Earlier this year, I began penning a series on the technical indicators we use in much of our analysis, both in these weekly “Technically Speaking” posts and in our weekly Real Investment Reports. While we often discuss what these signals are indicating, there are often questions involving exactly what these indicators are measuring.
Technical analysis is often dismissed by investors for three reasons:
- A lack of understanding of exactly what technical analysis is,
- An inability to properly apply technical analysis to portfolio management, and;
- The media narrative that “technical analysis” doesn’t work.
There is no “one method” of technical analysis that works for everyone. Every technician uses different methods, indicators, and time-frames for their own analysis. Much depends on your personal investment time frame, risk tolerance and investing behavior.
These articles are an attempt to clearly define some of the more common technical indicators we use in our own portfolio management practice and how we apply them.
(Note: we will be providing our specific methods of technical analysis, indicators, etc., in our forthcoming premium section of Real Investment Advice. Click here for pre-subscription information.)
We are going to continue our journey with the Williams %R Index.
What Is Williams %R
Accordingly to Stockscharts.com:
“Developed by Larry Williams, Williams %R is a momentum indicator that is the inverse of the Fast Stochastic Oscillator. Also referred to as %R, Williams %R reflects the level of the close relative to the highest high for the look-back period. In contrast, the Stochastic Oscillator reflects the level of the close relative to the lowest low. %R corrects for the inversion by multiplying the raw value by -100. As a result, the Fast Stochastic Oscillator and Williams %R produce the exact same lines, only the scaling is different. Williams %R oscillates from 0 to -100. Readings from 0 to -20 are considered overbought. Readings from -80 to -100 are considered oversold. Unsurprisingly, signals derived from the Stochastic Oscillator are also applicable to Williams %R.”
Why do we care about that?
As I have written previously:
“Market downturns are an ’emotionally’ driven imbalance in supply and demand. You will commonly hear that ‘for every buyer, there must be a seller.’ This is absolutely true. The issue becomes at ‘what price.’ What moves prices up and down, in a normal market environment, is the price level at which a buyer and seller complete a transaction.
The problem becomes when the ‘buyer at a higher price’ fails to appear.”
The same goes for “buying stampedes” as well.
At some point, buyers and sellers reach a point of “exhaustion” or more commonly termed “overbought” or “oversold” conditions. This is simply the point at which buyers are unwilling to pay “higher” prices, or sellers are unwilling to accept “lower” prices. Historically, these “overbought” and “oversold” conditions have represented better “entry” or “exit” points for investment capital. The chart below shows the S&P 500 index overlaid with the 14-week Williams %R indicator.
The Williams %R is calculated using the following formula:
%R = (Highest High – Close)/(Highest High – Lowest Low) * -100
- Lowest Low = lowest low for the look-back period
- Highest High = highest high for the look-back period
- %R is multiplied by -100 correct the inversion and move the decimal.
Here is a table of the calculation used for the chart above.
The “average” number of periods, usually 14-periods (minutes, hours, days, weeks, months), can be any length of period chosen by the investor. The longer the “average” the “slower” the movement of the index. This is where it becomes important to “marry” the duration of the index to your investment horizon. Since our portfolios are “long-term” in nature, our example uses a 14-period weekly chart (3-months).
As noted by Stockcharts:
“As a bound oscillator, Williams %R makes it easy to identify overbought and oversold levels. The oscillator ranges from 0 to -100. No matter how fast a security advances or declines, Williams %R will always fluctuate within this range. Traditional settings use -20 as the overbought threshold and -80 as the oversold threshold. These levels can be adjusted to suit analytical needs and security characteristics. Readings above -20 for the 14-day Williams %R would indicate that the underlying security was trading near the top of its 14-day high-low range. Readings below -80 occur when a security is trading at the low end of its high-low range.
