to the daily chart for AAPL.
Arms Index or TRIN Indicator on AAPL Chart
The TRIN indicator is available in two formats. The TRIN shows data on the NYSE exchange, whereas the TRINQ shows data on the NASDAQ exchange. However, this can change depending on the charting platform a trader uses.
Therefore, when you trade stocks listed on the NYSE, it is ideal to use the TRIN indicator while TRINQ is more helpful when you want to trade stocks listed on the NASDAQ exchange.
The next chart below shows the TRINQ applied to the Nasdaq 100 index to get a better idea on the indicator and its application to the stock chart.
TRINQ and NDX chart
How to calculate the Arms Index (TRIN)?
While it is not important to know the intricate details on how the TRIN index is formed, it is important that a trader knows the basic workings of the indicator so they can better apply it to their trading.
There are four major variables that are crucial for the TRIN indicator and its values to be calculated. There are:
Advancing issues: This is the indicator that shows the number of stocks (in the exchange) that closed higher on the day
Declining issues: This indicator shows the number of stocks (in the exchange) that closed lower on the day.
Advancing volume: This shows the summed up volume of all stocks (in the exchange) that closed higher on the day. Or simply put, the sum of volume of all advancing issues
Declining volume: This shows the summed up volume of all stocks (in the exchange) that closed lower on the day. Or simply put, the sum of volume of all declining issues
The above four parameters are readily available from the exchange and provides adequate data by itself.
Once we have the above values, the TRIN or the Arms Index calculation is very simple.
Another way to put the above calculation is simply by dividing the AD Ratio (Advance/Decline Ratio) by the AD Volume Ratio.
How to read the data from TRIN or Arms Index?
So far we learned that the TRIN indicator or the Arms index is a ratio of the advancing issues and declining issues alongside considering the volumes supporting them. Visually, the Arms index oscillates around the value of 1.0 or the zero-line or the neutral point.
The TRIN or Arms index moves opposite to the advance and declining issues.
When there is a strong up day in the markets (advancing issues are higher than declining issues), the TRIN index falls below 1.0. Likewise, when there is a strong down day in the markets (declining issues are more than advancing issues), the TRIN or Arms index moves above 1.0
There are also times when there are extreme readings on the Arms index or the TRIN. When this happens, the Arms index signals that sentiment in the market is extremely bullish or extremely bearish and indicates that a reversal or a reversion to the mean is on the cards.
Once the TRIN signals these extreme positions, traders can wait for price confirmation and act accordingly.
While the TRIN or the Arms index has a neutral point of 1.0, the extreme values can vary from one exchange to another. Ideally, the extreme values are read as 2.0 which usually signal that the market has formed a short term bottom.
Day trading with the Arms Index (TRIN)
Based on the above information, let’s look at how the TRIN can be used to signal turning points in the markets.
The chart you see below is marked with the key turning points in the market. Here the value of 1.75 is selected.
Arms index (TRIN Indicator) shows turning points in prices
From the above example we can see a lot of observations.
For starters, when the Arms index is above 1.0 (the neutral point) but below 2.0 it signals that stocks are under pressure and that a short term decline is on the cards. This is the time when day traders need to exit their long positions if any, or short sell the stock in question.
Similarly, when the Arms index is below 1.0 it signals buying pressure in the markets and thus, day traders can expect to see a short term reversal in the prices. In such circumstances, short positions are not recommended.
While the TRIN is a good indicator by itself, traders should always use the information in the context of the market trend. Thus, using moving averages or other trend indicators are a great way to trade with the TRIN or the Arms index.
In the above chart there are three instances highlighted where the TRIN signaled a short term correction in prices. On the price chart, the sessions or candlesticks marked by the Red arrow indicate the price action which signals the upside move in prices.
In the first instance, we had a morning star type of candlestick pattern. In the second instance, we had a harami type of candlestick pattern with support taken from the 50 and 200 periods EMA. In the final scenario we had a bullish reversal candlestick pattern after the TRIN indicated a decline.
What’s common to all the above three examples is a three step process.
TRIN signals a correction and price falls accordingly
Price confirms a reversal (which could also be validated by the respective volume of the security being analyzed)
The previous high is breached, signaling a continuation
It is up to the day trader on how they wish to trade thereafter. For starters, day traders can look at exiting after a fixed take profit level, or in some cases depending on the trend, one can continue to add to the positions.
Detecting extreme readings in the Arms Index
One of the drawbacks of the TRIN or the Arms index is that the turning points are not exact. Therefore, instead of focusing on the exact turning point in prices, traders should look at entering the trade when there are a few more validations to the bias.
Sometimes, the Arms Index can also post extreme readings. The next chart below shows the AAPL stock chart with the TRIN index.
Extreme readings in TRIN coincide with sharp reversal in prices
Here you can see in the first instance where the Arms Index posted an extreme reading above 1.75 and below 0.5. These extreme readings usually coincide with sharp reversal in prices.
Trading break outs with the Arms Index
The Arms index can also be used to trade break outs with a reasonable about of consistency. In this day trading strategy, traders can use the Arms Index alongside the Bollinger bands which is a good indicator to measure volatility in prices.
The chart below shows the Arms index with the Bollinger bands. Because the bands are a good measure of volatility, the turning points can be used to position the trader ahead of the volatile breakout, especially during the Bollinger band squeeze which represents a contraction in prices.
TRIN Indicator with Bollinger bands
Traders can use this strategy to take profits for a certain risk/reward set up or use the method to trade into the trend and build a long term position in the markets based off the short term signals given by the TRIN indicator.
Is the Arms Index a good indicator for day trading?
The answer to this depends on how well a trader is familiarized using the Arms index or the TRIN indicator. There are many different ways to day trade with the Arms index than just the methods shown in the above examples.
For one, traders can use the oversold and overbought levels as a confirmation to enter into a trade based on the analysis of their own trading strategy. Here, the TRIN can be a helpful tool to validate these turning points in prices without interfering in one’s existing trading strategy.
Another way is to look for the extreme readings in the indicator. Depending on the stock or the security in question, an extreme reading can typically signal a strong price movement that day traders are alerted to ahead of time.
The TRIN indicator is also ideal for trend traders. Although this would mean that traders need to keep an eye on the long term charts as well as the short term charts in order to pick the intraday or the short term reversals indicated by the Arms index.
One of the important aspects of using the Arms index is that it only signals the turning points in prices with some degree of accuracy. This doesn’t mean that traders can throw caution to the air. Another aspect is that traders need to come up with their own methods of when and where to take profits on the trades.
