Commodity Investing: Top Technical Indicators

In any asset class, the primary motive for any trader, investor or speculator is to make trading as profitable as possible. In commodities, which include everything from coffee to crude oil, we will analyze the techniques of fundamental analysis and technical analysis used by traders in their buy, sell or hold decisions.

It is believed that the technique of fundamental analysis is ideal for investments involving a longer period of time. It is more research-based; it studies demand-supply situations, economic policies and finance as decision-making criteria.

Traders usually use technical analysis, as it is appropriate for short-term judgment in markets, and analyze the past price patterns, trends and volume to construct charts to determine future movement.

Identifying the market for commodities

Momentum indicators are most popular for commodity trading, contributing to the trusted adage, “buy low and sell high.” Momentum indicators are further divided into oscillators and trend following indicators. Traders must first identify the market (ie whether the market is trending or fluctuating before applying any of these indicators). This information is important because trend following indicators do not perform well in a fluctuating market; Similarly, oscillators tend to be misleading in a trending market.

Moving averages

One of the simplest and most widely used indicators in technical analysis is the moving average (MA), which is the average price over a specified period of time for a commodity or stock. For example, a five-period MA would be the average of the closing prices over the past five days, including the current period. When this indicator is used intraday, the calculation is based on the current price data instead of the closing price.

The MA tends to smooth out the random price movement to bring out the hidden trends. It is seen as a lagging indicator and is used to observe price patterns. A buy signal is generated when the price crosses above the MA from below bullish sentiments, while the reverse is indicative of bearish sentiments – hence a sell signal.

There are many versions of MA that are more elaborate, such as exponential moving average (EMA), volume adjusted moving average and linear weighted moving average. MA is not suitable for a fluctuating market as it tends to generate false signals due to price fluctuations. In the example below, notice that the slope of the MA reflects the direction of the trend. A steeper MA shows the momentum supporting the trend, while a flatter MA is a warning signal there may be a trend reversal due to declining momentum.

In the chart above, the blue line depicts the nine-day MA, while the red line is the 20-day moving average, and the 40-day MA is depicted by the green line. The 40-day MA is the smoothest and least volatile, while the 9-day MA shows maximum movement, and the 20-day MA falls in between.

Moving Average Convergence Divergence (MACD)

Moving Average Convergence Divergence, otherwise known as MACD, is a widely used and effective indicator developed by money manager Gerald Appel. It is a trend-following momentum indicator that uses moving averages or exponential moving averages for calculations. Typically, the MACD is calculated as 12-day EMA minus 26-day EMA. The nine-day EMA of the MACD is called the signal line, which distinguishes bull and bear indicators.

A bullish signal is generated when the MACD is a positive value, as the shorter period EMA is higher (stronger) than the longer period EMA. This indicates an increase in upward momentum, but if the value starts to decline, it shows a loss in momentum. Similarly, a negative MACD value is indicative of a bearish situation, and an increase further indicates growing downward momentum.

If negative MACD value decreases, it indicates that the downtrend is losing its momentum. There are more interpretations for the movement of these lines such as crossings; a bullish crossover is indicated when the MACD crosses above the signal line in an upward direction.

In the chart above, the MACD is represented by the orange line and the signal line is purple. The MACD histogram (light green bars) is the difference between the MACD line and the signal line. The MACD histogram is plotted on the center line and represents the difference between the MACD line and the signal line shown by bars. When the histogram is positive (above the center line), it gives out bullish signals, as indicated by the MACD line above its signal line.

Relative Strength Index (RSI)

The Relative Strength Index (RSI) is a popular technical momentum indicator. It attempts to determine the overbought and oversold level in a market on a scale of 0 to 100, thus indicating whether the market has reached a top or bottom. According to this indicator, the markets are considered overbought above 70 and oversold below 30. The use of a 14-day RSI was recommended by American technical analyst Welles Wilder. Over time, nine day RSI and 25 day RSI’s became popular.

RSI can be used to check for divergence and failure swings in addition to overbought and oversold signals. Divergence occurs in situations where the asset makes a new high while RSI does not move past its previous high, indicating an impending reversal. If the RSI falls below its previous low, a confirmation of the impending reversal is given by the failure swing.

To get more accurate results, be aware of a trending market or fluctuating market as RSI divergence is not a good enough indicator in case of a trending market. RSI is very useful, especially when used complementary to other indicators.

Stochastically

Famous securities trader George Lane based the Stochastic indicator on the observation that, if prices have seen an uptrend during the day, the closing price will tend to drop near the top of the recent price range.

Alternatively, if the prices have fallen, the closing price tends to be closer to the bottom of the price range. The indicator measures the relationship between the asset’s closing price and its price range over a specified period of time. The stochastic oscillator contains two lines. The first line is the %K, which compares the closing price to the most recent price range. The second line is the %D (signal line), which is a smoothed form of %K value and is considered the most important of the two.

The main signal formed by this oscillator is when the %K line crosses the %D line. A bullish signal is formed when the %K breaks through the %D in an upward direction. A bearish signal is formed when the %K falls through the %D in a downward direction. Divergence also helps identify reversals. The shape of a Stochastic bottom and top also works as a good indicator. For example, say a deep and wide bottom indicates that the bears are strong and any rally at such a point could be weak and short-lived.

A chart with %K and %D is known as Slow Stochastic. The stochastic indicator is one of the good indicators that can best be clubbed with the RSI among others.

Bollinger Bands®

The Bollinger Band® was developed in the 1980s by financial analyst John Bollinger. It is a good indicator to measure overbought and oversold conditions in the market. Bollinger Bands® are a set of three lines: the middle line (trend), an upper line (resistance) and a lower line (support). When the price of the commodity under consideration is volatile, the bands tend to expand, while in cases where the prices are serially bound, there is contraction.

Bollinger Bands® are useful for traders who want to detect the turning points in a range bound market, buy when the price drops and hit the lower band and sell when the price rises to touch the upper band. However, as the markets begin to trend, the indicator begins to give false signals, especially if the price moves away from the range it has been trading. Bollinger Bands® are considered suitable for low-frequency trends.

The Bottom Line

There are many technical indicators available to traders, and choosing the right ones is essential for informed decisions. To be sure of their suitability for the market conditions, the trend following indicators are suitable for trending markets, while oscillators are well suited in fluctuating market conditions. However, beware: the improper application of technical indicators can lead to misleading and false signals, leading to losses. Therefore, starting with Stochastic or Bollinger Bands® is recommended for those who are new to using technical analysis.

Investopedia does not provide tax, investment or financial services and advice. The information is presented without regard to the investment objectives, risk tolerance or financial circumstances of any particular investor and may not be suitable for all investors. Investing involves risk, including the possible loss of principal.