Technical indicators are extremely valuable tools that can be used to determine various aspects of the trend, most important of which is the momentum. The primary purpose of using a technical indicator is to understand the momentum, that is the velocity with which price is changing. Velocity tends to rise steadily as the trend begins, but then starts to slowdown as the trend approaches maturity. For example, once an uptrend begins, the momentum tends to increase at a faster pace because of the change in trend. However, as the uptrend continues, the momentum starts to fade as the intensity of price appreciation slows down. This slowing momentum is usually not very evident to the naked eye just by looking at the price action itself. Therein come technical indicators into action, as these tools can help us in better understanding the momentum of the prevailing trend and help us answer questions such as: is the momentum strong, is the momentum slowing, is the momentum suggesting that a trend reversal could be in sight, etc.
1. Moving average (MA)
The MA – or ‘simple moving average’ (SMA) – is an indicator used to identify the direction of a current price trend, without the interference of shorter-term price spikes. The MA indicator combines price points of a financial instrument over a specified time frame and divides it by the number of data points to present a single trend line.
The data used depends on the length of the MA. For example, a 200-day MA requires 200 days of data. By using the MA indicator, you can study levels of support and resistance and see previous price action (the history of the market). This means you can also determine possible future patterns.
2. Exponential moving average (EMA)
EMA is another form of moving average. Unlike the SMA, it places a greater weight on recent data points, making data more responsive to new information. When used with other indicators, EMAs can help traders confirm significant market moves and gauge their legitimacy.
The most popular exponential moving averages are 12- and 26-day EMAs for short-term averages, whereas the 50- and 200-day EMAs are used as long-term trend indicators.
3. Stochastic oscillator
A stochastic oscillator is an indicator that compares a specific closing price of an asset to a range of its prices over time – showing momentum and trend strength. It uses a scale of 0 to 100. A reading below 20 generally represents an oversold market and a reading above 80 an overbought market. However, if a strong trend is present, a correction or rally will not necessarily ensue.
4. Moving average convergence divergence (MACD)
MACD is an indicator that detects changes in momentum by comparing two moving averages. It can help traders identify possible buy and sell opportunities around support and resistance levels.
‘Convergence’ means that two moving averages are coming together, while ‘divergence’ means that they’re moving away from each other. If moving averages are converging, it means momentum is decreasing, whereas if the moving averages are diverging, momentum is increasing.
5. Bollinger bands
A Bollinger band is an indicator that provides a range within which the price of an asset typically trades. The width of the band increases and decreases to reflect recent volatility. The closer the bands are to each other – or the ‘narrower’ they are – the lower the perceived volatility of the financial instrument. The wider the bands, the higher the perceived volatility.
Bollinger bands are useful for recognizing when an asset is trading outside of its usual levels, and are used mostly as a method to predict long-term price movements. When a price continually moves outside the upper parameters of the band, it could be overbought, and when it moves below the lower band, it could be oversold.
6. Relative strength index (RSI)
RSI is mostly used to help traders identify momentum, market conditions and warning signals for dangerous price movements. RSI is expressed as a figure between 0 and 100. An asset around the 70 level is often considered overbought, while an asset at or near 30 is often considered oversold.
An overbought signal suggests that short-term gains may be reaching a point of maturity and assets may be in for a price correction. In contrast, an oversold signal could mean that short-term declines are reaching maturity and assets may be in for a rally.
7. Fibonacci retracement
Fibonacci retracement is an indicator that can pinpoint the degree to which a market will move against its current trend. A retracement is when the market experiences a temporary dip – it is also known as a pullback.
Traders who think the market is about to make a move often use Fibonacci retracement to confirm this. This is because it helps to identify possible levels of support and resistance, which could indicate an upward or downward trend. Because traders can identify levels of support and resistance with this indicator, it can help them decide where to apply stops and limits, or when to open and close their positions.
8. Ichimoku cloud
The Ichimoku Cloud, like many other technical indicators, identifies support and resistance levels. However, it also estimates price momentum and provides traders with signals to help them with their decision-making. The translation of ‘Ichimoku’ is ‘one-look equilibrium chart’ – which is exactly why this indicator is used by traders who need a lot of information from one chart.
In a nutshell, it identifies market trends, showing current support and resistance levels, and also forecasting future levels.
10. Average directional index (ADX)
The ADX illustrates the strength of a price trend. It works on a scale of 0 to 100, where a reading of more than 25 is considered a strong trend, and a number below 25 is considered a drift. Traders can use this information to gather whether an upward or downward trend is likely to continue.
ADX is normally based on a moving average of the price range over 14 days, depending on the frequency that traders prefer. Note that ADX never shows how a price trend might develop, it simply indicates the strength of the trend. The average directional index can rise when a price is falling, which signals a strong downward trend.
The Benefits of a Technical Indicator
- Technical analysis indicator provides a viewpoint on the strength and direction of the price action of the stock. As discussed earlier, their main function is to alert, confirm and predict.
- Stock prices fluctuate continuously and hence it can become cumbersome to make a track. But here is when the Technical analysis indicator comes handy. These Technical analysis indicators smooth out the data and make it easier to understand. They help in plotting the movements of the stock on a chart.
- Technical analysis indicator determines the support and resistance levels. This indicates whether the price has dropped lower (support) or has climbed higher (resistance).
- Also some indicators help to determine the future price of a share.
- Technical indicators help in establishing upward and downward trends. This is critical for both traders and investors.
- Technical analysis indicator can act as an alarm, alerting a technical analyst of any major price action or volatility