|
The Ultimate Guide to Technical Indicators
Most people that see technical indicators for the first time feel a bit overwhelmed by all of the lines and numbers. It’s a lot like showing an equation containing a sigma symbol (Σ) to a fifth-grader — it might make sense when it’s explained to them, but until then, it looks impossible to understand.
Technical indicators are indispensable tools for analyzing historical market data and predicting prices. Since they’re quantitative in nature, they can generate clear buy and sell signals without subjective analysis. They can also be easily incorporated into automated trading systems.
Let’s take a look at different types of technical indicators, some of the most common indicators, and how to use them to increase your risk-adjusted returns.
Table of Contents
- What Are Technical Indicators?
- Common Technical Indicators
- Moving Averages
- Moving Average Convergence-Divergence
- Relative Strength Index
- On-Balance Volume
- The Bottom Line
What Are Technical Indicators?
Technical indicators are mathematical calculations involving price, volume, open interest or other quantitative metrics used by traders to conduct technical analysis.
For example, a moving average takes the closing price over the past X sessions and applies the average to each period plotted on the chart to create a new line. Traders can see how the current price compares to the average, as well as where the trend is headed on a chart with volatile price action.
Technical indicators typically appear in two places on a chart:
- Overlays use the same scale as a security’s price and they’re plotted over the top of a chart. Since they interact with the price, they are commonly used to show areas of potential support or resistance. Some examples of overlays include moving averages and the Ichimoku Cloud.
- Oscillators use a different scale (e.g. 0-100) as prices and are plotted above or below a price chart. Since they oscillate between two extremes, they are commonly used to gauge a price’s momentum. Some examples of oscillators include the relative strength index (RSI) and the moving average convergence-divergence (MACD).
Technical indicators can be further divided into two categories based on their purpose:
- Leading Indicators are designed to forecast where prices may be heading and are commonly used to generate buy and sell signals. For example, when the relative strength index (RSI) reaches an overbought level, the indicator suggests that traders should sell or go short a stock.
- Lagging Indicators are designed to follow price movements to provide broader insights. For example, moving averages show where prices have been in the past. While they don’t necessarily predict the future, they can be used to generate buy and sell signals.
Traders may use many technical indicators when analyzing a security and/or combine them with other forms of technical analysis, such as candlesticks or chart patterns. The two most common uses of technical indicators are alerting you about possible reversals or confirming other forms of technical analysis that explicitly generate a buy or sell signal.
Technical indicators may also form the basis for automated trading systems given their quantitative nature. For example, an automated trading system may generate a buy signal — or even execute a limit order — whenever the RSI crosses below 30.0 and the price rises above the 5-day moving average.
Common Technical Indicators
There are thousands of different technical indicators — and more are created every day, but some have withstood the test of time better than others. These simple indicators also form the basis for more complex indicators. For instance, moving averages serve as the basis for the MACD indicator.
Let’s take a look at some of the most common technical indicators and how they are calculated.
Moving Averages (MA)
Moving averages are the most common technical indicator used to smooth prices and show trends. In addition to spotting trends more easily, moving averages form the basis for trading strategies, like the moving average crossover, serve as key levels of support and resistance, and even form the basis for more complex technical indicators.
The two most common moving averages include:
- Simple Moving Averages (SMA) – SMAs are the simplest type of moving average formed by computing the average price over a specific number of periods.
- Exponential Moving Averages (EMA) – EMAs are reduce lag by applying more weight to recent prices. For example, a 10-day EMA applies an 18.18% weighting to the most recent price.
Most traders use moving averages in conjunction with other technical indicators when making decisions. For example, they may use the 50- and 200-day moving average as an indicator of support or resistance, but look for confirmation using other technical indicators or chart patterns. They may also use moving averages as inputs for other technical indicators.
TrendSpider enables traders to create real-time email or SMS alerts when the price of a stock reaches a moving average — or any other overlay technical indicators — without writing a single line of code. You can even add other criteria to the alert to create more specific trading systems.
Moving Average Convergence-Divergence (MACD)
The moving average convergence-divergence (MACD) is an oscillator designed for both trend following and momentum. By analyzing convergences or divergences between two EMAs, the indicator shows how quickly the price is moving relative to its historical norms. This can help traders see when a trend may be gaining or losing momentum.
There are several parts to the MACD:
- MACD Line: The 12-day EMA minus the 26-day EMA.
- Signal Line: The 9-day EMA of the MACD Line.
- Histogram: The MACD Line minus the Signal Line.
The 12-day, 26-day, and 9-day settings are the most common numbers used in MACD calculations, but the indicator can be customized to use any periods. Traders may want to experiment with different settings on different securities to find the inputs that work best in a given scenario. TrendSpider makes these tests a lot easier with security-specific backtesting.
Many traders look for divergences between the MACD and the current price action. When the underlying security is making lower prices, but the MACD is moving upwards, it could be a sign that a trend reversal may be imminent. The opposite is true for a bearish divergence, which could signal the start of a new bearish downtrend in a security’s price.
Relative Strength Index (RSI)
The relative strength index (RSI) is an oscillator that’s helpful for measuring momentum. By dividing the average gain by the average loss over a specified period of time, the indicator creates an index that measures the strength of a trend. The oscillator’s value varies from zero to 100, although it rarely reaches either of the extremes.
The calculation for RSI is simple:
100 – (100 / (1 + (average gain / average loss)))
Many traders look for overbought conditions, above 70.0, as an opportunity to sell or go short and oversold conditions, below 30.0, as a buying opportunity. Like the MACD indicator, traders also look for instances where the underlying security price experiences divergences with the RSI line. These divergences could point to near-term reversals in trend.
On-Balance Volume (OBV)
On-balance volume is a volume-based technical indicator that measures buying and selling pressure. By keeping a running total of positive and negative volume, traders can easily gauge buying and selling pressure that goes beyond merely looking at a security’s price. After all, price movements alone may not be relevant if there’s no volume to back it up.
There are a few different ways that traders use OBV:
- Volume often precedes price, so a rising OBV could reflect positive volume pressure, which could lead to higher prices. The opposite is true for a falling OBV value.
- Bullish or bearish divergences could point to a near-term trend reversal in the same way that they do for the MACD and RSI indicators.
- OBV can be used to confirm a price trend or the efficacy of other technical indicators.
The Bottom Line
Technical indicators are mathematical calculations that create lines and numbers that are commonly used in technical analysis. While traders rarely rely on a single technical indicator to make a decision, they are often combined to create powerful trading signals in manual or automated trading systems. They’re also great when used for confirmation.
TrendSpider goes beyond just showing technical indicators on a stock chart — you can set up real-time alerts involving one or more indicators and combine them with chart patterns and other forms of technical analysis. This lets you build complex trading systems without the need to write a single line of code, as well as backtest them.
Sign up today for a free trial and see how TrendSpider can help you level up your trading.