Remember that prices can continue to post reversals when moving within a trend. Therefore, day traders should not mistake this to be a change of trend but rather the price corrections within a trend.
In conclusion, the TRIN indicator or the Arms Index is a versatile indicator used to pin point with a high degree of precision on the turning point in prices. The only thing being that the Arms Index is limited to the stock market and the trading exchanges in question, which puts this indicator ideally useful for stock day traders.
Price scaling is the concept of determining how to show or display price along the y-axis of the price chart. Every stock chart, as one might know comprises of two axes, the x-axis which is typically used to plot time and the y-axis which is used to plot the price values.
Simple as it may sound, price scaling deals with how to plot the price on the y-axis. There are basically two ways to plot price, which is the arithmetic and the logarithmic versions. It goes by different names such as semi-log scale and linear scale.
The term semi-log is used interchangeably with a logarithmic price scale. The reason why the term semi-log is used is because on a price chart, while the y-axis can be logarithmically scaled, the x-axis is linear. Meaning that the x-axis represents equal units of time (60 minutes, 1 day, 1 week or 1 month which is linear) while the y-axis can be logarithmic.
While most traders don't typically pay much attention to the way the price scale is set, there are some aspects that every trader should know. What's important to understand is that there is nothing mystical about the type of price scale one chooses except in some circumstances where one type of price scale surely trumps the other.
In this article we will look at the five key differences between the semi-log and the linear scale in the price charts.
1. Linear and log-scale measures price changes differently
The way the linear price scale chart and the logarithmic price scale chart shows the values on the y-axis is greatly different. Most commonly, one expects to see a uniform distribution of the values on the y-axis. This is made possible using a linear chart.
On the other hand, the logarithmic chart displays the values differently, making both these types of price scaling rather unique to each other.
When using a linear price chart, the values on the y-axis are structured in a way that the distances between the units are equal in distance. This means that with a linear scale, if the distance was 5 units, then the values on the y-axis would be 0, 5, 10 and 15 and so on.
The chart below shows an example of the linear scale chart for AAPL stock chart. Here, you can see that the price chart has a y-axis divided at 0.20. Therefore, you will find values such as 114.00 and 114.20, where the units are distanced by $0.20.
The linear price scale chart therefore shows equal values, where price moves from $100 to $100.20 or even $114.80 to $115.00.
Example of linear scale chart with distance of $0.20
With a logarithmic chart, the y-axis is structured such that the distances between the units represent a percentage change that is spread across equally. For example, this percentage difference can be 5%, 10% or 15%.
The main difference being that while the linear price chart shows values that are equally distributed in absolute dollar terms, with the logarithmic chart, the y-axis values are distributed in equal percentage terms.
The next chart below shows the same AAPL stock chart but with logarithmic scale enabled.
Example of log scale chart with distance of 0.30% approximately
In the above chart you can easily notice how the values on the y-axis are distributed. While prices look rather congested at the bottom, such as 140.40, 140.70 and so on, the distribution becomes spread out further apart as price values progresses.
Thus, near the top end of the chart, the distribution of values (in absolute dollar terms) is more dispersed and we see values such as 142.70, 143.10 (a distance of $0.40) and 144.00 and 144.50 (a distance of $0.50) and so on.
2. A logarithmic stock chart plots percentage changes more clearly
One of the big differences between a logarithmic chart and the semi-log or linear scale chart is evident from the name itself.
If price of a security moved in a linear fashion in absolute dollar terms, a linear chart will no doubt make sense. To put it differently, this is akin to saying that a linear chart works best when you have a stock or a security that moves $10 every month or over a regular period of time.
We know that the markets rarely exhibit such tendencies.
On the other hand, it is common to expect a stock or a security move 10% or 20% over a certain period of time regularly. In this instance, using the logarithmic price chart makes more sense as it captures the price movement of the stock or security in question more clearly.
The next chart below shows a comparison of the Intel stock chart (INTC). On the left side is a linear price scale and the right side represents a logarithmic price scale.
Comparison of the linear and logarithmic scales for INTC price chart
Although both the linear and the log-scale charts might look the same in terms of representing the information, the differences stand out when you closely look at the distribution of the price values on the y-axis.
Comparing this to the price movement on the two types of charts it is evident that the linear price chart shows a more curved line in prices. You can also notice the linear chart somewhat depicts the idea that price moved rather slowly in the initial periods before price started to move more rapidly in the latter parts.
This distortion occurs because the values are distanced in absolute dollar terms. On the other hand the logarithmic chart shows a steady 1% approximate percentage change in the values and shows a more uniform scale of price change over the period of time.
Therefore, a logarithmic chart is more suited in the above example as it depicts the growth of the stock price on a steady note with a fairly straight trajectory. When the pace of growth starts to change, the logarithmic chart also adjusts accordingly and depicts the change accordingly, which isn't the case with a linear chart because the values remain the same, regardless of whether price moved just $0.50 or 5%.
3. Logarithmic scales are useful for long term perspective
We have learned so far that with the linear scale, the price values are equally distributed and in absolute dollar terms. This means that a move from $100 to $150, which represents a 40% move is the same as a move from $200 to $250.
You can see that the distribution here is of $50 per unit, but in percentage terms, you have a 40% move initially (from $100 to $150) and a 22% approximate move from $200 to $250.
What this tells us is that a logarithmic price scale is more applicable in determining the long term duration of the chart. In such cases, the large price movements are better depicted using a logarithmic chart which focuses on the percentage move.
On the other hand, a linear price scale is more applicable for analyze the security that is moving in a tight range or within a short time frame such as intraday trading sessions.
Obviously, it makes more sense to focus on the absolute dollar moves on an intraday basis rather than focus on the percentage move in the price of underlying security.
Linear scale is ideal for intraday charts or short term charts
The above chart example shows a 10-minute price chart for AAPL using a linear price scale. Here the units are distributed at an equal distance of $0.20. You can also see an example of a simple breakout method relatively easy to spot and trade.
Because of the equal distribution in absolute dollar terms, the $0.20 price range that was established in the sideways market gives the upside and the downside target at a distance of $0.20 making it relatively easy to trade the short term price charts using the linear price scale.
Even if you would use a logarithmic scale on the intraday charts, because the price movements are typically confined, you will get the same results as using the linear scale chart.
Likewise, the linear scale charts are practically useless when it comes to depicting the long term price movements on the charts. Here, the logarithmic scale chart is more applicable and useful in conveying information such as ensuring that the price movement is relative to the percentage change rather than the absolute values.
4. It is the stock or security that will eventually determine what price scale to use
When it comes to analyzing stocks, the price of the security is usually analyzed in relative terms. Metrics such as price earnings ratio, price book values and so on are used. Thus, when depicting the price of the security in question, it makes more sense to represent or analyze the security's stock movement in percentage terms rather than in absolute values.
