Ever wondered how successful Wall Street traders make money? How they forecast where the price of a stock or currency pair will go? Well, worry no more. In this article, part of our series on technical analysis, we will look at 5 of the most popular technical indicators that the most successful traders use.
What Are Technical Indicators?
A background first. There are several factors that contribute to the movement of stocks or other financial assets. For example, financial assets are known to move when there is a major economic release such as inflation, earnings, and consumer confidence data. In the market, this is known as fundamental analysis. Traders who are focused on using this information are known as fundamental traders.
At the same time, the participants in the financial market are human beings. This means that they are usually guided by greed, fear, and other emotions. As a result, they use the various methods of trading to find market opportunities. These methods, which have been created using mathematical formulas are known as technical indicators.
Broadly, there are four types of indicators.
- Trend indicators are used to tell you the direction an asset is moving in. These include indicators like moving averages, Ichimoku Kinko Hyo, and MACD.
- Momentum Indicators. These are used to measure or show the strength of a trend. They can be useful in forecasting when a reversal will happen.
- Volume indicators. These tell you how volume of financial assets is changing over time. The volume indicators are used to show you the strength of a trend. Examples of these are On-balance volume and money flow index.
- Volatility indicators. These indicators tell you how volatile the financial assets are at a particular time. These indicators include Bollinger Bands and Average True Range (ATR).
Technical Indicators #1: Moving Averages
If you watch financial media regularly, you have certainly heard the commentators talk about moving averages. It is without a doubt the most common technical indicator out there. It is also used as a foundation for other types of indicators like Bollinger Bands and MACD. There are four main types of moving averages, which are weighted MA, exponential MA, simple MA, and smoothed MA. However, we recommend that you use EMA because it tends to react faster to the movements.
While traders use various strategies when trading moving averages, a common approach that we recommend is that of combining two averages. In this, you add a longer-term moving average and a shorter-term one as shown on the chart below. On this USD/JPY pair, the 14-day and 7-day EMAs were placed. Short trades were then placed when the 14-day EMA made a cross-over while buy trades were initiated when the 7-day EMA crossed-over the 14-day EMA.
Tips for Using Moving Averages
- Only use moving averages when the markets are trending.
- Test various periods to see one that shows better guidance.
- Combine moving averages with other indicators.
Technical Indicators #2:Bollinger Bands
Bollinger Bands is a popular technical indicator that was developed by a technician known as John Bollinger. The indicator is a volatility indicator that has three lines. The middle line is usually the simple moving average while the upper and lower bands are the standard deviations. When there is a very narrow bands, it is usually an indication that the market activity is relatively quiet. If there are very wide bands, it indicates that there is a lot of volatility in the market.
When the market is ranging, you should look for the so-called Bollinger Bounce. This is the price in which the price tends to bounce from one side to another. When this happens, you should short when the price hits the higher band and go long when it hits the lower band.
When the market is trending, you should use the so-called Bollinger Squeeze. When this happens, the bands tend to get very close to one another, which is an indication that a breakout will happen. If the candles breakout above the upper band, it is an indication that the price will move upwards. Another approach when there is a strong downward trend is to short provided the price is trading along the lower band. A good example of this is shown below.
Technical Indicators #3:Relative Strength Index (RSI)
Once again, if you are a regular watcher of the major financial media, you have likely heard them talk about the Relative Strength Index (RSI). The RSI is an oscillator that was developed by Welles Wilder. The indicator usually oscillates between zero and 100. RSI is calculated by finding the Relative Strength, Average Gain, and Average Loss. When applied in a chart, traders focus on three key levels. When the indicator reaches 30 and continues to move lower, it is said to be oversold. When it reaches 70 and continues to move higher, it is said to be overbought. When it is moving horizontally at around 50, it is said to be neutral. A good example of this is shown on the chart below.
While this concept works well, it is important to be cautious. As you can see in the chart above, there are times when the indicator moves below 30 but the downward trend continues. This means that caution should be made when using the indicator.
Technical Indicators #4:MACD
The Moving Average Convergence Divergence (MACD) is another popular indicator you can use today. The indicator turns two moving averages into a momentum oscillator. It does this by subtracting the longer MA to the shorter MA. The indicator usually fluctuates above and below the zero line. While traders use various approaches to trade the MACD, the most popular one is to look at the crossovers of the fast- and slow-moving averages. When the signal line crosses the MACD line, it is usually said to be a bullish signal. Similarly, when the signal line crosses the MACD, it is usually said to be a bearish signal. A good example of this is on the Apple chart below.
Technical Indicators #5: Stochastic Oscillator
This indicator was developed by George Lane in the 1950s. The indicator is used to show the location of the close relative to the high-low range of an asset. Unlike other indicators, this one does not follow the price and the volume. Instead, it follows the speed of the price. The easiest method of using the stochastic oscillator is to identify areas where the %K and %D lines make a crossover when they are in the upper and lower bands. When the two lines are below the lower band of 20 and they make a crossover, it is usually said to be a good time to buy. When the two make a crossover when they are above the 80 level, it is usually said to be a good place to short. A good example of this is shown on the chart below.
As you can see, technical indicators can be useful tool to determine the entry point of trade. These tools are also essential when designing your own trading algorithms. Still, these tools don’t do too well on their own. They work perfectly when they are combined with fundamental analysis. It is also recommended to combine a few of them before you enter a trade.
Crispus is a finance professional with more than a decade in the industry. Over the years, Crispus has written in-depth articles on leading platforms like CCN, Marketwatch, and Seeking Alpha. He also runs a Forex education and managed account company called WestEndFx.