Technical Indicators

In addition to charts which form the mainstay of technical analysis technicians also use certain indicators breadth indicators and market sentiment indicators to gauge the overall market situation.

Breadth Indicators:

The Advance Decline Line: The advance decline line is also referred to as the breadth of the market. Its measurement involves steps;

Calculate the numbers of net advances/ declines on a daily basis. To do this, look at the number of shares that have advanced on that day and subtract from it the number of shares that have declined on the day.

How is the breadth of market analysis used? Typically, the breadth of market is compared with one or two market averages. Ordinarily, the breadth of market is expected to move in tandem with a market average. However, if there is a divergence between the two, the technical analysts believe that it signals something. More specifically if the market average is moving upwards, whereas the breadth of market is moving downwards, it indicates that the market is likely to turn bearish. Likewise, if the market average is moving downwards but the breadth of market is moving upwards it signals that the market may turn bullish.

New Highs and Lows: As part of stock market reporting, information is provided on the 52 week high and low prices or each stock. Technical analysts consider the market as bullish when a significant number of stocks hit the 52 week high each day. On the other hand, if market indices rise but few stocks hit new highs, technical analysts view this as a sign of trouble.

Volume: Volume analysis is an important part of technical analysis. Other things being equal, a high trading volume is considered a bullish sign. If heavy volumes are accompanied by rising prices, it is considered even more bullish.

Sentiment Indicators: Short Interest ratio: The short interest in a security is simply the number of shares that have been sold short but not yet bought back.

The short interest ratio is defined as follows:

Short interest ratio = Total number of shares sold short / Average daily trading volume

Investors sell short when they expect the prices to fall. So when the short interest ratio is high it means that most investors expect the price to fall. The technical analyst, however, interprets it differently. He considers a high short interest ratio as a sign of bullishness. His reasoning is as follows: If he short interest ratio is high, there will be as great demand for shares because those who have sold short would have to repurchase them, regardless of whether their expectations come out to be true or not, to close out their positions. Thus demand will have a buoying effect on the prices.

Mutual Fund Liquidity: According to the theory of contrary opinion, it makes sense to go against the crowd because the crowd is generally wrong. Based on this theory, several indicators have been developed. One of them reflects mutual fund liquidity.

If mutual und liquidity is low, it means that mutual funds are bullish. So, contrarians argue that the market is at, or near, a peak and hence is likely to decline. Thus, low mutual fund liquidity is considered as a bearish indicator.

Conversely whether mutual fund liquidity is high, it means that mutual funds are bearish. So contrarians believe that the market is at, or near a bottom and hence is poised to rise. Thus, high mutual fund liquidity is considered as a bullish indication.

Put / Call ratio: Another indicator monitored by contrary technical analysts is the put / call ratio.

Speculators buy calls when they are bullish and buy puts when they are bearish. Since speculators are often wrong, some technical analysts consider the put/call ratio as a useful indicator. The put/call ratio is defined as:

Number of puts purchased / Number of calls purchased