Although this might miss most traders' eyes, using the correct chart type plays an important role in one's analysis. In most cases, the current technology now a days allows for the charting platform to automatically adjust between linear and logarithmic scale automatically.
Therefore, chances are that traders are automatically shown the appropriate price scale without even knowing the difference between the two types of price scales.
At the end of the day, the security that one is analyzing typically dictates whether you should choose a linear price scale or a semi-log chart or a logarithmic scale chart.
Even within stocks, not all securities behave similarly. While on one hand there are stocks that have explosive price movements, there are also stocks that are typically confined to a range, at times over years.
Therefore, despite looking at a long term price chart and if the security in question has been range bound, a linear chart is more ideal to use than a logarithmic price chart.
5. Trends are better judged with a log-scale chart
Price action can be judged quite differently depending on the type of price scale one uses. Let's start with a simple example of drawing trend lines for the same security and compare how the trend lines evolve between a linear or a semi-log scale chart and a logarithmic chart.
Trend lines plotted on a linear and a logarithmic chart
The above chart shows the Intel Corp (INTC) chart where on the left we have a linear price chart while on the right is the logarithmic price chart.
The trend lines plotted on both the charts are exactly the same. If you spare a few minutes looking at the trend lines it is not that difficult to spot the differences.
As you can see price action can also greatly differ depending on the type of price scale one is using.
This brings us to the question of which of the above two charts types is showing the right information? It is the logarithmic price scale chart on the right side which shows the trend lines much better as compared to the trend lines from the left.
Is linear or a logarithmic scale better?
The answer to this question depends on a number of factors such as the security in question and how price behaves and of course the time frame as well. However, the log scale or the semi-logarithmic price scale is broadly preferred to the linear scale.
Chances are that one might not have really noticed the difference as the logarithmic price scale fits perfectly well. With most charting platforms now being more advanced, the trader doesn’t really have to bother much as to which of these two price scales to use, unless one switches to this option manually.
Nearly all charting platforms default to the logarithmic scale as the units are equally spaced in percentage terms, making it easier to use the log scale as a base chart across any security that a trader wants to analyze.
As illustrated above in some of the differences, there are clearly certain scenarios where using one type of price scale is definitely better. At the end of the day it is all about the security that is being analyzed and the security’s price behavior that will eventually determine what type of a price scale one should choose.
Technical indicators form an essential element to day trading and are valuable tools for day traders as well as prop trading firms. In fact, without the use of technical indicators, more than half the automated trading strategies or algorithmic trading would not exist.
While there is always a debate between technical analysis and fundamental analysis and thus by extension, technical and fundamental indicators, the fact remains that in the very short term, such as day trading, technical analysis calls the shots.
Technical analysis is all about forecasting price by analyzing the past price history. Over the years, the field of mathematics and physics to some extent has found its use in developing various technical indicators.
Today, one can find technical indicators from the very simple such as moving averages to the more complex technical indicators such as Elliott wave counting, as an example.
No matter how simple or complex a technical indicator is, most often these indicators can be categorized into two classes; leading or lagging technical indicators.
What is a leading technical indicator?
A leading technical indicator is basically designed to lead the trader into anticipating what price will do next. A leading technical indicator in a way is a forecasting tool in its entirety. Magical as it may sound, a leading technical indicator relies upon the most important variable, which is price.
A leading indicator forecasts based on a number of factors, but most commonly uses momentum or even volume as a means to predict what price will do next.
Other examples include reading market sentiment such as the Japanese Candlestick patterns which do a good job in leading the trader into anticipating potential turning points in prices.
The chart below shows a few of the candlestick patterns based on the candlestick charts which are probably the best examples of how leading indicators work. The patterns identified in the chart below signal a shift in sentiment.
Of course, despite the simplicity shown in this example, it is always best for the trader to confirm such signals with other indicators as well.
Japanese Candlestick patterns signal market changes
An important aspect to bear in mind with leading technical indicators is that they are not always right as eventually it is price that is the ultimate leading indicator. Look at the above chart and you will find examples where despite a bullish signal given, price behaves otherwise.
Other examples of leading indicators include momentum or volume oscillators. These indicators focus on the principle that momentum or volume starts to change ahead of price itself (lending support from the principles of physics).
Thus, many technicians have developed various technical indicators measuring momentum or volume in an effort to build a robust technical indicator that could signal what price could do in the near future.
Some examples of leading technical indicators include the Relative Strength Index (RSI) or even simply volume, which is more easily recognizable. Volume tends to show changes even before price as it truly represents the ever-changing buying and selling pressures in the market.
Below is a classic example.
You are looking at a 10-minute chart for Microsoft (MSFT) with only volume as the indicator.
Volume as a leading indicator
If you closely analyze price and volume, you can see that from the area marked 'start' and the subsequent rally in price, volume starts to fall. For someone who viewed the chart without volume would easily mistake price to be in a strong uptrend.
As price peaks out near $66.30 posting a high, you can see that volume is not confirming the bullish momentum led rally, signaling ahead that prices could fall.
Eventually, price makes another attempt at $66.30 and crashes strongly and this time the decline in price is confirmed by strong selling pressure as indicated by the strong volume bars.
What is a lagging technical indicator?
A lagging technical indicator is often said to be smoother and less prone to fake signals. However, as the name suggests, lagging indicators often signal very late into a trend and thus come at a risk of a price reversal.
Still, many traders prefer to use lagging technical indicators as it helps them to trade with more confidence. Usually traders make use of two or more lagging indicators to confirm the price trends before entering the trade.
This can be viewed as a conservative way to trade, but do not let this draw you into a false sense of security that you can make money consistently by being conservative. Despite the obvious advantages of the lagging indicator over the leading indicators, they are by no means fool proof.
A lagging indicator often makes use of price as an input variable and in most cases, requires a longer look back period in order to ascertain trends.
Let’s look at a classic example of a lagging indicator set up which is a 50 period and a 200 period moving average. We know the golden and a death crosses, which are nothing but bullish and bearish crossovers of the 50 and 200 SMA’s.
Generally, the security is said to be bearish when the 50 SMA crosses below the 200 SMA and the security is said to be bullish when the 50 SMA crosses above the 200 SMA.
The following example shows the 50 and 200 SMA applied to the daily chart for QQQ ETF chart.
Moving averages as a lagging indicator
In the above chart notice the four signals generated by the bullish and the bearish crossovers of the 200 and 50 period moving averages. In the first signal from the left, if one went short on the security after the bearish signal was given, it would have been a losing trade.
