Traders use technical indicators to identify unique opportunities in the markets that could be overlooked by viewing price charts alone. There are various concepts and theories behind technical indicators and how they can most effectively be used to improve trading performance.
Since there is not one indicator that is profitable in all markets all of the time, each trader must decide which technical indicators are most appropriate for his or her style of trading, chosen market(s) and risk tolerance.
Having an awareness of different types of technical indicators allows traders to look for different aspects of the markets that can lead to ideal trading conditions. Here, we provide a brief introduction to the four broad categories of technical indicators: momentum, trend, volatility and volume.
Momentum indicators help traders identify the speed of price movement by comparing prices over time. While this type of indicator is typically applied to price, it can also be used to analyze volume.
A basic momentum indicator is calculated by comparing the current closing price to previous closing prices. These technical indicators typically appear as a line below a price chart that oscillates as momentum changes. When a there is a divergence between price and a momentum indicator, it can signal a change in future prices.
If prices are making lower lows (or troughs) while the lows of a momentum indicator are becoming higher, for example, this can indicate a strong buying possibility as prices may soon change direction and become bullish. Examples of momentum indicators include Momentum, Relative Strength Index (RSI) and Stochastic.
Since markets tend to oscillate up and down continuously, it can be difficult to differentiate bullish or bearish trends in the market from the normal oscillations and “noise” of the markets.
Trend indicators are used to measure the direction and strength of a trend using some form of price averaging to establish a baseline. As price moves above the average, it can be thought of as a bullish uptrend, and when prices fall below the average it signals a bearish downtrend.
This averaging of price can also be referred to as “smoothing” since it effectively evens out the bumpy oscillations in price to help clearly define a trend. The most popular trend indicators include Moving Averages, MACD and ADX.
Volatility is a measurement of the amount and speed at which price moves up and down. When used in technical analysis, volatility indicators measure the rate of price movement, regardless of direction.
This is generally based on a change in the highest and lowest historical prices in a security, commodity, currency pair or other trading instrument.
Volatility indicators provide useful information about the range of buying and selling that take place in a given market, information that can help traders determine potential points where the market may change direction. Figure 1 shows an example of a volatility indicator accompanied by a paint bar study (the color of the price bars changes in response to the indicator’s values).
Figure 1: A volatility indicator (“VSTOPS”) applied to a 5-minute chart of the ES.
It should be noted that “volatility” is a concept that applies to options trading as well; however, this is different than volatility indicators used in technical analysis. When referring to options, volatility measures the rate and magnitude of the change of price for the underlying instrument on which the option is based.
Volume represents the amount of trading activity that occurs during a given interval, independent of price. Similar to trending indicators, most volume indicators are based on some form of averaging or smoothing of raw volume.
As volume levels move above their average, it can point out a strengthening of a trend or a confirmation of a trading direction. The strongest trends often occur while volume increases; in fact, it is the increase in trading volume that can lead to large movements in price.
Popular volume indicators include On Balance Volume, the Money Flow Index and the Chaikin Money Flow. Figure 2 shows an example of a volume indicator.
Figure 2: A volume indicator (“BAR ANALYZER”) applied to a 1-minute chart of the ES.
It is important to understand not only how indicators work, but in which markets they may be most effective. Technical indicators must be applied correctly to the markets in order to provide the most profitable results. Imagine, for instance, using a trend indicator in a market that is constantly changing direction and rarely forming a trend. It simply would not be effective.
Traders should be selective and avoid filling a chart with every possible indicator. More technical indicators do not necessarily lead to more accurate trading.
In trading, timing is everything and waiting for too many indicators could cause traders to miss out on significant trading opportunities. Traders should apply the indicators that provide unique signals and work best in combination with their trading styles.
This article is an excerpt from the book Make Money Trading: How to Build a Winning Trading Business by Jean Folger and Lee Leibfarth of PowerZone Trading.
To learn more from Jean and the team at PowerZone Trading, be sure to visit their website at PowerZoneTrading.com.