Traders need every edge they can get to stack the odds in their favor. That's why so many of them rely upon technical indicators to inform their trade decisions.
Charting indicators have long been used by traders and longer-term investors to gauge the market and find the best entry and exit points for their investments.
If you're looking for a way to tighten up your trading, read on to find out which technical indicators may help you.
The Short Version:
- Technical indicators are a trading aid that can help give traders a pulse on the market, by measuring volume, price, volatility and more.
- The moving average can help inform investors of stock trends and any changes in the trend.
- Volume can indicate a trend's robustness and what stage the trend is in.
- After you're comfortable using basic technical indicators, you'll be able to layer more on to get even more viewpoints of the market.
What Are Technical Indicators?
Technical indicators are essentially a trading aid. These indicators are offered by most brokerage platforms as graphical overlays on a stock’s price chart.
Stock prices and volumes can give traders a pulse on the market and provide cues of a trend or a reversal. Technical indicators can help to clearly outline the most important information to traders.
In general, the best use of technical indicators is for risk management purposes. They can give traders an idea of whether the probabilities are in favor of their chosen strategy, which then helps traders make more informed decisions.
Technical indicators can help long term investors as well. Imagine you have found an attractive business that is going through some temporary issues, and has collapsed in price. You want to get in as you believe you will be getting a bargain, but you don’t know when the wave of selling will be over. Technical indicators can tighten up this process and provide a more accurate entry point.
6 Best Technical Indicators
Here are 6 technical indicators that traders and investors rely upon most often to find optimal entry and exit points.
Volume comes with most price charts as standard. But it’s often completely overlooked despite the wealth of information it provides on price movements.
In the short term, stock price movements are the results of mismatches in supply and demand. When there are more buyers than sellers, prices move up and vice versa. In each of those changes of price, thousands of shares are changing hands and across trades every second.
That is where the value of volume comes in. Let's say you’re watching prices break out of a consolidated range but are worried that you might be faked out before price reverses. One way to see how serious that breakout is to look at the underlying volume and compare it to the rest of the period.
How to Use Volume to Your Advantage
If you see that the breakout is occurring on unusually low volume, it may be that a single large buyer came in and bought a large block of stock in one go. The problem with this is that once he has bought what he’s interested in, there won't be any more buyers at that price, and the share price will immediately retreat.
Compare that to a situation with higher than usual volume. Here we can assume that there are many different buyers buying all at once, which makes it a much more robust wave of buying. This kind of breakout has a higher chance of succeeding and being maintained.
Another great use of volume is to spot a trend’s robustness, or to see what stage the trend is in. No one wants to be the last one in on a trend trade, right before it changes course. Volume can help with that.
When looking at a longstanding trade, take a look at the volume bars over the same period. Are they remaining constant or are they declining over time? A decline in volume on increasing prices may be a warning that there are less and less available buyers to raise prices. In general, trends are more fragile on low volumes.
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2. Moving Averages
The moving average is perhaps the most well known technical indicator out there. It’s used by traders and investors alike, as well as both retail and institutions.
The moving average is most often used as a judgment of trend and changes in the trend. Generally speaking, a stock whose price is above its moving average slope is considered in an uptrend, while one below its moving average is considered in a downtrend.
The popularity of the moving average can turn it into a self fulfilling prophecy. Because so many traders follow it, a price dip below a significant moving average can trigger a wave of selling, making this indicator a key one to follow.
The period used for the moving average is key. A long-term moving average changes its slope only after a significant change in prices that holds for a long time. The issue here is that the moving average may be slow to react to a significant change in the stock. A short term moving average has the opposite problem and is prone to false signals as prices jump below and above it.
There are a few ways to counter this. One is by combining different indicators, like combining the 10-, 50- and 200-day moving averages.
3. Golden Cross and Death Cross
Another common use of combining different moving averages is by using the Golden Cross and Death Cross. This relies on following two different moving averages, and watching them converge. The direction of the moving average is potentially bearing or bullish for future prices.
A Golden Cross — in which the graph of shorter-term moving average crosses above the longer-term average — is bullish. Many investors wait for this sign to invest as it often signals the beginning of a new uptrend.
Again, because it is so widely followed, this can also become a self-fulfilling prophecy, as a wave of buying occurs as soon as a Golden Cross happens.
A Death Cross — or a downward trending short-term moving average — is bearish. This may warn of a potential long term downtrend in stock prices. Many traders may exit positions once a death cross occurs.
4. Relative Strength Index (RSI)
If the moving average was an indicator based around trends, the Relative Strength Index is a tool for predicting reversals. Stocks can either be trend-following or range-bound, (meaning that it’s either going up/down or bouncing around a set price range). The RSI can give traders an edge in a range-bound market.
The RSI looks at the average gains and losses per day of a stock, and then graphs it out as an oscillating graph that ranges from between 0 and 100. Readings above 70 are considered overbought while readings below 30 are considered oversold. The RSI is generally plotted underneath the stock price in its own separate window. Generally speaking, a line is graphed with a reading between 0 and 100.
5. Timing Reversals With RSI
This tool is great for timing reversals in stocks that may be overbought or oversold. However, traders should keep in mind that a stock that is heavily trending up will look overbought on the RSI, and oversold when trending down.
It's also important to note whether the stock you're following is in a strong trend or range-bound. If it's been trending heavily, moving averages can be more useful than the RSI. If however the stock has been range bound or chopping sideways, the RSI can show traders attractive entry and exit points.
6. Bollinger Bands
Bollinger Bands rely on the volatility of prices. When using the indicator, traders will see two bands, one above and one below the moving average.
To create the bands, the indicator plots a short term moving average and calculates what 2x the standard deviation of prices for that period is. The standard deviation represents the volatility of prices, as it shows the distance from the average. The reason for using twice the standard deviation is to mark periods of significant volatility.
If prices close outside of these bands, it may signal that a reversal is likely. This is because for prices to close outside of the bands would require an especially volatile price change, which historically leads to at least short-term reversals.
There is no technical indicator that can guarantee trading results. However, the indicators above can give traders a better read on the markets, position themselves more accurately, and make smarter trading decisions.
Traders and investors just starting out with technical indicators should focus on what indicator suits their trading style best. Once you’re comfortable, you can try adding a few other overlays to work with what you have.
What's important when doing that however is to not get lost in the information and lose sight of your original trading strategy. Remember, these indicators are tools and not strategies in of themselves.
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