It is important to note that overbought readings are not necessarily bearish. Securities can become overbought and remain overbought during a strong uptrend. Closing levels that are consistently near the top of the range indicate sustained buying pressure. In a similar vein, oversold readings are not necessarily bullish. Securities can also become oversold and remain oversold during a strong downtrend. Closing levels consistently near the bottom of the range indicate sustained selling pressure.”
Williams %R is a “tool” that can be used to help identify better entry or exit points for investor capital. However, like any tool, if used improperly it will provide poor results. It is for this specific reason that most investors deem “technical analysis” to be nothing more than “voodoo” and disregard it entirely.
But should you?
As Stockcharts notes:
“Like all technical indicators, it is important to use the Williams %R in conjunction with other technical analysis tools. Volume, chart patterns and breakouts can be used to confirm or refute signals produced by Williams %R.”
This is absolutely correct.
The reason that technical analysis fails most investors is that their investment time horizon exceeds the time-frame of the analysis. For example, most investors are investing capital to perform with the market over the forthcoming year which is why “benchmarking” is so widely adopted. However, they then utilize very short-term (hourly or daily) analysis to manage their portfolio. This “duration mismatch” leads to technical signals that create “bad” entry/exit points for investors more commonly known as “whipsaws” or “head fakes.”
In our own practice, our portfolios are designed for longer-term holding periods. Therefore, outside of short-term trading opportunities, we are more interested in the overall “trend” of the market. Our major concern is a more “major” change in the overall trend that could lead to large losses of capital during the portfolio investment horizon. This is why our focus is primarily on weekly and monthly, and even quarterly, measures which provide a better “match” to our overall investment goals.
There Is Not Just One
There is no indicator that is an “absolute.” Since markets are driven largely by emotion, large price movements can create “false” buy or sell signals in a price based indicator.
“One can’t simply use a single metric to manage risk in their retirement portfolio. It takes a suite of indicators, observing them all in unison, and making buy and sell decisions based on the weight of the evidence at hand.” – Adam Koos
This is why all indicators perform the best when:
- Used in conjunction with other, confirming technical indicators,
- Periods and duration are matched to investment horizons,
- Combined with the overall investment discipline (buy/sell strategy), and;
- Utilizes the K.I.S.S. principle (Keep It Simple, Stupid)
The two biggest problems that investors run into when trying to implement technical analysis into their portfolio management are:
- Using too many different indicators which create contradicting signals which leads to investment “paralysis.”
- A lack of a “buy” and “sell” discipline which corresponds to the technical signals being given. Any portfolio management process is only as good as the investor discipline to adhere to it.
Currently, with the Williams %R index starting to register an overbought condition, it suggests the current advance in the market is getting a bit stretched. This doesn’t mean one should sell everything and go to cash. However, as I noted this past weekend:
“In the intermediate-term, the market is moving back to rather extreme overbought conditions. The market can most assuredly get even more overbought from current levels, but does suggest that upside is becoming more limited from current levels. However, with the weekly ‘buy signal’ triggered this past week, we must give the bulls some room to run.”
“With our portfolios nearly fully allocated, there is not a lot of actions we need to take currently as the markets continue to trend higher for now. We will continue to monitor our exposure and hedge risk accordingly, but with the weekly “buy signal” registered we are keeping our hedges limited and are widening our stops just a bit.”
Technical analysis IS NOT some “black box” approach to portfolio management. However, what technical analysis does provide is a method to extract “emotion” from the “buy/sell” process. For us, the fundamentals dictate WHAT we “buy” and “sell” in portfolios, but it is the technicals that drive the WHEN those decisions are implemented.
You may not agree with our methods, but it is what works for us in our process. I hope you find it useful to yours.
Lance Roberts is a Chief Portfolio Strategist/Economist for RIA Advisors. He is also the host of “The Lance Roberts Podcast” and Chief Editor of the “Real Investment Advice” website and author of “Real Investment Daily” blog and “Real Investment Report“. Follow Lance on Facebook, Twitter, Linked-In and YouTube