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Two Technical Analysis Components that Gauge Strength of a Prevailing Trend, Predict Trend Reversals and Help Time Entries and Exits for Index Credit Spread & Iron Condor Options

There are four major components of technical analyis that help investors make stock and option trading decisions:

Price Based indicators

Volume Based Indicators

Advance/Decline Based Indicators

Volatility Based Indicators


However, only two of these components, volume and advance/decline based indicators, offer the best capabilities to gauge strength and duration of a prevailing trend, and to predict the timing of a trend reversal, where ultimately helps us better time our credit spread and iron condor entries and exits.

This article primarily focuses on the the Volume and Advance/Decline-based indicators and makes a case that changes in volume will many times precede changes in price of a stock or index.  In other words, changes in volume is an early and somewhat hidden predictor of a stock or index's future price.

Volume Based Technical Indicators - Below is a 60 day volume based chart showing the SPY, an ETF that tracks at 1/10th of the value of the S&P 500 index - SPX.  The chart comprises the price of the SPX, 60 minute volume bars, the 12 day volume simple moving average (thin blue line), and the SBV Oscillator, which is the selling/buying volume oscillator.  We can see that the SBV Oscillator, which is a volume based technical indicator, gives a trader additional confidence of when the index has a trend reversal.  In this case we can see that the SBV Oscillator gave an early and false "go long" signal around October 30th, and the way to reduce false signals is to look at a longer-term chart to confirm the trend reversal, and mix in some additional price based, advanced/decline based, and volatility based indicators.

Below is a longer term 1 year chart with 1 day volume bars.  We can see that from this bigger-picture perspective the trend reversal was not confirmed until the 2nd week of November.  In order to minimize false "go long" or "go short" triggers, one would do the following:

1) The "go long" is triggered on Oct 30th from the 60 day chart.

2) Zoom out to the 1 year chart to see what this chart is saying; in this case between October 1st and the first week of November the SBV Oscillator tells us to "stay out" or "continue to be short".  Because the 1 year chart is telling us to "continue to be short" we decide to not to open a trade.

3) Back to the 60 day chart, we get another "go long" trigger around Nov 3rd. 

4) Looking at the 1 year chart, once the SBV Oscillator starts to climb where it's just ready to turn green, which is near the end of the 2nd week of November, this validates a trend reversal and we then "go long".

Below shows the original 60 day volume chart, but we've added the MVO indicator (Market Volume Oscillator) that combines a volume oscillator with Stochastics, which is a popular price-based indicator.  Our goal is to add a few additional volume/price hybrid and Advance/Decline based indicators to help reduce false trend reversal triggers.  Per the MVO, when we see a green or red blip on the chart, it tells us that there is extra heavy buy-volume or sell-volume at that point in time.  Around Nov 1st, a few days after the false "go long" trigger by the SBV Oscillator, the MVO shows another heavy sell-volume day, telling us to continue to stay "short" and/or remain out of the market.

The chart below shows all of the volume, volume/price hybrid and advance/decline based indicators that we monitor on a daily basis to help us gain insight into the strength of the prevailing trend, and to give us a high probability of predicting when trend reversals will happen. 

SBV Oscillator - Selling/Buying Volume Oscillator is an indicator that shows bullish volume accumulation and bearish volume accumulation.  That is, it calculates the difference between volume that is generated as the index advances (buying volume) and volume that is generated as the index pushes lower (selling volume).

Chaikin Money Flow (CMF) -  Developed by Marc Chaikin and is based on the Accumulation/Distribution Indicator, which defines the degree of buying or selling pressure.  The CMF is calculated as the sum of Accumulation/Distribution over specified period divided by sum of volume for the same period.

Volume Accumulation Oscillator (VAO) -  Shows the cumulative volume of the day adjusted by price.  VAO belongs to the group of volume/price-based indicators.  If the closing price of a stock or index is above the mid-point of the day's trading range, all of the volume is assigned to the buyers, but if the closing price is below the mid-point of the day's trading range, all of the volume is assigned to the sellers.  That is, the VAO assigns volume according to the relationship between the closing price and the average price for the day.  VAO is considered to be more sensitive to the volume-price relationship than the On Balance Volume indicator.  Like OBV, the VAO can be used to confirm a trend, and a divergence of the price direction as compared to the VAO may indicate a change in market sentiment and a near-term trend reversal.

Advance/Decline Ratio - The A/D ratio is calculated by dividing the number of stocks that advanced in price for the day by the number of stocks that declined in price for the day.

Momentum Advance Decline Volume Ratio  - Momentum A/D volume ratio takes into account the actual number of shares that traded in the advances and declines volume segments for a given bar.  Advances momentum volume, for example, reflects the actual volume of those stocks that presently belong to the advances group.

MVO - Market Volume Oscillator - The MVO is based on the PVO (Percentage Volume Oscillator) and Stochastics a popular price-based technical indicator. Combining the power of two different indicators in one provides a means to analyze price and volume at the same time.  The PVO measures the relationship between two volume moving averages (VMAs) by revealing the volume surges (abnormal volume activity) that may lead to a trend reversal.  It is commonly known that large volume surges are generated as a result of greedy buying or panic selling.  The larger the volume surge is during a price move up, for example, the more that greedy buying is taking place. The larger the volume surge is during a downward price move, the more extreme is the panic selling.  In the majority of cases, heavy greedy buying and extreme panic selling lead to a shift in supply and demand and changes in a market's mood and trend direction.  Overall, the PVO describes a level of panic selling and greedy buying.  The MVO comprises the PVO that is further smoothed/formed via the Stochastics equation giving is further predictive power.


To be continued......