This is because by the time price moved lower and the SMA’s reacted to this, price already fell significantly and started to pull back higher.
Likewise in the next example we get a bullish crossover. If a trader were long on this signal, it would once again end up with a loss because we see that price pretty much stalls near the previous highs before falling back lower.
The third bearish signal we see worked somewhat in our favor however as price fell only a few points lower before starting to reverse the trend.
Among the four signals, it was only the last signal that worked as the bullish crossover signal saw a meaningful rally in prices thereafter.
What the above example tells us is that despite being lagging, the lagging indicators are by no means fool proof.
What are the differences between leading and lagging indicators?
As the name suggests, leading and lagging technical indicators are clearly two different sides of the coin. Lagging indicators mostly focus on the output and one can see that lagging indicators are often more smooth in terms of values and even in visual terms.
On the other hand, leading indicators are more sensitive to the values and can often result in choppy markets. Leading indicators can also be easily influenced by short term volatility in the markets.
For a day trader it is all about finding the right combination of technical indicators as both these two types of technical indicators tend to have their own short comings. Furthermore, entirely different set of trading strategies can be easily built depending on the type of indicator one uses.
One of the biggest differences is that leading indicators often forecast what might happen. However, this may or may not come to pass. For example, a leading indicator could suggest that price of the security might fall. Traders will need to seek confirmation from other indicators in order to validate this view.
A lagging indicator on the other hand gives a confirmation of the leading indicator. However some times, depending on the input values of a lagging indicator, it could be too late as price would have already behaved as expected and could be moving on to establishing a new trend for example.
From the above, what we know that there is no clear winner among these two types of technical indicators and in fact the trader will need to focus on both the leading and lagging indicators in order to get a full picture of the market.
For example, what better way to view the markets then to have a leading indicator signal a potential downtrend and to have a lagging indicator validate this view.
Drawbacks of leading and lagging indicators
Both leading and lagging indicators comes with their own set of drawbacks. For starters, leading indicators tend to be very choppy and react to prices quickly. This means that leading indicators are prone to giving false signals making them somewhat unreliable.
On the other hand, lagging indicators are slow to react meaning that whatever price trend a trader wanted to capture would have already completed the strong part of the trend, meaning that there would be significant risks of a pull back or a reversal in price.
Combining leading and lagging technical indicators
While there are certain technical indicators that are considered to be leading indicators, there are some patterns/phenomena as well that are good example of leading indicators. Examples include price action itself, and of course divergence.
Let’s see how a trader can make use of a leading and a lagging indicator to get a better view of the markets. In this following example, we take a look at how one can combine the concept of divergence as a leading indicator and moving averages as a lagging indicator to trade.
The following chart shows a 15-minute time frame where we have a standard Relative Strength Index (RSI) and two exponential moving averages. The settings (inputs) for these indicators are pretty standard, if not randomly selected, to prove the point how leading and lagging indicators can work together.
Example of using leading and lagging indicators
Here, we first notice a bearish divergence on the chart, identified by price making a higher high while the 14-period RSI makes a lower high. This bearish divergence is a leading indicator and informs the trader of a potential bearish trend that is likely to take place.
Note that with leading indicators, there is a possibility for the signal to be invalidated. Thus, traders who typically would act on the signal from the leading indicator will be at a loss, something which we will cover shortly.
Getting back to the above example, you can see that after the leading indicator (divergence) signaled a bearish trend, this is confirmed by the moving averages bearish cross over.
The moving averages are lagging indicators and when viewed in the context of the bearish trend that was initially pointed out by divergence, the trader is at a better odds of trading this short signal by acting upon the validation of both the leading and lagging indicators.
You can see how powerful, yet simplistic it is when it comes to combining both the leading and lagging indicators.
Is leading or lagging indicator, better to use?
For traders, it is often the dilemma of finding a balance between the leading and lagging indicators. Rely solely upon leading indicators and chances are that you could end up being whipsawed by price and prone to many false signals.
Rely solely on lagging indicators and while there is a chance of making some money, you would most likely end up with just a few bread crumbs, missing out on most of the profits already.
With the drawbacks obvious, it is clear that traders are at better odds of developing a strong trading strategy that focuses on combining both the leading and lagging indicators. When both these indicators tend to confirm one another, the probability that the trade will result in a profit is much higher, thus reducing the risks.
At the end of the day, it is up to a trader on how they want to trade. Certainly there are traders who rely just on leading indicators and others who rely just on lagging indicators and have managed to make a profit consistently.
For day traders it is all about understanding the indicators that are being used and the information that they signify that matters which will help them to become better at analyzing the markets.
Thus, there is no clear winner when it comes to choosing between leading or lagging indicators, but rather a tie!
The Absolute Breadth Index or ABI for short is a market indicator that is used by technicians in determining the levels of volatility in the market. Unlike other volatility indicators, the Absolute Breadth Index does not factor the market direction.
Appropriately, the Absolute Breadth Index is also known as the going nowhere indicator because it does not show which way the market is moving.
Developed by Norman G. Fosback, the Absolute Breadth Index was first introduced in a book "Stock market logic" that was authored by Fosback. The Absolute Breadth Index widely finds its use in the stock markets only.
The ABI is also known as market momentum indicator and its calculation is relatively simple. The Absolute Breadth Index is based on the advancing and declining issues, two indicators that are readily available to technical analysis and day traders.
The ABI shows how much of activity there is in the market via the volatility and shows how much of change is taking place in an exchange such as the NYSE exchange or the NASDAQ exchange. The Absolute breadth index can also correspond to the market sector as well.
The ABI is a breadth indicator because it measures the breadth of the market by taking into account the advancing issues and the declining issues. Thus, the output of the ABI is rather simple.
What is a market breadth indicator?
Contrary as this may sound (to the ABI); a market breadth indicator is used to determine which way the market is moving. To do so, the breadth indicators utilize the advance, decline and unchanged issues. These values are published by the respective stock exchanges and are readily available.
The chart below shows the NYSE # of advancing issues and the NYSE # of declining issues (bottom).
What these indicators convey is simply the total number of stocks that were advancing or declining on the day. For example, in the below chart, the final reading was 1125 for advancing issues and 1787 for declining issues.
NYSE # of advancing and declining issues
Thus, based on these values (as well as the number of issues that did not change) a market breadth indicator can be developed.
The breadth is nothing but either the difference between the number of rising and falling stocks, or a ratio or some other derivative. What this tells the trader is the momentum and volatility. When you have a large number of stocks that are rising (advancing) or falling (declining) it indicates higher market volatility or breadth.
