The ChoosaBroker Trading Academy
11.5. Introduction to Technical Indicators
Technical indicators are calculations based on the price and the volume of a security that measure such things as trends, momentum, money flow, and volatility. Indicators are typically utilized as secondary tools to actual price movements and are used in two main ways – to confirm price movement, and to generate buy and sell signals.
Explained below are 8 of the most widely employed technical trading indicators.
Moving average is a popular statistical concept. They came to be adopted by financial market traders to smoothen fluctuations in asset prices so that the broader trend can be ascertained. Moving averages can be grouped in to two main categories:
- Simple Moving Average – A Simple Moving Average (SMA) is nothing but the average price of an underlying asset during a specific period of time.
- Exponential Moving Average – The Exponential Moving Average (EMA) looks very similar to a simple moving average but attach greater weight age to recent prices.
First conceived by Gerald Appel in 1979, the Moving Average Convergence Divergence (MACD) is a combination of two exponential moving averages (EMA), which are merged to form a single momentum barometer by deducting the longer term EMA from the shorter EMA. The resultant indicator attains the twin benefits of being not just a trend locater, but also a momentum oscillator.
- A crossover between the MACD line and the signal line is widely used to pinpoint buy or sell zones.
- The main MACD line closing above or below the centreline also constitutes legitimate trading signals. A bullish centreline crossover is one in which the main MACD Line rises above zero to turn positive. A bearish centreline crossover develops when the MACD line falls in to negative territory.
- Divergences in direction of MACD with underlying price are one of the post powerful technical trading signals.
Stochastic is a popular momentum oscillator that helps find out if an underlying asset is in overbought or oversold territory. It shows the location of current price relative to the high-low set during a defined period of time, making it a handy tool for traders looking to enter on market weakness and exit on strength. The Stochastic Oscillator is composed of two lines – the %K and the %D. When both of these lines are plotted on a technical chart, it is referred to as a “Full Stochastic.”
- Once the %K line crosses above the 80-mark on the Stochastic-scale, the underlying asset is deemed to be in “overbought” territory, and is likely to decline. Contrarily, when the %K line drops below the 20-mark on the Stochastic-scale, prices are considered to “oversold,” and are ripe for a bounce higher.
- When the %K cuts the %D from below, it signals that prices are gaining at a faster than average rate, and the bias is for long trades. Conversely, when the %K crosses the %D line from above, traders should look to enter in to short trades.
- Divergences between the Stochastic oscillator and price provide powerful trend reversal signals. When a high or low in an underlying asset is not confirmed by indicator, divergence is said to have occurred.
The Relative Strength Index (RSI) is a simple, yet highly effective momentum oscillator that measures the rate at which the price of an underlying asset is changing. First propounded by J. Welles Wilder in his 1978 classic trading book, “New Concepts in Technical Trading Systems,” the RSI fluctuates between 0 and 100, with readings below 30 indicating an “oversold” market, while those above 70 represent “overbought” conditions.
Technical trading signals generated by the RSI can be broadly classified in to the following categories:
The RSI is regarded as being overbought when above the 70-mark and oversold when under 30. However, these levels should not be taken as the Holy Grail. Each market has its own internal dynamics, which may result in different areas acting as overbought/oversold zones. If any asset is repeatedly crossing above 70, the overbought level should be should be raised to 80. The reverse is true in case of oversold markets.
The RSI, just like price charts, often have the tendency to form chart patterns, the most common among which are double tops and double bottoms. Trendline and support/resistance analysis is also applicable to RSI, and can often facilitate early entry in to a trend.
Another highly reliable RSI signal is when underlying prices make a fresh high or low, which isn’t confirmed by the RSI. Such signals are termed as “Divergences.” On the first sign of weakness in the RSI, traders can initiate shorts below last major pivot low. Contrarily, when the RSI is positively diverging, any close above the most recent structure high can be used to get long in the market.
Bollinger Bands are overlaid on a price chart, and help traders’ assess the volatility in an underlying asset’s price. John Bollinger first introduced the concept behind the indicator on a television show aired on the Financial News Network in 1983. The indicator is composed of a central moving average (simple or exponential), sandwiched between an upper band and a lower band. The two bands are plotted above and below the moving average at a pre-defined standard deviation away from price.
The width of the band is a very good indicator of the current volatility in the market. The narrower the bands, the less volatile a market is, and vice versa. Furthermore, by comparing the location of price relative to the Bollinger Bands, a trader can also deduce if the asset is relatively over or under priced.
The most common strategy adopted by traders is to go long when price touches the lower band and exit when price moves back to the central moving average. Contrarily, when price touches the upper band, traders prefer to go short, and cover when price moves back to the centre-line.
The above strategy may seem theoretically plausible, but in reality, the extent of a price move can never be dictated by a mathematical envelope. As a result, this idea of buying low and selling high will lead to a lot of false trades. John Bollinger instead advocates that since the bands mimic technical oscillators, the best results can be achieved by integrating Bollinger Bands with classical chart patterns.
Average Directional Index
Trend following is by far the most popular and the most profitable of trading strategies – whether it be short term or long term. And the trend determining indicator of choice for a vast majority of professional market operators is the Average Directional Index (ADX).
The ADX not only indicates the presence of a trend, but also measures its strength. Readings typically ranges between 0 and 50. The higher the indicator, the stronger is the trend. Conversely, low levels are symptomatic of weak or no trends.
The ADX is made up of three lines, all of which measure different aspects of price action:
- ADX line
- DI+ line
- DI- line
Commodity Channel Index
The CCI is amongst the most widely used gauge of price momentum across diverse assets and time frames. It is especially useful in spotting cyclical trends and areas that are likely to act as reversal zones, making it an integral part of many profitable technical trading systems.
The CCI was first introduced by Donald Lambert through an article he wrote for the “Commodities” magazine in 1980. Lambert primarily created the indicator to locate oversold and overbought levels. The CCI does this by measuring an underlying asset’s price variation from its mean.
SAR is the acronym for “stop and reverse.” The primary function of the indicator is to find potential reversal points in the price of an underlying asset. It is foremost a trend-following indicator and is used to determine entry and exit points in a strongly trending market.
Typically, Parabolic SAR appears as a series of dots above or below price. If the parabola is below price, the trend is considered to be bullish, while a parabola above indicates bearishness. Often these dots act as support during an uptrend, and resistance in case of a down trend.
The Parabolic SAR works best when the market is trending, and is prone to whipsaws during consolidation phases. SAR follows the trend like a trailing stop. In case of an uptrend, the dots continuously rise as long as the trend is in place. The reverse is true during a downtrend.
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