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SMART INDICATORS

Our Strategy is to Follow Leading Indicators. Why? Leading technical indicators follow the Smart Money...

We previously stated in our Smart Money tab that the goal of our fundamental analysis is to narrow down our stock selection to only those that are heavily undervalued before any of their trend starts. Our fundamental analysis is the preliminary step of our overall analysis to qualify potential undervalued stocks.

As part of our second phase of our analysis, we drill further into those undervalued stocks with our technical analysis which is mainly based on very specific leading indicators because leading indicators follow the Smart Money. Technical analysis looks at how a stock has performed historically. Specifically, this means how pricing and trading volumes have changed over time. With technical analysis, the purpose is to look at what has happened previously with a stock and use that information to gauge or forecast what may happen with its price going forward. This strategy relies on charts, ratios and other historical indicators to determine whether a stock’s current price is sustainable or if the price may drop in the future. With technical analysis we are assuming that all of the relevant factors that could affect a stock’s movements (profits, earnings, etc.) are already factored into its pricing history. We combine multiple technical indicators into a single trading strategy to limit the risk while still earning strong returns. What is the difference between the two broad categories: Leading vs lagging technical indicators. The most obvious difference is that leading indicators predict market movements and react to prices quickly, while lagging indicators confirm trends that are already taking place and are far slower to react.

Characteristics of Lagging Indicators

  • Alert traders about trends that have started and are apparent.

  • The downside is that entry signals will come later since the trend is already in place. Hence, they lag the market.

  • Less profit as a smaller portion of the overall move is captured.

  • They do not show any upcoming price moves but confirm that a trend is underway.

  • Because the trend is already in place, these indicators send fewer false signals.

  • These are used to confirm the price trend before traders enter a trade.

  • Used to analyze the market using an average of previous price action data.

  • Lagging indicators report background conditions when price is already in motion.

Characteristics of Leading Indicators - the Smart Indicators

  • Anticipate future directions of a market in order to enable traders to predict market movements ahead of time.

  • Send trading signals before new trends or reversals develop.

  • Aim to signal trend changes before they develop.

  • Use past price data to forecast future price movements in the market.

  • Allow to anticipate future price movements and therefore, traders are able to enter trades potentially at the start of the move.

  • Provide more profits as a larger portion of the overall move is captured.

  • The downside is that traders place orders before a move actually happens which creates risk exposure.

  • A leading indicator is understood to indicate where price is going.

The Volume factor: The Driving Force behind Leading Indicators.

Some of the greatest traders all used volume as the cornerstone of their own trading philosophy.

They understood the power of using volume and price action, and it allowed them to succeed, where so many traders had failed. What drives leading indicators? Volume after all is the fuel that drives the market, both higher and lower. Volume is truly the only leading indicator, however the analysis and interpretation of volume is more complex. Professional traders use volume to determine their interest in the market – it is their way of understanding accumulation prior to up momentum and distribution prior to down momentum. Based on the volume driving force that is incorporated in diverse leading indicators, we zoom into these leading indicators which provide the following valuable information about stock evaluation:

  • The idea behind many leading indicators is that price follows volume, a widely held belief among many technical analysts.

  • They help to understand whether the price is going to reverse or continue on its trend.

  • A leading indicator such as the On-balance volume (OBV) is a proven-effective leading indicator that allows to spot turning points and valid signals across a wide variety of markets and time frames.

  • Volume precedes price change, thus it helps to predict security price movements in advance.

  • Most of those leading indicators are designed to determine when the “smart” money and “not-so-smart” money are active. It is believed that the money that predominantly moves markets – institutional funds – are most active on low volume days while retail traders and investors are most active on high volume days. (The assumption is that retail traders tend to be more reactive to whipsaw movements in the market than larger investors.)

  • OBV can also be used with the indexes such as the Dow Jones industrial average or the S&P 500, to estimate the possible direction of the broad market.

  • They can generate several signals such as overbought and oversold conditions, divergences, turning points, buying and selling pressures and failure swings.

  • It helps to understand when institutions (pension funds, investment funds and large trading houses) begin to buy into an issue that retail investors are still selling and vice versa.

  • Volume confirms the strength of a trend or suggests its weakness.

  • Rising volume indicates rising interest for a stock and falling volume suggests a decline in interest, or a statement of no interest in a stock.

  • Extreme volume readings, i.e. climax volume, often highlights price reversals.

  • Points where the market trades on high volume are the points of strong support and resistance.

  • Breakouts and market spikes can be validated or ignored with the help of volume.

  • Large volume signifies that there are a large number of market participants involved in the price action, including financial institutions, who bring the highest turnover to the market. If the financial institutions are trading, it means they are interested in a price at certain level and they literally push the price up or down.

  • Low volume tells us that there are very few participants in the market, and that neither buyers nor sellers have any significant interest in the price.

  • Volume helps us to determine the health of a trend. An uptrend is strong and healthy if volume increases as price moves with the trend, and decreases when the market moves into a counter trend.

  • When prices are rising and volume is decreasing, it tells us that a trend is unlikely to continue.

  • When a market is falling and volume is decreasing, the downtrend is unlikely to continue.

Prices will either continue to decrease, but at a slower pace or stop falling and start to rise. By now you understand why we focus on leading indicators for our technical analysis. With leading indicators we narrow down our selection to undervalued stocks that have not showed a trend yet, but rather potential for larger gains and a margin of safety; our goal is to anticipate market moves before trends start in order to reap the most profit possible for each trade.