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If you've had the chance to read over some of the articles I've written here at Zacks you'll find that I often refer to three technical indicators; Fibonacci Retracement, stochastics, and the “25x5.” Rather than explain them in every article I write, I've decided to give you the guide to the indicators I use. To put these indicators in context, I look at the three of them as key ingredients to each trade I put on. The three parts are trend, trace, and trigger.

We have heard it in various shapes and forms but overall the theme is the same; “The trend is your friend.” Sure there is an entire camp of traders out there dedicated to countertrend trading, or going against the grain, but without a trend there could be no countertrend. There are hundreds of different indicators traders use to identify not just the trend but the strength of the trend. After years of trading everything from stocks to options to futures to forex I have learned to subscribe to the KISS method; Keep It Simple Stupid. The simplest way to measure a trend is to use a moving average.

A moving average is the average of price over a specified period. When I look at equities I use a 25 day simple moving average. I say simple moving average because there are a few different ways to calculate a moving average. Weighted moving averages, for example, put more emphasis on recent price action than past price. Exponential moving averages accomplish the same, with even greater weighting on the recent prices. Sure there are probably three or four more popular versions of a moving averages out there but let's stick with the basics here. And trust me, just because it's basic doesn't mean it doesn't work.

I throw one wrinkle into my calculation that makes it a little fancier than your run of the mill SMA. I shift it to the right by 5 days, hence the “25x5”. It's a little quirk that I picked up in the text of a famous future trader's trading system and it works for me. Feel free to experiment with whatever period SMA or whatever shift or anything else you'd like to play with. The point here is simple; when a stock is trading above the 25x5 SMA I say it's in an uptrend. When below it, a downtrend. The logic is that if a stock is trading above the average of the last 25 trading days, then it must be going up compared to that frame of reference.

The slope of the moving average can help tell us what type of market we are in and how aggressive the trend is. A sideways moving average tells me the trend is weak and we could be in a range bound market. The larger the slope to the upside, the more bullish the trend is, the further to the downside the more bearish the trend is. Below is a chart of Nike (NKE - Free Report) highlighting the interaction between the 25x5 SMA and Nike’s stock price.

Trace is the part where you go nuts drawing potential areas of support and resistance on your chart. Now, it's easy to pick out double tops, double bottoms, trend lines and things like this. What is harder to figure out is where will a stock find support after a major run up? Or once a breakout occurs and we are in uncharted territory where will the stock find resistance? And just because you may see something on the chart that should be significant in your eyes, it doesn't mean that the market is going to agree with you. This occurs often in a momentum trading style and one of the best tools available is the Fibonacci retracement and extension.

Fibonacci is the short name for Italian mathematician Leonardo Pisano Bigollo. Born in 1170, long before anyone traded stocks, “Fibonacci” is well known for observing a sequence of numbers that came to be known as Fibonacci Numbers. The sequence starts with 0,1 then adds the previous 2 numbers to get the third. Do that for a few numbers and you have {0,1,1,2,3,5,8,13,21,34,55…} The sequence isn’t as important as the ratio between numbers in a set. As you get further and further along the sequence, the ratio of two sequential numbers approaches 1.618, also known as the “Golden Ratio.”

This “Golden Ratio” pops up all over from classic architecture to population growth to aesthetic beauty. This ratio is the basis for the Fibonacci retracement levels I use to calculate areas of potential support and resistance. The popular levels I use are 23.6, 38.2, 50, 61.8 and 76.4. How I use it is easier to visualize than explain. Take the starting point and end point of a recent rally. Apply these percentages to the difference between the start and end then add to the start. Below is a chart of high flying stock Pixelworks (PXLW - Free Report) with Fibonacci retracement levels drawn to show areas of support if the stock comes down off its highs.

A trigger is a mechanism you use to tell you when it’s time to enter a trade. Armed with the direction of the trend, having already traced areas of potential support and resistance, you need the trigger to tell you when it’s time to make the decision to buy. I have experimented with various triggers including moving average crosses, parabolic SAR, MACD and a host of other indicators. What I have found is that the stochastic indicator is the most black and white trigger I can use when it comes to equity trading.

The mathematics behind the stochastic indicator are a bit complicated but basically it belongs to the family of indicators known as oscillators. These indicators help traders decide if a stock is relatively overbought or oversold. It’s important to note that stocks can remain overbought or oversold for extended periods of time. Put this right up there with “Markets can stay irrational longer than you can stay solvent.”  

The stochastic indicator takes this a step further and compares different timeframes of overbought/oversold calculations. This helps us see a clear trigger to enter a trade. You can read the stochastic by first determining overbought/oversold. This is as easy as reading the stochastic value. Readings above 50 indicate overbought with readings above 80 as extremely overbought. Conversely, readings below 50 indicate oversold with readings below 20 as extremely oversold. Then I look for a crossover of the stochastic indicators two lines. When looking for a buy, I want a stochastic that was recently overbought and has a crossover which I call a bullish cross. Below is a chart of the iShares Biotech Index ETF (IBB - Free Report) highlighting areas where stochastic bullish crosses occurred when the stochastic indicator was in extreme oversold territory.

Put these all together and you get a pretty solid trading system. You have the direction and strength of the trend which tells you which direction to trade in. You then have areas of potential support and resistance which helps you ignore the market noise between significant price levels. You have a trigger that tells you when to enter the trade at the support level in the correct direction. All you need is proper risk management and the odds are firmly in your favor.  

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