Technical analysis indicators can appear arcane, opaque and difficult to understand. But it needn’t be this way and once mastered they are indispensable tools for traders.
Whilst the construction of technical analysis indicators and oscillators is often complex, applying them and understanding how to use them to generate valuable trading signals is a lot more straightforward. In this article, ETX Capital guide traders through five different indicators and explain the basics of how to use them.
Indicators can generally be divided into two camps – trend following and momentum. Trend following indicators tend to lag price action. Momentum measures the rate that prices change and is said to lead price action.
The first two indicators you’ll read about are trend-following in nature. These are the different moving averages and Bollinger Bands. The final two indicators – the RSI and Stochastics – are momentum indicators. The exception is the MACD, or moving average convergence divergence, which combines aspects of trend-following and momentum to produce one of the most popular and valuable technical indicators.
A moving average is one of the simplest and most popular technical analysis indicators that traders use. The aim is to filter out ‘noise’ by smoothing short-term fluctuations in price action. A moving average is a lagging indicator – it is good at showing a trend but signals tend to be given after a change in the price action.
There are 3 major types of moving average – the Simple or Arithmetic, the Weighted and the Exponential. These vary in their construction and tend to produce differing results using the same inputs, but their purpose is exactly the same.
Time frames for moving averages vary and can be based on hours, days, weeks or even years. Intervals can also be changed, depending on the type of security being traded and the approach of the trader. For example, in equities trading 50-day and 200-day averages are common. In commodities, 4-day, 9 day and 18-day averages have become quite standard.
Commonly closing prices are used but it is possible to use open, high, low or even typical prices as the basis for the average. In addition to providing trading signals, averages can act as support and resistance levels when determining the price targets.
Bollinger Bands make use of moving averages to produce trading signals based on market volatility. Devised by John Bollinger, they are among the simplest technical analysis indicators to use.
A 20-day simple moving average of the security is plotted. Above and below these are the bands, which are 2 standard deviations away from the moving average. You don’t need to know about standard deviations to understand the indicator; suffice to say that this methodology ensures around 95% of all price action remains within the two bands.
Moving average convergence divergence – MACD – is one of the most popular technical analysis indicators for traders. It incorporates trend following and momentum characteristics. This indicator shows the relationship between two moving averages to identify changes in market trends.
The MACD line shows the difference between two exponential moving averages (EMAs). Usually, this involves subtracting the 26-day EMA from the 12-day EMA.
A nine-day EMA of the MACD line is the third element and this is known as the Signal or Trigger line. When the two lines crossover it’s taken as a signal that a change in trend is likely.
When adding your MACD indicator to your chart, you have the option of defining these moving averages according to your own desired time frames, however, most people stick to the 26-12-9
The Relative Strength Index (RSI) is one of the simplest ways to gauge momentum. Developed by J. Welles Wilder in the 1970’s, it’s based on the simple notion that prices will tend to close higher in an uptrend and close lower in a downtrend.
RSI is constructed by comparing the average gains on up days and average losses on down days over a given period, usually 14 days. A shorter time period may be appropriate for less volatile markets.
The reading is a number between 0 and 100. Rising markets will produce readings closer to 100 while falling markets will result in readings closer to zero.
Stochastics is a momentum indicator that shows where the most recent closing price fits in relation to the price range over a predetermined number of days, usually 14. The indicator is based on the premise that prices have a tendency to close at or near highs in when the security is in an upward trend, and at or near lows when prices are trending lower.
A reversal signal is given on divergence. For example, if the market continues to make new highs but prices are tending to settle at the lows of the day, it can foreshadow a reversal in the uptrend. From a logical viewpoint, this makes sense as if prices are not able to settle at the highs of the day it suggests buyers are losing interest and taking profits sooner.
Whilst you do not need to know the formulae used to work out the indicator, it is useful to how the basis of its construction so you can apply it to your trading. The indicator usually incorporates two lines, the %K and %D lines which oscillate between 0 and 100. The %K shows the latest close in relation to the average range of the last 14 days. The %D line takes a 3-day moving average of that line.
For ‘slow stochastics’, which is more commonly used, the data is further smoothed by taking a moving average (usually 3 or 5 days) of the moving average. In this situation, the %K line is the 3-day moving average of the simple 14-day stochastics (the original %D line), and the %D line is a 3 or 5-day moving average of the new, ‘slow’ %K line.