This article is designed to introduce the concept of technical indicators and explain how to use them in your analysis. We will shed light on the difference between leading and lagging indicators , as well as look into the benefits and drawbacks.
Many, if not most, popular indicators are shown as oscillators. With this in mind, we will also show how to read oscillators and explain how signals are derived. Later we will turn our focus to specific technical indicators and provide examples of signals in action. A technical indicator is a series of data points that are derived by applying a formula to the price data of a security.
Price data includes any combination of the open, high, low or close over a period of time. Some indicators may use only the closing prices, while others incorporate volume and open interest into their formulas.
The price data is entered into the formula and a data point is produced. However, one data point does not offer much information and does not an indicator make. A series of data points over a period of time is required to create valid reference points to enable analysis.
By creating a time series of data points, a comparison can be made between present and past levels. For analysis purposes, technical indicators are usually shown in a graphical form above or below a security's price chart. Once shown in graphical form, an indicator can then be compared with the corresponding price chart of the security. Sometimes indicators are plotted on top of the price plot for a more direct comparison. A technical indicator offers a different perspective from which to analyze the price action.
Some, such as moving averages , are derived from simple formulas and the mechanics are relatively easy to understand. Others, such as Stochastics , have complex formulas and require more study to fully understand and appreciate.
Regardless of the complexity of the formula, technical indicators can provide a unique perspective on the strength and direction of the underlying price action. A simple moving average is an indicator that calculates the average price of a security over a specified number of periods.
If a security is exceptionally volatile, then a moving average will help to smooth the data. A moving average filters out random noise and offers a smoother perspective of the price action. By applying a day simple moving average to the price action, random fluctuations are smoothed to make it easier to identify a trend.
This may sound straightforward, but sometimes traders ignore the price action of a security and focus solely on an indicator. Indicators filter price action with formulas. As such, they are derivatives and not direct reflections of the price action. This should be taken into consideration when applying analysis. Any analysis of an indicator should be taken with the price action in mind. What is the indicator saying about the price action of a security? Is the price action getting stronger?
Even though it may be obvious when indicators generate buy and sell signals, the signals should be taken in context with other technical analysis tools.
An indicator may flash a buy signal, but if the chart pattern shows a descending triangle with a series of declining peaks, it may be a false signal. All the earmarks of a MACD buying opportunity were present, but the stock failed to break above the resistance and exceed its previous reaction high. This non-confirmation from the stock should have served as a warning sign against a long position. For the record, a sell signal occurred when the stock broke support from the descending triangle in March As always in technical analysis, learning how to read indicators is more of an art than a science.
The same indicator may exhibit different behavioral patterns when applied to different stocks. Through careful study and analysis, expertise with the various indicators will develop over time. As this expertise develops, certain nuances, as well as favorite setups, will become clear. There are hundreds of indicators in use today, with new indicators being created every week.
Technical analysis software programs come with dozens of indicators built in and even allow users to create their own. Given the amount of hype that is associated with indicators, choosing an indicator to follow can be a daunting task. Even with the introduction of hundreds of new indicators, only a select few really offer a different perspective and are worthy of attention. Strangely enough, the indicators that usually merit the most attention are those that have been around the longest time and have stood the test of time.
When choosing an indicator to use for analysis, choose carefully and moderately. Attempts to cover more than five indicators are usually futile. It is best to focus on two or three indicators and learn their intricacies inside and out. Try to choose indicators that complement each other, instead of those that move in unison and generate the same signals. For example, it would be redundant to use two indicators that are good for showing overbought and oversold levels, such as Stochastics and RSI.
As their name implies, leading indicators are designed to lead price movements. Most represent a form of price momentum over a fixed lookback period, which is the number of periods used to calculate the indicator. For example, a day Stochastic Oscillator would use the past 20 days of price action about a month in its calculation. All prior price action would be ignored. Many leading indicators come in the form of momentum oscillators.
Generally speaking, momentum measures the rate-of-change of a security's price. As the price of a security rises, price momentum increases. The faster the security rises the greater the period-over-period price change , the larger the increase in momentum. Once this rise begins to slow, momentum will also slow. As a security begins to trade flat, momentum starts to actually decline from previous high levels. However, declining momentum in the face of sideways trading is not always a bearish signal.
It simply means that momentum is returning to a more median level. Momentum indicators employ various formulas to measure price changes. RSI a momentum indicator compares the average price change of the advancing periods with the average change of the declining periods. During this period, the stock advanced from the upper 60s to the low 80s. When the stock traded sideways in the first half of December, RSI dropped rather sharply blue lines.
This consolidation in the stock was quite normal and actually healthy. From these lofty levels near 70 , flat price action would be expected to cause a decline in RSI and momentum.
If RSI were trading around 50 and the stock began to trade flat, the indicator would not be expected to decline. The green lines on the chart mark a period of sideways trading in the stock and in RSI.
RSI started from a relatively median level, around The subsequent flat price action in the stock also produced relatively flat price action in the indicator and it remains around There are clearly many benefits to using leading indicators. Early signaling for entry and exit is the main benefit. Leading indicators generate more signals and allow more opportunities to trade. Early signals can also act to forewarn against a potential strength or weakness. Because they generate more signals, leading indicators are best used in trading markets.
These indicators can be used in trending markets, but usually with the major trend, not against it. In a market that is trending up, the best use is to help identify oversold conditions for buying opportunities.
In a market that is trending down, leading indicators can help identify overbought situations for selling opportunities. With early signals comes the prospect of higher returns and with higher returns comes the reality of greater risk. More signals and earlier signals mean that the chances of false signals and whipsaws increase. False signals will increase the potential for losses. Whipsaws can generate commissions that can eat away profits and test trading stamina.
As their name implies, lagging indicators follow the price action and are commonly referred to as trend-following indicators. Rarely, if ever, will these indicators lead the price of a security. Trend-following indicators work best when markets or securities develop strong trends. They are designed to get traders in and keep them in as long as the trend is intact. As such, these indicators are not effective in trading or sideways markets.
If used in trading markets, trend-following indicators will likely lead to many false signals and whipsaws. Some popular trend-following indicators include moving averages exponential, simple, weighted, variable and MACD. Using a moving average crossover to generate the signals, there were seven signals over the two years covered in the chart.
Over these two years, the system would have been enormously profitable. This is due to the strong trends that developed from Oct to Aug and from Nov to Aug However, notice that as soon as the index starts to move sideways in a trading range, the whipsaws begin.
The signals in Nov sell , Aug sell and Sept buy were reversed in a matter of days. Had these moving averages been longer and day moving averages , there would have been fewer whipsaws. Had these moving averages been shorter 10 and day moving average , there would have been more whipsaws, more signals, and earlier signals.
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.More...