As W. D. Gann said, “I found that over 90% of the traders who go into the market without knowledge or study usually lose in the end.”
Technical indicators can play a major role when you are unsure whether to enter or exit trades. They help you in predicting the stock market up to a certain level of accuracy, maximizing your profits and reducing your risks. In simple terms, Technical Indicators are numerous charts that represent the market/price patterns and if read correctly help you decide whether the prices are heading north or south, or whether the stocks are overbought or oversold. They are charts formed from a series of data points that are derived by applying a formula to the price information of a particular instrument. Price/Volume indicators are the most basic technical indicators used to predict a particular stock.
Technical indicators help in analyzing the price of an instrument from a whole new perspective. Some indicators, called moving averages, are easier to understand whereas others like stochastics are derived from more complex formulas. While analyzing the stock market, it is advised to follow up to two or three indicators and those which complement each other. All the brokerage firms offer charting capability and you can use that to perform technical analysis. Please go to top stock brokers if you need help selecting a broker for trading.
Broadly speaking, there are two main types of technical indicators.
These usually track price changes and help you generate the buy or sell signals. They generally provide more trading opportunities but then it is riskier to follow these indicators.
Some of the more common leading indicators are:
- Commodity Channel Index (CCI). The CCI is designed to identify cyclical turns in commodities. It may also be applied to stocks or bonds and helps in assessing whether a particular instrument has been overbought or oversold. CCI draws a relationship between the instrument’s price, its moving average and normal deviations (D) from that average (called the Mean Absolute Deviation). The formula can be given as: CCI draws a relationship between the variations of the current price of the instrument from its mean. CCI is primarily used to detect divergences from the price trends and is more of an overbought/oversold indicator
- Momentum. Momentum measures the rate of change in a securities price. “Bullish and bearish interpretations are found by looking for divergences, centerline crossovers, and extreme readings.” The faster the price rises or falls, the greater is the momentum.
- Relative Strength Index (RSI). RSI is also a momentum indicator which does a comparison of the price changes during the advancing periods with those during the declining periods. It helps in determining whether an instrument is overbought or oversold with the help of its vertical scale. RSI is plotted from 0 to 100, where values below 30 are oversold and values above 70 are overbought. The warning given when the values are in either of those extremes is called trend setting.
RS = Average Gain / Average Loss
- Stochastic oscillator. “Stochastic oscillator is a momentum indicator that shows the location of the close relative to the high-low range over a set number of periods.” The stochastic oscillator does not follow the volume or the price; rather it follows the momentum of price. The oscillator is useful in, “identifying bull and bear set-ups to anticipate a future reversal” and for “identifying overbought and oversold levels.” It helps in finding the range between the highest and lowest prices of an instrument during a given period. “Divergence-convergence is an indication that the momentum in the market is waning and a reversal may be in the making.” It can be described as:
Where H and L are, the highest and the lowest prices, respectively, over the last n periods, and %D = 3 period exponential moving average of %K
- Williams %R. It is also a momentum indicator which is pretty much the inverse of the Stochastic Indicator. It shows the current closing price in relation to the high and low for s period of n days. It is very useful in measuring the overbought and oversold levels but unlike the stochastic oscillator, its range is from 0 to -100. So if the reading is between 0 to -20, the instrument is considered overbought and from -80 to -100, it is considered oversold. Typically, Williams %R is calculated using 14 periods and can be used on intraday, daily, weekly or monthly data. As put forward by this indicator, -100 indicates the close today at the lowest low of the past n days whereas 0 indicates is a close today at the highest high of the past n days. Williams has also written down the signals which should initiate a buy and sell call based on the model given above.
Leading indicators have a lot of benefits because it helps in early entry or exit. They give a warning signal before the actual event takes place. Thus, leading indicators can result in great returns but there is also a danger of false indications that can increase the risk involved.
These also follow the price but after the changes have taken place and are called trend-following indicators. But the signals from Lagging Indicators tend to be a little late and increase the risk.
“One of the main benefits of trend-following indicators is the ability to catch a move and remain in a move. Provided the market or security in question develops a sustained move, trend-following indicators can be enormously profitable and easy to use. The longer the trend, the fewer the signals and less trading involved. The benefits of trend-following indicators are lost when a security moves in a trading range.”
Two of the more common lagging indicators are:
- Moving averages. In simple terms, it is an average of the data points. By the nature of its definition, a moving average always changes as it collects the latest points from the market but then there is always a lag because some of the points they come from past prices. Moving averages help in identifying the direction of trend and smoothens out the noise. Simple moving average (SMA) and exponential moving average (EMA) are two very popular moving averages. One cannot say that EMA is better than SMA or vice versa. Both have slightly different behaviors. Again the period for which the moving averages are calculated have their own significance. SMAs are used for short-term trends and trading. Longer moving averages, that range for more periods show gradual changes and good for long-term investors.
- Simple moving average. Most of the moving averages are computed by using the closing prices. The SMA is simply the average of closing points for a specific period and with every average, we keep on discarding the earliest piece of data and add the fresh ones.
- Exponential moving average. EMAs are basically weighted moving averages that try to reduce the lag by giving less weight to old price points.
To calculate an EMA
EMA = (?*?) + (Previous EMA * (1- ?)
P = Current Price
? = Smoothing Factor =
n = Number of Periods
- Moving Average Convergence Divergence (MACD). This is an example of a centered oscillator that fluctuates above and below zero. MACD is the difference between the short EMA and the longer EMA (usually the difference between 12 week EMA and 26 week EMA). So, it has the benefits of both leading indicators as well as lagging indicators. By using EMA’s, it utilizes the properties of lagging indicators but by calculating the difference between 2 EMA’s it becomes a leading indicator with a little lag. This difference helps in analyzing the price momentum. Positive MACD indicates the price momentum is increasing and negative MACD means the price momentum is decreasing. The MACD line is plotted along with the EMA of the MACD called the signal line. The difference between the MACD line and the signal line is plotted as a bar graph called the histogram time series.
We have covered some of the key indicators used to predict the market movements. When it comes to the usage of technical indicators, a fine balance has to be maintained. We would love to have an indicator which responds quickly and gives early market signals. But then, such indicators also have the possibility of throwing false signals and increasing risk. So a fine balance has to be maintained. Longer moving averages have slower movements as compared to shorter moving averages which generate relatively more signals. But then again, while longer moving averages do not help in early entries or exits, shorter averages might also raise false signals.
As such, analysts advise to use complementary market indicators which balance out the shortcomings and reduce your risk.
About the author
Punit Gupta is an entrepreneur and full-time stock trader. Punit specializes in building startups by bootstrapping. Currently, Punit is developing a brokerage selection platform, Best Trading Brokerage. Punit attended Georgia Institute of Technology Atlanta and worked with an Atlanta based startup for 7 years before quitting to start his own venture.
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