Market guru Dr Alexander Elder is one of the contributors to a newer generation of technical indicators such as the force index, which is an oscillator that attempts to measure the force, or the power, of bulls behind particular market rallies and of bears behind every decline.

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The three key components of the force index are the direction of price change, the extent of the price change and the trading volume. When the force index is used in conjunction with the popular technical analysis tool the moving average (MA), it is argued that the resulting figure can more accurately measure significant changes in the power of bulls and bears.

How to calculate it

The force index is calculated by subtracting yesterday's close from today's close and multiplying the result by today's volume. If closing prices are higher today than yesterday, the force is positive. If closing prices are lower than yesterday's, the force is negative. The strength of the force is determined either by a larger change in price or a larger volume; either situation can independently influence the value and the change in force index.

The raw value of force index is plotted as a histogram, with the center line set to zero. A higher market will result in a positive force index, plotted above the center line; a lower market points to a negative force index, below the center line. An unchanged market will return a force index directly on the zero line. The raw line that is plotted over the day-to-day on the histogram forms a jaggedness and the moving average smooths the line. Therefore, at minimum, you'll want to use a two-day exponential moving average (EMA) for the appropriate level of smoothing.

Interpreting the Force Index

In general, it is argued that traders will want to buy when the two-day EMA of force index is negative and sell when it is positive. These traders, however, should always keep in mind the overarching principle of trading in the direction of the 13-day EMA of prices. The 13-day EMA of force index is a longer-term indicator, and, when it crosses above the centerline, the bulls are exerting the greatest force. When it is negative, the bears have control of the market. Of particular importance are divergences between a 13-day EMA of force index and prices, which correspond with precise points, indicating crucial turning points of the market.

As indicated by closing prices, the difference between yesterday and today's close gives the degree of the day-to-day victory of either the bulls or the bears. Similarly, volume is added into the calculation to give a greater sense of the degree of bulls or bears' victories. Volume also indicates the level of momentum in the market, as propelled by the power of either bulls or bears.

Force index is one of the better indicators for combining both price and volume into a single readable figure. When force index hits a new high, a given uptrend is more likely to continue. When force index hits a new low, the bears have greater strength and the downtrend will usually sustain itself.

A flattening force index is also an important situational circumstance for traders. A flattening force index means that the observed change in prices is not supported by either rising or declining volume and that the trend is about to reverse. On the opposite side of the matter, a flattening force index could indicate a trend reversal, if a high volume corresponds with only a small move in prices.

So, this is the basic manner in which force index can be used alone, or in conjunction with a moving average, to identify whether bulls or bears have control of the market. When volume is considered, an accurate sense of the market's momentum may also be quickly garnered.

Short or longer-term trading

The system can be used on either a short-term or a longer-term basis to gain a rather precise picture of the force, or the power of the bulls and the bears, in the market. 

The two-day exponential moving average (EMA) plotted on a histogram gives the shortest-term indication of the force of the bulls or the bears. When the two-day EMA exceeds the centerline, the bulls are stronger. When it is below the centerline, the bears are shown to be stronger.

When used in conjunction with other trend-following indicators, the effectiveness of the two-day EMA can be enhanced even more. By using any other trend-following indicator to identify an uptrend, you can pinpoint the best buying points at the very moments that the two-day EMA of force index declines. When another trend indicator shows a downtrend, a two-day EMA of force index will identify the precise areas at which shorting is the appropriate trading decision.

To identify a short-term bottom in a market uptrend, wait until the two-day EMA of force index turns negative. You will then be buying when a longer-term uptrend is experiencing a temporary pullback. More specifically, place your buy order above the high price of the day when the two-day EMA of force index turns negative during an uptrend. You are then protected from a decline in prices as your order will not be executed if prices decline; however, if, as expected, the uptrend resumes, your long order will be filled in a strong bull uptrend.

If you lower your buy order to within one tick of the high, you can place a protective stop below the low of the day (or the previous day's low if it was the lower price) once your buy stop is triggered. This tightens your stop so that you are able to exit the trade early if the trend is weak.

In the case where a two-day EMA of force index turns positive in a market downtrend, the preferred strategy is to sell short. This is a quick opportunity provided by market bullishness, allowing you to place an order to sell short just below the low of the latest price bar. If the quick dose of bullishness is sustained longer than anticipated, you can raise your sell order every day to stay within a tick of the latest low. Then, when prices slide, your short trade is executed, and you can place a protective stop above the high of the latest price bar (or the previous bar if that was the higher price). You can then move your stop to break even as soon as possible.

You can also use the two-day EMA of force index to add to your long and short positions: you can add to long positions in an uptrend every time the force index turns negative, and supplement your shorts when the force index turns positive. On a longer-term basis, when the two-day EMA of force index falls to its lowest level in a longer period of time (a month, for example), the bears have exceptional strength, and prices will likely fall even lower. Alternatively, when a two-day EMA of force index rallies to its highest level in a month, bulls are exhibiting strength, and prices are likely to rise higher.

In deciding when to close out either a long or a short position, the two-day EMA of force index is a crucial tool. If a short-term trader buys when the two-day EMA of force index is negative, he or she should sell when it turns positive. If the trader goes short when the indicator is positive, he or she should cover when it turns negative. A longer-term trader should exit his or her position only if the trend changes, or if there is a divergence between the two-day EMA of force index and the larger trend.

Divergences are also crucially important when trading on the basis of force index. Bullish divergences occur when prices fall to a new low while the force index makes a shallower bottom. Bullish divergences between the two-day EMA of force index and the price are strong buy signals. Strong sell signals are issued by bearish divergences between the two-day EMA of force index and the price. When prices rally to a new high while force index hits a lower second top, a bearish divergence is realised.

Intermediate-term Force Index

Instead of relying exclusively on the two-day EMA of force index, we can identify longer-term changes in the strength of bulls and bears by using a 13-day EMA of force index. Like the two-day EMA of force index, the 13-day figure indicates bulls are in control when it is above its centerline. When it is below the centerline, bears are stronger. When the indicator remains at or near its centerline, the market is said to be "trend-less:" the force index or other trend-following trading indicators will not give accurate trading information.

When a 13-day EMA of force index reaches a new high, an uptrend is confirmed. This essentially means that the rally has strength and prices will jump on heavy volume. As the uptrend becomes long in the tooth, prices either rise more slowly than before, or volume becomes progressively thinner. The 13-day EMA of force index then displays lower and lower tops, eventually dropping below its centerline. This important trend is the final indication that the bullish trend has run its course.

A brand-new high in a 13-day EMA of force index histogram indicates the likelihood of a sustained rally. A bearish divergence between the 13-day EMA of force index and price is a strong indication to sell short. If prices reach a brand new high but the 13-day EMA of force index hits a lower peak, the bulls are losing control, and the bears are ready to step in and take over.

The continuance of a downtrend is typically indicated by the 13-day EMA of force index broaching a new low. If, by contrast, prices fall to a new low but the 13-day EMA of force index traces a shallower low, bears are losing their power. This is a bullish divergence, and it is a strong buy signal.

Conclusion

When a downtrend begins, prices usually drop initially on heavy volume. When the 13-day EMA of force index falls to new lows, the decline is confirmed. When the downtrend begins to lose strength, either prices fall more slowly or volume gradually declines. The 13-day EMA of force index then reaches ever-shallower bottoms, finally rallying above its centerline: the bear has been beaten, and a bullish reversal is nigh.