Market breadth is often referred to as positive breadth or negative breadth. As the name suggest, positive market breadth is where the number of advancing issues clearly outrank the number of declining issues.
Likewise, negative market breadth is when the number of declining issues outranks or overwhelms the number of advancing issues.
The advancing and declining issues are based on stocks making 52-week highs and/or 52-week lows. This data provides the long term bullish or bearish direction.
The market breadth indicator puts the trader on the right side of the market. Obviously you wouldn’t want to buy stocks when clearly the number of declining issues is much higher than the number of advancing issues.
Besides the Absolute Breadth index, other market breadth indicators include the famous, advance decline index, the advance decline ratio and so on.
How to calculate the Absolute Breadth Index
The Absolute Breadth Index is calculated as follows.
Advancing issues: The advancing issues are the number of stocks that are increasing in price on the exchange
Declining issues: The declining issues are the number of stocks that are decreasing in price on the exchange
It is important to know that the stock or security that is being analyzed needs to correspond to the exchange in question. It is common knowledge that when the Absolute Breadth Index posts a high, it usually coincides with a market bottom.
Similarly, a low reading on the ABI indicates a market top, although such signals are not that common as compared to the market bottoms coming off higher ABI values.
Below you can see a split chart. On the left side, we have the stock chart for Visa Inc. (V) and on the right is the QQQ Powershares ETF. Common to both is the Absolute Breadth Index. The areas marked by the circles indicate the market bottoms and the relative value of the ABI during that time.
Absolute Breadth Index Example
In some versions of the ABI indicator, an exponential moving average (EMA) is applied to the ABI as well, in order to smooth out the volatility. When the EMA is brought into the picture, the ABI can be used as a better indicator to spot the market bottoms.
Difference and similarities between the Absolute Breadth Index and the Advance/Decline Index
The Absolute Breadth Index looks somewhat similar to the advance decline index. The only difference being that it takes into account the absolute values. For example, if the difference between the advancing and declining issues was 300, then the absolute breadth index would show this as 300.
However, if the difference was -300, meaning that there were more declining issues than advancing issues, even then, the Absolute breadth index would show 300, because the absolute value of any negative number is positive.
In mathematical terms, absolute value is indicated with the | symbol.
So, -300 in absolute terms would be |-300| = 300 (no negatives)
What we can understand from this is that while the advance decline index can rise and fall around the zero-line, with the Absolute Breadth index, the values are always positive.
While the advance/decline indicator is usually applied to the exchange, the ABI on the other hand can be applied to sectors as well. Thus, the Absolute Breadth index is ideal for analyzing the volatility of sectors such as bio technology and so on.
Trading with the Absolute Breadth index
According to Fosback, the Absolute Breadth Index can be used to signal ahead of time, the potential price changes in the security or the exchange that is being analyzed. It is important to note that the ABI is ideally used for the NYSE as the values for the advancing and declining issues are easily found.
There are also similar indicators for other exchanges such as the AMEX or the Nasdaq. Traders can also build their own absolute breadth index for example such as looking at the number of advancing and declining stocks within a portfolio or within a sector.
Historically, higher values on the ABI suggest that prices are likely to rise over the next 3 through 12 month period of time. Fosback also suggests in his book, Stock market logic that there was a higher level of confluence when the ABI was based on dividing the weekly ABI by the total issues that were traded.
This meant that instead of using the daily values of the number of advancing and declining issues, a weekly value would be considered. The absolute value would then be divided by the total number of issues that were traded. The final result would then point to higher prices in stocks over the coming three or twelve month period.
No matter which way one looks at the ABI, the fact remains that this indicator is suited for long term trading. Thus, stock traders who are familiar with swing trading will find that the Absolute breadth index offers a better view of timing the entries in the market.
Let’s look at some examples on how one can use the Absolute Breadth index to enter a trade.
In the following chart, we have the daily stock chart for Microsoft (MSFT) and the Absolute Breadth index. We also have a 50 and 200 day simple moving average to depict the trend.
After the first bullish crossover of the SMA, the question is where to enter the trade.
Based on the ABI value of 3800 which was plotted after the initial bottom was identified by the market, after the bullish crossover of the SMA, we simply wait for the ABI to reach back to the 3800 value.
This happens nearly three months later after the golden cross signal, identified by the bottom that was formed. Price initially rallies after the bottom and then slips back to the 200 day SMA.
While the declines would have sent investors to remain cautious, the bottom coincides with a somewhat higher reading in the ABI, which would have increased the confidence in the trader.
Adding to positions here would have seen prices rally back and the struggle near the previous resistance would have offered enough clues for traders to exit the position.
Also note that when price was near this resistance forming a high, the ABI value was also lower which was another signal that a temporary market top was being formed.
In the next example, you can see that as price declined, it fell back to the previous support low that was formed. However, this time around, we again see a higher ABI value indicating a market bottom was in place.
Trading with the Absolute Breadth Index
However, with the 50 and 200 day SMA bearish, we wait for bullish confirmation which occurs around late September. Incidentally, as price makes a small bottom, this is validated by higher ABI value and also the price level is near the previous resistance level.
Considering the above factors (bullish SMA, resistance turning to support, higher ABI value), a long position would be a perfect timing. Of course, the trading strategy can be further fine tuned and used alongside timing indicators such as the Stochastics oscillators.
The ABI can also be used with chart patterns or even candlestick patterns to confirm the market bottoms and the potential reversals that might occur by taking into account factors such as support/resistance levels, candlestick patterns and confirmation with volume of the security being analyzed as well.
Another example of using the Absolute breadth index is combining the indicator with Bollinger bands. The Bollinger bands indicator is a volatility indicator and therefore fits perfectly well with the ABI.
In the next example below, we have the daily stock chart for Twitter with the default Bollinger band settings applied to the chart, alongside the ABI indicator. Here, the market bottoms can be correlated with higher readings on the Absolute breadth index to develop a short term trading strategy.
Bollinger bands with Absolute Breadth Index indicator
In the above example we have two instances for a long position. In the first, the bottom in the stock is validated by the top in the ABI. Identifying the nearest resistance level, we then take a long position when this resistance is breached.
In the second example, a similar set up is formed where the bottom in prices coincides with a top in the ABI. The break out from the previous resistance is marked by a strong rally in prices.
From the above two examples, we can conclude that the Absolute Breadth Index is a relatively simple tool that can predict the market tops and bottoms. While this technical indicator might not be that appealing for day traders, it can be definitely be used by long term and swing traders as the indicator is best used on daily charts.
