Technical Analysis - New Highs and New Lows

As I mentioned several times I believe that it is important to understand the nature of the technical studies in order to properly use them in technical analysis. Use of indicators without understanding the principles that move them may lead into situations when a trader starts to blame an indicator for fake signals.

New Highs & Lows indicators are from the group of Breadth indicators and they represent the number of all stocks reaching the new 52-week highs or lows. These indicators are applied to the indexes and exchanges only (to the basket of stocks) - they cannot be applied to an individual stock.

Initially the New High/Lows indicators were applied to the New York Stock Exchange (NYSE). Now many traders started to apply it to the S&P 500 index which is well known as one of the best indexes reflecting stock market sentiment.

So what does New Highs and New Lows show?

I would set 4 basic principles behind these indicators which summarize my understanding of the New Highs and New Lows based technical studies:

1. When we see that the number of new highs increases and the number of new lows decreases during the price advance we have to understand that the bullish sentiment is dominant on the market. Basically we see that the number of stocks making new highs (moving up) increases and it attract investors to play up. Every day we see more and more stocks involved into uptrend and there is a possibility that the index will continue to move up.
2.  When we see that the number of new highs declines and the number of new lows raises during the price drop we have to understand that the bearish sentiment is dominant on the market. Basically we see that the number of stocks making new lows (moving down) increases and it attract investors to play down and possibility of further crash is still high.
3.  When we see that the number of new highs started to decline and number of new lows started to raise while the index price is still moves up we may tell that some stock from the index basket started to drop after being overbought and this change in the sentiment may involve other stocks into declining movement which may lead the index into the recession.
4.  When we see that the number of new lows started to decline and number of new highs started to raise while the index price is still moves down we may tell that some stock from the index basket started to advance after being oversold and this change in the sentiment may involve other stocks into a recovery process which may lead the index and majority of stocks from this index into the new up-trend.

here are 2 popular technical indicators based on the New- Highs and New Lows numbers - New Highs/Lows Oscillator and New Highs/Lows Ratio:

New High/Lows Oscillator = New Highs - New Lows

New High/Lows Ratio = (New Highs - New Lows) / (New Highs + New Lows) * 100

By applying the principles discussed above to the oscillator and ration we may say that:

1. When then the New Highs/Lows Ratio or Oscillators moves along with a price moving average (price trend) it confirms the current trend.
2.  When we start to see the divergence between the New Highs/Lows Ratio or Oscillators and price moving average it could signal about coming trend reversal.

Comparison of the New Highs/Lows to the behavior of the price moving average helps to look beneath the surface and can often warn about coming trend reversals. Yet, investors should be very careful with applying New Highs and New Lows based technical indicators to the basket with the small number of stocks. Such indexes as Dow Jones Industrials (DJI - basket of 30 stocks), Dow Jones Utilities (DJU - basket of 15 stocks) and Dow Jones Transportation (DJT - basket of 20 stocks) may lead to confusion since in majority of the cases we may see only making New Highs (New Lows = 0) or only making New Lows (New Highs = 0) stocks. To simplify the analysis and help with analysis of the small basket indexes, the moving average could be applied to the New Highs/Lows based technical studies.

Another point is that an investor (trader) should understand that New Highs/Lows indicators are based on the daily data and it could be difficult to use them on the intraday level. It would be logical to use them on charts where 1 bar equal at least to 1 day - lower timeframes become less informative.