Trading Indicators Every Trader Should Know About
Trading indicators are a part of every trader’s tool kit. Some use it in simplistic forms to gauge the price behaviour while some take it to complex levels to hunt for profitable trading opportunities and manage risk.
Technical indicators are derivatives of past trading data that include price and volume. As the data is historical, trading indicators are generally considered lagging. However, that doesn’t, at all, make them less useful for traders. If used well, indicators can add huge value to any trader’s trading strategy.
Types of Indicators
Overlays: An overlay indicator is plotted alongside the price on the chart, using the same scale as the price. Indicators like moving averages and Bollinger bands fall under this category.
Oscillators: As the name goes, oscillating indicators move between the maximum and minimum values, showing overbought and oversold levels. Oscillators are plotted below or above the price chart.
The interpretation of both types of indicators is subjective and changes from trader to trader based on their trading strategy, style, and a host of other factors.
Here are the top indicators that every trader should know about.
Moving Averages
A moving average is the average of price for a set time frame plotted alongside the price. The average keeps moving as the new price information is incorporated and the old price information is dropped.
For example, a 50-day moving average (50DMA) will be plotted by joining the moving averages of the last 50-days price. As new price data comes in each day, the 50th day is dropped and replaced by the latest day’s price.
Here is a chart of Apple Inc. with its 50DMA moving average line.
A rising moving average signifies an up trending price and a falling moving average signifies a down trending price. A flat moving average signifies a sideways price movement.
Traders use various timeframes on moving averages depending on their trading strategy. For example, a positional trader may use a 50DMA to enter and exit trades, while a short-term swing trader can use 21DMA.
Price crossing the moving average also signals a change in trend. A bullish crossover is when the price moves from below the moving average to above and vice versa for a bearish crossover.
You can also use a mix of moving averages to gauge how trends in different timeframes are shaping up. For example, a 21DMA moving from below to above 50DMA signifies that the short-term trend might have turned up. If both the moving average start trending up after the crossover, that would mean that both short and medium trend has turned up.
Moving averages further have two types - simple and exponential. Simple moving averages give equal weights to prices across the time frame, while exponential moving averages give higher weightage to the current price, therefore being more responsive to recent moves.
Bollinger bands
Bollinger band is another widely used overlay indicator that produces a range in which the price would typically move. As the price hits the upper end of the band, it usually corrects and when it reaches the lower end of the band, it goes back up.
However, strongly trending prices tend to remain at extreme levels of the band for long periods. Therefore, one can’t rely solely on the Bollinger band, it has to mix other indicators to make trading decisions.
The width of the band gets adjusted as per the volatility in the price. The band gets narrower as volatility decreases and expands when the volatility increases.
Here is an Apple Inc. chart with Bollinger bands plotted alongside the price
Relative Strength Index (RSI)
A relative strength index is an oscillating indicator that plots the gain vs loss in the price for the given time frame.
It’s a momentum indicator that oscillates between 0 to 100, with higher readings suggesting overbought conditions and lower readings suggesting oversold conditions. Relative strength is quite useful in identifying new trends and gauging the strength of the trend.
Interpretation of RSI isn’t as simple as it sounds and one should not blindly buy at oversold levels and sell at overbought levels. The indicator tends to remain at extreme levels in strongly trending markets. Taking positions solely based on RSI readings may not be a wise trading strategy in such markets.
Here is a chart of Apple Inc showing buy/sell signals on RSI
Moving Average Convergence Divergence (MACD)
*My Choice*
MACD plots the difference between a short-term and a long-term moving average. An increasing and large divergence signifies an increase in momentum while converging MACD signifies a loss of momentum.
MACD is an oscillating indicator that is plotted along with a signal line. The crossovers in the signal and MACD line indicate the change in trend.
MACD can also be plotted as a histogram with readings below zero construed as bearish and above zero considered bullish. The depth or height of the histogram shows the strength of the momentum on the downside and upside, respectively.
I personally use MACD to stay within trending momentum.
Conclusion
Indicators aren’t the holy grail to making money in trading but can be quite helpful when mixed with other technical and fundamental tools.
Though knowing about the trading indicators is great, trading successfully using these indicators takes a long time for all traders. Many of the signals given by these indicators can’t be followed blindly, which is where the trading experience comes in.
As you practice more in trading, you will eliminate many false signals and will also develop a decent sense of when to follow which indicator. Some traders swear by only one indicator and trade profitably using the indicator for long periods.
If you are a newbie, you need to find indicators that best suit your trading strategy. You don’t need to know a whole lot of them, only a couple of the right ones would do the job. Do enough back testing and observe the indicator for some time before putting in big money on trades. Start small and scale up when you find the best fit for yourself.
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