Volatility assessment through the absolute breadth index is an unconventional method because traditionally, volatility is measured by monitoring the price change or the rate of chance or the trading ranges that are usually established.
Thus, the ABI as a market volatility indicator is rather different compared to the more conventional indicators such as Bollinger Bands or Average True range indicators.
Although the absolute breadth index is used to assess the volatility from an exchange, it can also be used to assess the volatility of a portfolio of stocks or analyzing the advancing and declining stocks in a sub-sector, which makes it unique.
Furthermore the fact that the Absolute Breadth Index ignores market direction makes it unique in terms of indicating when volatility is rising or falling.
The Breadth Thrust indicator is a technical indicator used to measure the market breadth. As with most breadth measuring technical indicators, the Breadth Thrust indicator is based on the exchange's advance and declining issues data.
What puts aside the Breadth Thrust indicator is that it is used as a timing indicator and is used as a long term trading indicator. The Breadth Thrust indicator can signal the bull markets or periods of renewed bullish momentum with a good level of accuracy.
The Breadth Thrust indicator is also known as the Zweig Breadth indicator, which was named after the namesake, Marty Zweig, one of the veterans on Wall Street. Zweig also authored a book, "Winning on Wall Street." Zweig was known for combining both fundamentals and technical analysis in his analysis of the markets and the Zweig Breadth Thrust indicator is one of his famous works.
According Zweig and eventually the principle that determined the Breadth Thrust indicator was that if the market breadth shows a positive reversal within a short span of time, it signaled the start of a new bull market.
The signal was based upon analyzing the 10-period exponential moving average based on the ratio of the NYSE advancing and declining issues. The Zweig Breadth Thrust indicator was therefore said to be oversold below 40 and overbought above 61.5.
When the 10-day exponential moving average moved from 40 to 61.5 in a period of 10 days then it was the breadth thrust indicating a potential bull market in the making.
The Zweig Breadth Thrust indicator is widely watched and is commonly referred to on the financial news media as well. The signals from this indicator are widely reported as the same as a 50 and 200 period moving averages signaling the golden or the death cross.
Below is an example stock chart for the QQQ Powershares trust ETF where you can see the standard Zweig Breadth Thrust indicator applied with the default settings.
As you can see, the Breadth Thrust indicator oscillates between the fixed values of 40 and 61.5. When the Breadth Thrust indicator reaches the oversold level (40) you can expect to see a lot of chatter and activity in the markets as it signals a possible turning point in the markets.
If one observes the below chart closely, it is not hard to miss the turning points in the markets signaled by the Zweig Breadth Thrust indicator.
Zweig Breadth Thrust Indicator
This brings us to the question on whether the Breadth Thrust Indicator can be relied upon to signal market tops (and bottoms).
How does the Breadth Thrust Indicator work?
Unlike other typical overbought/oversold signals generated with momentum oscillators, the Zweig Breadth Thrust focuses on the rate of change from the oversold to overbought levels.
In other words, with the Breadth Thrust indicator it is all about how quickly the NYSE advance and decline numbers go from not so good, to really good within a short span of time. Marty Zweig closely observed this phenomenon and came up with the Zweig Breadth Thrust signal or ZBT signal for short.
The ZBT calculation is very simple. According to Zweig, firstly, the ratio of the advancing issues divided by the sum of advancing and declining issues is calculated.
Mathematically, this first step is denoted as:
Once the ratio is derived, a 10-day exponential moving average is derived and Zweig originally named this the 18% trend. For the indicator to signal, the ratio had to move from below 0.40 or 40% to above 0.615 or 61.5% within 10 trading days if not less.
This concept according to Zweig, works on the principle that the rapid change of money in the markets is pushing the stocks higher and signals a continuation of the uptrend on increased liquidity.
Among the many studies conducted on the Zweig Breadth Thrust Indicator, there were no signals generated for nearly 25 years between the periods of 1984 and 2009 which goes to show that the indicator is best used for long term trading in the markets.
The first major signal from Zweig came in March 2009 when the major U.S. indices posted a bottom. This came at the time following the 2008 global financial crisis and the U.S. Federal Reserve unleashed its massive quantitative easing program.
The chart below shows this major market bottom that was called by the Zweig Breadth Thrust indicator.
Zweig Breadth Thrust Indicator gives a major signal in March 2009
The March 2009 signal occurred as the ZBT moved from oversold to overbought within just 8 trading days. It is important to note the signals because one could simply interpret the Zweig Breadth Thrust indicator as a mere oscillator that turns at market tops and bottoms which is incorrect.
How the Breadth Thrust Indicator signals continuation in the markets
While most investors and traders tend to look at the Zweig Breadth Thrust indicator as one that can signal market bottoms, a lesser known fact is that the ZBT can also tell traders when to stay long in the markets.
This usually happens during times of economic or fundamental uncertainty in the markets. Let’s explore this example in a bit more detail.
During October 2015, the markets were in a state of uncertainty with the slowdown from China and the possible start of a tightening cycle from the U.S. Federal Reserve. For normal investors panicking under these circumstances mean cutting down their exposure to the equity markets.
However, the Zweig Breadth Thrust indicator shows something else.
The chart below shows the period between September and October 2015. Notice that towards the latter part of September, as the markets made a major bottom, the Zweig Breadth Thrust indicator signaled a buy.
Zweig Breadth Thrust Indicator, September 2015
Within a span of 8 trading days, the ZBT moved from below 0.40 to above 0.615, signaling a buy. The S&P500 rallied nearly 4% before stalling near the top at 2100. Traders would have been able to use this opportunity to add to their positions or to build new trading positions.
What’s interesting about this signal though was the fact that the markets stalled within a short span of time after the late September 2015 signal. Soon after, the markets fell sharply by early 2016.
Even here, the ZBT managed to signal the bottom in the markets as the S&P500 fell to lows of 1850, following the first U.S. Fed rate hike after the global financial crisis.
Using market breadth indicator as a confirmation tool
The market breadth indicator can also be used as a confirmation tool for the trends and can help traders in assisting them in picking the turning points. Due to its capability as a technical indicator, the Zweig Breadth Thrust indicator can also be used to confirm trading signals.
Due to the fact that the market breadth indicator makes use of the number of advancing and declining stocks in an exchange it can be helpful in predicting the turning points that can be confirmed by other technical indicators.
Bear in mind that the Zweig Breadth thrust indicator is also a good fit for investors who focus more on the fundamentals. The flexibility of this indicator to be used both for fundamentals as well as technical analysis makes it one of the favorite with both investors as well as traders.
To better understand on how to use the market breadth indicator as a confirmation tool, let’s look at an example.
