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Friday, December 21, 2012 - 06:00
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Friday, December 21, 2012 - 06:00
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Friday, December 21, 2012 - 6:00am

While there are hundreds of technical indicators available, many of them give the same signals, and using several that are similar adds little value to your analysis process.

The wide variety of indicators may disguise the reality that most indicators simply apply different mathematical techniques to closing prices in their calculation. For example, the relative strength index (RSI) and stochastics will usually give buy and sell signals at about the same time. To avoid the problem of duplicating signals, traders should know exactly want they want to learn from each indicator on a chart.

Below is a daily chart of PowerShares QQQ ETF (Nasdaq: QQQ). The prices are shown with Bollinger Bands. Stochastics and RSI are shown in the lower part of the chart.

Prices seem to have turned down after nearing the upper Bollinger Band. This could indicate that the next move in QQQ will be down with the initial price target being $61.70, the lower Bollinger Band. The stochastics indicator confirms the bearish outlook and gave a sell signal while it was in overbought territory. RSI is included on the chart to help determine the direction of the trend, and this indicator is also bearish.

RSI is a widely misused indicator. Some traders look for overbought and oversold signals from the indicator while others use pattern analysis and trendline breaks to generate signals. These rules work sometimes, but generally offer signals that are more difficult to interpret than the stochastics indicator, which gives very clear buy and sell signals. Instead of looking at RSI as an overbought/oversold indicator, traders might find it more useful to look at RSI as a trend identification tool.

Range rules can be applied to RSI to confirm the direction of the trend. These rules recognize that RSI usually stays within a range when prices are trending. When prices are in an uptrend, RSI will tend to bottom near 40 and top at about 80. In a downtrend, RSI usually tops near 60 and finds a bottom near 20.

On the chart of QQQ, the RSI range from 20 to 60 has been highlighted as a blue rectangle. In the most recent market action, RSI turned down after reaching a level of 58, a sign that QQQ is set for a fall.

Bollinger Bands, stochastics and RSI are independently confirming bearishness for QQQ, suggesting a short trade. Ultimately, though, we trade price, which is shown in the next chart.

Fibonacci retracement levels have been added to the chart. The 50% retracement level offered resistance and has at least temporarily stopped the advance off the November low. Aggressive traders could short the market now given that the indicators point to a decline in a price. Conservative traders could wait for a move below the 38.2% retracement level and short on a close under $65. In either case, a close above $67 (the 61.8% retracement level) would indicate that prices are moving higher and short trades should be closed.

A successful trading strategy should use several independent indicators and include both a price target and a stop-loss level. The charts shown above demonstrate one way to trade that idea. Traders could use different indicators, but it is important to understand what your indicators are saying and follow them with discipline.

Action to Take --> Short QQQ at $65 or less. Set stop-loss at $67, about 3.5% above the recent price. Set initial price target at $61.70 for a potential 5% gain in one to three months. If you are not comfortable shorting, you can use the ProShares Short QQQ (NYSE: PSQ), an inverse fund that goes up in price when the index falls, instead.

Buy PSQ at the market price. Set stop-loss at $24.80. Set price target at $26.90 for a potential 4% gain in 1-3 months.

This article originally appeared on TradingAuthority.com:
Multiple Technical Indicators Point to Danger in the Stock Market

Michael J. Carr does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.