Indicators are invaluable trading and investment tools. They provide helpful direction, visual signals, and trend analysis that traders can use to understand what’s going on in the financial markets at any given moment.
A technical indicator is, in essence, a mathematical calculation based on an asset’s price, volume, or even another indicator. Because they are primarily used to analyze short-term pricing movements, they aren’t very useful for long-term investors. They are extensively used however by active traders who could potentially benefit from short-term price movements in the markets.
Indicators help traders navigate the markets and spot or confirm opportunities as they emerge. The 3 main functions of technical indicators are to:
- Alert traders of a trend
- Predict the direction of an assets future price
- Confirm the analysis presented by other indicators
There are four main types of indicators:
Trend indicators – Which help determine a price direction (like downward or upward). Popular trend indicators include; Moving Averages, Moving Average Convergence Divergence (MACD), and Parabolic Stop and Reverse (Parabolic SAR)
Momentum indicators – These help determine when a financial instrument (stock, options, futures, currencies, etc) is gaining or falling in the market. Popular momentum indicators include; Stochastic Oscillator, Commodity Channel Index (CC1), Relative Strength Index (RSI)
Volatility Indicators – That show changes in market prices over a specified period of time (the faster prices change, the higher the volatility). Popular volatility indicators include; Bollinger Bands, Average True Range, Standard Deviation.
Volume Indicators – That account for the volume of executed trades, or in the case of the Forex market, the number of price changes that appeared in a specific time interval. Popular volume indicators include; Chaikin Oscillator, On-Balance-Volume (OBV), Volume Rate of Change.
Together, these indicators form the basis of technical analysis. The trick is to pick a combination of indicators that work for your style of trading, and that will help you make smarter trading decisions.
Let’s take a close look at 3 of the most widely used technical indicators.
When peaks are connected, they form an upper trendline, and when the troughs are connected, a lower trendline appears. In this way, the trendline acts as an identifier of uptrend or downtrend.
Moving Averages
Support and resistance levels can be used, supported by trendlines.
When the market is going upwards, resistance levels form, and the price moves back towards the trendline. Whereas, when the market moves downwards, support levels occur, and the price moves up to the trendline.
According to historical analysis, when the price makes support levels at the trendline, it prevents the price from further declining, and this principle applies to longer timeframes as well.
Other ways to use support and resistance levels are through indicators. Moving averages are a well-known identifier of support and resistance levels. Moving averages smooth the historical price data and predict future price movements.
Moving Averages (MA) is a good way to gauge an asset’s median price during a specific period of time. Whenever the price changes in real-time, it affects the median price. The MA is most commonly used for smoothing out price and volume fluctuations. It registers events that have already happened, so it’s an indicator that provides actual data which is most commonly used to confirm a trend and define areas of support and resistance.
Several other methods can be applied to identify support and resistance levels, like Camarilla Pivot Point or Elliot Wave principle.
MACD indicator
MACD is another popular trend-following indicator. It stands for Moving Average Convergence/Divergence and helps traders see changes in the strength, direction, momentum, and duration of the trend in price movements. The MACD is displayed in the form of a bar graph. The indicator’s histogram helps traders assess the performance of bears and bulls, meaning that you can evaluate the market sentiment. The histogram shows the difference between 2 EMAs, a fast and a slower one.
To find the best market entry period, the indicator applies the signal line, which is a 9 period SMA. Every parameter of the EMAs and the SMA can be customized to suit your preferred time frame. When the MACD histogram goes up, it indicates the bulls have strength, so it’s time to buy and vice versa. The MACD key signal comes at the intersection of the histogram with its signal line: when the MACD goes below the signal line, you should sell, and when the MACD goes above the signal line – it’s time to go long.
Bollinger Bands
Bollinger Bands are used to measure price volatility and help identify when prices may have moved too far relative to recent trading activity. As the name suggests, Bollinger Bands (BB) are made up of a combination of bands using Moving Averages (MA).
Bollinger Bands are made up of three bands:
– The central band – which is a simple moving average (SMA);
– The upper band – which is a MA + 2 standard deviations;
– The lower band – which is a MA – 2 standard deviations.
When trading on BB, remember the price is likely to keep within the upper and lower bands. It’s like channel trading; when the volatility is high, the BB broadens, and when there is low volatility, the BB contracts.
Here is what the indicator shows:
– After the bands become narrow, expect high volatility;
– If the price gets out of the upper band, expect a trend continuation upwards, and vice versa;
– When the highs and lows inside the bands come after the highs and lows outside the bands, expect a trend reversal.
One of the simplest ways to apply Bollinger Bands is to use the upper and lower bands as price targets. For example, if you’re trading gold and the price bounces off the lower band and crosses above the 20-day average, the upper band becomes the price target.