The chart below shows a standard 50 and 200 periods moving averages applied to the S&P 500 daily chart. Here, after the uptrend was signaled by the bullish positioning of the two moving averages, we can look to the Zweig Breadth indicator to signal turning points in the markets.
Zweig Breadth Thrust indicator as a market confirmation tool
There are two ways these signals are confirmed using the Zweig Breadth Thrust indicator.
In the first instance, every time the market slips below the 50 day moving average, we can look to the ZBT to signal the start of a new uptrend. This is the simplest application of using the ZBT to confirm the uptrend already signaled by the moving averages.
This can also be confirmed by using other common oscillators such as the Stochastics or the MACD. In this aspect, the Zweig Breadth thrust indicator behaves the same way as any other oscillator, with the exception being that the ZBT tracks the advancing and declining issues.
The second way in using the market breadth thrust indicator is to combine the technical aspects such as support and resistance in the price chart and utilizing the rapid changes from oversold to overbought levels.
In this second instance, one can notice how the resistance level that was identified at 1920 was breached initially. On the first decline back to this level we can see that it was validated by the market breadth thrust indicator which moved from the oversold to overbought levels rather quickly, signaling a market bottom.
This was the indication required to confirm that the support level would hold and therefore would have triggered a buy signal at support.
A few sessions later, we can see that towards early November, price fell back to this level. Knowing that support was already established here, the turning point in the market coincided with the breadth thrust indicator that signaled a buy.
To conclude, the Breadth Thrust indicator attempts to quantify the buyers and the sellers responsible for moving the market prices around. A momentum indicator, the Breadth Thrust indicator is rather simple in the way the calculations are done.
Due to the fact that the advancing and declining issues are confined to an exchange, the Zweig breadth thrust indicator can be applied to the NYSE, NASDAQ or the AMEX stock exchanges. When it comes to other markets such as futures or forex, the Zweig Breadth Thrust indicator is practically useless as with most market breadth indicators which are confined to the realms of the stock markets.
Yet, despite this limitation, traders can look to the market breadth thrust indicator to analyze the major equity indices such as the Dow Jones or the S&P500 to gauge the broader market sentiment. Due to the fact that most of the markets are interrelated, traders can focus on the cash markets and in turn interpret the signals onto the futures markets.
For example, one can make use of the market breadth thrust indicator on the Dow or the S&P500 cash markets and then translate the signals to the respective futures contracts. Because one can go long or short in the futures markets, this can be a great way to leverage the power of the market breadth thrust indicator and utilize the results in the derivatives markets as a result.
However, an important point to note that is that the Zweig Breadth Thrust indicator is a long term tool.
It is estimated that between the periods of 1945 and 2000, the Zweig Breadth Thrust indicator signaled a buy signal only fourteen times which led to an average gain of 24% approximately in the stock markets. This, by most trading standards is very slow in terms of the number of trading signals generated.
Unlike with most momentum or other oscillators, with the Zweig Breadth Thrust indicator it is all about the rate of change from how the indicator moves from 0.40 to above 0.615 within a short span of time. Therefore, traders need to keep a watchful eye on the ZBT as not all overbought or oversold signals represent buy and sell signals.
What's important to understand is the fact that the Zweig Breadth Thrust indicator is one of the many tools available for stock traders to identify possible reversals in the markets, more importantly the market bottoms.
Because of the fact that the Zweig Breadth Thrust indicator is a long term indicator it makes its practically useless for day traders or even swing traders. However, what's unique about the ZBT is that fundamentals based investors will find the ZBT to compliment their analysis and more importantly in timing the market entry.
The Bollinger Bandwidth indicator is derived from the famous Bollinger bands and its corresponding values. The Bollinger Bandwidth or BBW for short was first outlined by John Bollinger in his book, Bollinger on Bollinger Bands.
It was in this book that John Bollinger introduced the Bandwidth indicator including the %B (called as percent B) indicators which are the two indicators that are based along with Bollinger bands and the values of the indicator that it represents.
Among a number of different technical indicators available, the Bollinger bands are one of the most widely used technical indicators when it comes to measuring market volatility.
The bands are comprised of two lines which envelope price and are plotted at two standard deviation levels away from the 20-period simple moving average (SMA). In a way, the Bollinger bands not only measure volatility but also trends based off the 20-period simple moving average.
This gives the default setting of the Bollinger bands at 20, 2 and visually the Bollinger bands are identified by the three lines on the price chart. When volatility increases, the bands tend to expand and when volatility decreases, the Bollinger bands contract, giving it the classic Bollinger band squeeze and expansion.
This gives them the name Rubber bands as the bands tend to expand and contract reflecting volatility in the security and are very flexible. Strong trends are signaled when price breaks one of the bands and continues in the direction, to which the Bollinger bands automatically adjust to. This is also referred as walking the bands.
Similarly, one can expect to see a pullback when volatility fades by the time price reaches one of the upper or the lower Bollinger band.
The chart below shows an example of the standard Bollinger bands applied on the SPY ETF daily chart with the default settings of 20,2. One can of course choose the values that suit the security the best. Some of the common Bollinger band settings include three standard deviations for a 20-period SMA as well.
As with any technical indicator, testing different parameters are ideal to fine tune the responsiveness of the indicator being used.
Bollinger bands on SPY ETF daily chart
The Bollinger bandwidth indicator measures the percentage difference between the upper and the lower bands. The bandwidth indicator is actually an oscillator and is plotted on the sub-chart or a sub-window.
As and when volatility expands and contracts, thus resulting in the Bollinger band squeeze and expansion, the Bollinger bandwidth indicator decreases and increases in value, all the time oscillating between the fixed values.
The next chart below shows the Bollinger bandwidth indicator applied to the chart. In most cases, the Bollinger bandwidth indicator is used alongside the Bollinger bands.
Bollinger bandwidth indicator with Bollinger bands on SPY ETF Chart
In the above chart the Bollinger band is used to visually show how the bandwidth indicator reacts accordingly. When the distance between the two outer Bollinger bands contract, the Bandwidth indicator falls and when the upper and the lower Bollinger bands expands, the Bandwidth indicator rises.
Due to the fact that Bollinger bands are based on standard deviation of the 20-period SMA the Bollinger bandwidth indicator reflects rising and falling volatility, depicted as an oscillator that moves between fixed values.
The benefit of using the Bollinger bandwidth indicator is that it provides an easy way to visualize the price consolidation (low bandwidth values) signaled by the Bollinger band squeeze and periods of volatility (high bandwidth values) signaled by the Bollinger bands expansion.
The Bollinger bandwidth indicator does not use any special values and is based upon the standard settings of the 20 period SMA and the two standard deviation values.
