Profitable traders use trading indicators as an aid in their decision-making.
To quote Reminiscences of a Stock Operator…
“A professional gambler is NOT looking for long shots, but for sure money.”
When you’re looking for “sure money,” you need to trade when the odds are in your favor.
So with that, let’s talk about the top three trading indicators. We use these to track the market and gauge the direction it wants to head.
It’s not as complicated as some make it out to be…
Just keep one thing in mind … There is no magic.
We look at each trading indicator’s signal and determine if there’s a consensus. Always keep in mind that no trading indicator is 100% accurate.
Let’s start with my favorite—the VIX.
Trading Indicator #1: CBEO’s Volatility Index (VIX)
Investopedia can walk you through the interworking of the VIX.
Here we’ll tell you how to read it.
In general, the higher the VIX, the higher the volatility in the market. And volatility favors the bears.
The most important thing to remember about the VIX is that it is a short-term trading indicator. So the levels are always relative.
To illustrate this point, let’s look at a 3-year chart of the VIX.
As you can see, the pre-covid bull market levels don’t match the 2020-2021 bull market levels.
- Both were representative of bull markets.
- Each bull market established its own range.
Now let’s compare the 2020 COVID crash to the 2022 bear market.
- Both are bear markets.
- The VIX trended higher during both.
- But the range during the crash was much larger than the 2022 bear market.
Now compare the VIX chart above to the chart tracking the S&P 500 over the same period below…
Here’s what you need to understand…
- When the VIX rises, take note.
- A higher VIX is a signal…
- It’s telling you the market wants to go lower.
Remember, it’s a single trading indicator, and you should take it with a grain of salt.
With that in mind, let’s review my next favorite trading indicator … the Put-to-Call Ratio.
Trading Indicator #2: The Put-to-Call Ratio
First, let’s establish a few definitions.
- A put is a bearish bet. If you buy a put, you’re betting the underlying asset will fall in price.
- A call is a bullish bet. When you buy a call, you expect the underlying asset to increase in price.
You can track the put-to-call ratio with the ticker $CPC on thinkorswim, Barchart, and others.
When the bets are equal, that is, the same amount of put buyers to call buyers, the ratio is 1.0.
But since the market’s long-term trend is up, 1.0 is considered the top of the neutral range.
0.7 indicates that bullish bets outweigh bearish bets by about 30%. 0.7 is the bottom of the neutral range.
As long as the put-to-call ratio settles between 0.7 and 1.0, we consider it neutral.
Above 1.0, the market is telling us it is oversold with an excess of bearish bets. Below 0.7 and the market is overbought … That is, bullish bets are overweight.
In financial markets, balance is essential. Every transaction has a buyer and a seller.
When markets get out of proportion on one side or the other, the market pressures will eventually push the markets back to a neutral stance.
To help you understand this concept, let’s look back at a historical example.
The Right Call was a Losing Trade
In late 1998, the Euro was ready to take its place as a new currency on the world stage.
It was widely expected to be bullish for the currencies that would cease to exist after the Euro was established.
So most investors were long currencies like the German Mark and the French Franc.
But another international issue was brewing … Russia found itself in an unexpected financial crisis. In response, it delayed debt payments to creditors.
Many investors that were long the EU currencies were also long Russian bonds.
As the price of Russian debt fell, institutions faced a credit squeeze. And they were forced to reduce their exposure…
In other words, they had to liquidate positions to balance their books and reduce risk.
So currency investors looked to sell some of their holdings. But there was a problem.
No one was buying.
The passage of the Euro had already been priced in. Everyone who wanted to buy had bought.
Currency sellers overwhelmed the markets, and the price of the European currencies fell.
- The currency investors were right about the passage of the Euro.
- But the overcrowding of the trade caused an imbalance between buyers and sellers.
- As a result, currency prices fell.
Your take home from this example…
Market Forces Always Apply
The put-to-call ratio tells you the direction most investors are betting on. But can also indicate overcrowding and provide clues about an upcoming reversal.
When the put-to-call ratio gets outside the neutral zone between 0.7 and 1.0, we look for additional signs of a reversal.
As always, we consider this trading indicator in context with the rest of the market.
Now let’s look at one additional indicator—the relative strength index, aka RSI.
Trading Indicator #3: Relative Strength Index (RSI)
The typical RSI looks back 14 days. It provides a gauge of how investors have fared in a particular investment.
You can find the formula and history of RSI here.
For our purposes today, let’s review how to read it.
And please note that when we talk about RSI, we’re looking back just 10 days.
We believe markets have modernized and now price in new information faster than when the RSI trading indicator was developed in 1978.
Here are the key numbers:
- RSI is a scale from 0 to 100.
- Under 30 indicates oversold conditions.
- Above 70 indicates overbought conditions.
Check out this one-year chart tracking the S&P 500. Its 10-day RSI is shown at the bottom of the chart…
As you can see, the trend reversed every time the markets reached oversold or overbought conditions.
But not always immediately.
It’s also worth noting that sometimes the reversal was short-term. Other times it was long-term. But historically, oversold and overbought conditions are not maintained.
A note of caution on this indicator …. We use it to track daily charts only. RSI for intraday or longer periods are unreliable.
When we reference general RSI levels, we’re looking at four major stock indexes.
That’s it!
You’re smarter now than you were just a few moments ago.
Final Notes on Trading Indicators
Trading indicators can provide clues as to what the market wants to do.
But no indicator can provide a 100% accurate signal.
We review each indicator daily. We’re looking for signals that confirm or refute our current thesis.
If you want to know our latest thoughts, we’ll tell you!
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Remember, there is no magic…
The best signal is a consensus.
As investors and traders, we must question our views and beliefs. Being wrong is fine … Staying wrong can bankrupt you.
Never marry your theory.
Happy Trading!