Understanding Technical Indicators in Trading

Understanding Technical Indicators in Trading

Technical Indicators Explained

Technical indicators are pattern-based signals or mathematical calculations based on the price, volume, or open interest of a security or contract that is used by traders who use technical analysis.

By analyzing historical asset price data, technical analysts or chartists are looking for these technical indicators to predict future price movements as well as to judge entry and exit points for trades.

Technical Analysis Explained

Technical analysis is a trading specialization utilized to assess investments and determine trading prospects. It does this by diagnosing statistical movements accumulated from trading activity, such as price movement and volume.

Unlike fundamental analysts, who try to gauge a security’s intrinsic value established on financial or economic data, technical analysts are concentrating on patterns of price movements, trading signals, and various other analytical charting tools to appraise a security’s strength or weakness.

Technical analysis can be used on any security with historical trading data. It includes stocks, futures, commodities, fixed-income, currencies, and other securities. This type of analysis is far more dominant in commodities and forex markets, where traders are focusing on short-term price movements.

Meanwhile, technical indicators, also known as “technicals,” concentrate on historical trading data, such as price, volume, and open interest, rather than the fundamentals of a business, such as earnings, revenue, or profit margins.

Also, technicals are commonly used by active traders since they are created to examine short-term price actions. Yet, long-term investors may also use technical indicators to specify entry and exit points.

Two Basic Types of Technical Indicators

More often, traders are using many different types of technical indicators when they are analyzing a specific security.

With thousands of various alternatives, traders must select the indicators that would work best for them and they should familiarize themselves with how these technicals work.

Also, traders may combine several technical indicators with more subjective forms of technical analysis, such as examining at chart patterns, to come up with trade ideas.

Furthermore, technical indicators could also be incorporated into automated trading systems, given their quantitative disposition.

  1. Overlays

These are the type of technical indicators that use the same scale as prices that are plotted over the top of the prices on a stock chart. Examples of these type of technicals include moving averages and Bollinger Bands.

 

  • Moving Averages

In statistics, a moving average is a calculation employed to examine data points by constructing a sequence of averages of various subsets of the full data set.

In finance, a moving average (MA) is a stock indicator that is typically utilized in technical analysis. The basis for computing the moving average of a stock is to assist in smoothing out the price data by forming a continuously updated average price.

By calculating the moving average, the impacts of random, short-term instabilities on the price of a stock over a defined time frame are mitigated.

Moreover, it has two basic types, which are the simple moving average (SMA) and exponential moving average (EMA)

Simple Moving Average (SMA)

The simplest structure of a moving average, known as a simple moving average, is calculated by handling the arithmetic mean of a provided set of values over a specified period of time. In other words, a cluster of numbers, or prices in the case of financial instruments, are added concurrently and then divided by the number of prices in the set.

Exponential Moving Average (EMA)

The exponential moving average is a classification of moving average that provides more importance to recent prices in an attempt to make it more responsive to the latest information.

In calculating the EMA, a trader or an analyst must first compute the simple moving average (SMA) over a particular time period.

Next, a trader or an analyst must calculate the multiplier for weighting the EMA. It is referred to as the smoothing factor.  It commonly follows the formula: [2/(selected time period + 1)]. Therefore, for a 20-day moving average, the multiplier would be [2/(20+1)]= 0.0952. Then the smoothing factor must be integrated with the previous EMA to arrive at the current value.

Thus, the EMA gives a higher weighting to recent prices, while the SMA allocates an equal weighting to all values.

  • Bollinger Bands

A Bollinger Band is a technical analysis tool. It is characterized by a set of trendlines plotted two standard deviations (positively and negatively) away from a simple moving average (SMA) of a security’s price. Moreover, it can be adjusted to user preferences. Famous technical trader John Bollinger developed and copyrighted it. It was designed to discover possibilities that offer investors a higher probability of properly specifying when an asset is oversold or overbought.

  • Oscillators

Oscillators are a type of technical indicator that swings between a local minimum and maximum, which are plotted above or below a price chart. Examples of oscillators include the moving average convergence divergence and relative strength index.

  • Moving Average Convergence Divergence (MACD)

MACD is a trend-following momentum indicator that depicts the connection between two moving averages of a security’s price. To calculate the MACD one must subtract the 26-period exponential moving average (EMA) from the 12-period EMA.

The result of that calculation is the MACD line. A nine-day EMA of the MACD called the signal line. It is then plotted on top of the MACD line. So, it can serve as a catalyst for buy and sell signals.

Traders may buy the security when the MACD traverses above its signal line and sell, or short, the security when the MACD crosses below the signal line.

Moving average convergence divergence indicators can be analyzed in several methods. But the more common techniques are crossovers, divergences, and rapid rises/falls.

  • Relative Strength Index (RSI)

The relative strength index (RSI) is a momentum indicator utilized in technical analysis. It gauges the volume of recent price shifts to assess overbought or oversold conditions in the price of a stock or other asset.

The RSI is portrayed as an oscillator. This is a line graph that moves between two extremes and can have a reading from 0 to 100.

J. Welles Wilder Jr. originally developed the indicator and introduced in his seminal 1978 book, “New Concepts in Technical Trading Systems.”

Traditional interpretation and usage of the RSI are that values of 70 or above imply that a security is becoming overbought or overvalued. It may be primed for a trend reversal or corrective pullback in price.

An RSI reading of 30 or below shows an oversold or undervalued condition.

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