How does the Bollinger Band width indicator work?
The Bollinger Bandwidth oscillator measures the difference in values between the upper and the lower bands. The resulting value is then divided by the mid-band or the 20-period simple moving average.
The Bollinger bandwidth as an oscillator rises and falls reflecting the increase and decline in the volatility. When volatility increases, the Bollinger bandwidth rises and when volatility decreases, the Bollinger bandwidth declines or falls.
With Bollinger bands, it is a well known fact that when the upper and lower bands are relatively far apart, it indicates that the current trend could be ending or possibly signaling a pull back to the trend. Likewise, when the upper and lower Bollinger bands tighten or narrow, it signals that a possible strong move in the market is likely to occur.
The chart below shows some examples of the Bollinger bandwidth indicator and the following volatile move in the market.
Bollinger bandwidth and market volatility
The above chart shows how the lows formed on the Bollinger bandwidth signaled a potential strong move in the markets. In the first stance, the low period of consolidation was marked by a strong breakout in prices.
In the second scenario, the low period of volatility, marked by the Bollinger bandwidth indicator at the low and price near a short term top coincided by a strong decline in prices. This decline was later marked by the end of volatility with the Bollinger bandwidth indicator marking a high.
Finally, the third example shows prices near the high with the Bollinger bandwidth at the lows and the resulting decline in prices.
As you can see the peaks and troughs formed by the Bollinger bandwidth signal the rise and fall of volatility and this reflects the short term gains and declines in prices.
According to John Bollinger, the fall in the Bollinger Bandwidth indicator below 2% or 0.02 has led to many big moves in the S&P500 index. The chart below shows this example, where one can see that the market tops coincided closely with the Bollinger bandwidth indicator falling below the 0.02 or 2% threshold.
Bollinger bandwidth indicator and the 2% threshold
You can see how in all the three instances, price fell 5.6%, 3.6% and 7.6% approximately off the short term market tops.
However, Bollinger also cautioned that in most cases, price begins by making a false breakout often trapping weak positions near the top before making the strong declines or correction in price.
How to calculate the Bollinger bandwidth
Calculating the Bollinger bandwidth indicator is very simple. The first step is to subtract the values of the lower band from the upper band. This shows the difference or the price range, so to speak. This difference is then divided by the value of the middle band which is the 20-period SMA.
The result is therefore a normalized bandwidth value which can be compared to the different timeframes.
Mathematically, the Bollinger bandwidth is calculated as follows:
Trading with the Bollinger bandwidth indicator
The most common way to trade with Bollinger bands or any indicator to do with volatility is of course breakouts. Because breakouts usually occur after prices move in a sideways range, they make for the ideal set ups to trade with volatility indicators such as the Bollinger bands as well as the Bollinger bandwidth indicator.
While there are relatively limited indicators when it comes to measuring the volatility, the Bollinger bandwidth indicator measures the strength of the trend. In a way, the Bollinger bandwidth indicator can be used to not just spot the breakouts in prices but also as a trend strength indicator.
As a trend strength indicator, the Bollinger bandwidth can work as an effective tool to signal when a trend is likely to end.
However, an important distinction to make here is that the rise and fall of the Bollinger bandwidth indicator could mean either the change of the trend or the short term corrections within the trends.
In the following chart, we have the SPDR S&P500 SPY ETF intraday chart. Here we can see that while prices posted a low it was marked by a low in the Bollinger bandwidth. This potentially indicated that a possible breakout was in the making.
Bollinger bandwidth and price trends
However, remember that the Bollinger bandwidth indicator is not a trend direction indicator but only measures volatility.
Following the low in price, as the Bollinger bandwidth indicator starts to rise (indicating that volatility was also rising), we can see that price starts to post a steady increase as well.
The next low that was formed signaled a short term minor consolidation in price, which was nothing but a sideways range rather than a pullback in prices. As volatility continued to move at a gradual pace, price continues to keep up the uptrend.
In most cases, the Bollinger bandwidth indicator is ideally used alongside the Bollinger bands indicator as both these can complement each other. However, traders should note that the Bollinger bandwidth indicator merely does not tell you when the bands expand and contract, but can signal the extreme points in the volatility.
In the following chart the extreme values in the Bollinger bandwidth indicator signals the temporary peaks and troughs in prices. While the Bollinger bandwidth tends to oscillate and continues to form highs and lows, it is important to make the distinction of the extreme peaks and troughs that are formed by this indicator.
One of the unique characteristics of the Bollinger bandwidth indicator is that it not only signals the market tops and bottoms but also signals when one can expect to see a continuation or a reversal to the previous trend.
For example, in the first instance, the market bottom was signaled by a top in Bollinger bandwidth indicator. This top in the Bollinger bandwidth was one of the extremes, no matter which way one looks at it.
Bollinger bandwidth indicator at extremes
Likewise, the next market top that was formed was signaled by an extreme low in the Bollinger bandwidth indicator. In this instance, the market reversed direction and fell sharply (as denoted by the down gap that was formed in prices).
Traditionally, the Bollinger bandwidth indicator is said to signal a trade entry when the indicator falls to a historic low and starts to rise. This often signals a rise in volatility and depending on whether prices are at the peak or the trough they can set out on a new trend.
As shown in numerous examples above, the markets tend to move around and depending on whether a high or a low is formed in price relative to a rising Bollinger bandwidth indicator, the appropriate long or short positions can be taken.
However, as with most technical indicators in trading, using the signals from just one technical indicator can be disastrous as indicator signals when taken in isolation could lead to potential fake signals that could result in trading losses.
While the Bollinger bandwidth indicator is a versatile indicator that does a very good job in measuring volatility, trading solely based off the signals from the Bollinger bandwidth indicator is not a good trading strategy.
Due to the fact that the indicator focuses on measuring volatility, traders can look at adding other indicators such as moving averages as well as making use of support and resistance levels on the price charts in order to confirm the signals from the Bollinger bandwidth indicator and trade accordingly.
In most cases, the declines or the dips in price tends to coincide with a 50 or a 200 period moving average, which is a strong support level off which long positions can be taken, especially when it comes to the equity markets or ETF’s such as the SPY.
To conclude, the Bollinger bandwidth indicator alongside the Bollinger bands are two unique technical indicators that can given insights about the volatility in the markets. When used correctly, the Bollinger bandwidth indicator can be a great way to day trade the stock markets by picking the short term tops and bottoms in the price.
Traders can also go a step further and confirm these tops and bottom with other indicators such as volumes, or other tools such as the CBOE Volatility Index which is also another widely used indicator for market volatility.