An online guide to understand Trading Indicators

Four major trading indicators every investor comes across

Information and knowledge are the essential ingredients to every successful trading recipe. A big part in that stir play trading indicators – with their help, investors are able to read charts better and to make accurate predictions about future price movements. Understanding the basics of technical indicators is essential for traders therefore. This article focuses on the following four major indicators that every investor comes across when reading charts:

  1. Moving Averages
  2. Relative Strength Index RSI
  3. Moving Average Convergence Divergence MACD
  4. Stochastic Oscillator

So, what are these indicators and what benefits do they offer to traders?

 

1. Moving Averages

The Moving average is one of the most basic and most important indicators that every chartist comes across. It is calculated on the basis of averages of specified historical time periods. It does not forecast the price direction; it only defines the current direction based on historical data. That is why moving averages are also termed ‘lagging indicators’.

Two type of moving averages are popular: Simple Moving Average (SMA) and Exponential Moving Average (EMA). Simple Moving Averages give equal weight to all historical time periods. For Exponential Moving Averages, on the other hand, recent time periods weigh higher than those farther in the past. Hence, in order to better gauge the price direction, it is better to use Exponential Moving Averages. But they do have their own limitations: As they give more weight to recent prices, they are bound to swing more rapidly than SMAs.

As mentioned earlier, SMA and EMA are used to plot the historical price moves which will in turn help us identify support and resistance levels. But they are not strong indicators to rely on, because the shorter the period monitored by the Moving Average, the higher the fluctuation. Hence, it is advisable to plot moving averages as per need. For Day Trading, shorter duration averages are used, while in case of positional trading, longer duration moving averages are used. It is better not to rely on a single moving average, but to use more than one of these indicators. When using moving averages, investors always should consider the general market scenario: When the market trades sideways, these indicators can give many false signals, so it is not suggested to use them in such situations.

Moving Averages

Moving Averages

 

2. Relative Strength Index (RSI)

The RSI is a momentum indicator which measures the speed and change of price movements. It is also a lagging indicator, as it is calculated on the basis of the historical price. It is calculated as 100 – 100/(1 + RS*), wherein RS (or the relative strength) is defined by Gain ÷ Loss during the given time period. It is generally calculated on a 14-day time frame. It can be altered in order to increase or decrease sensitivity: The smaller the time frame, the more sensible the RSI. The value of the RSI ranges from 0 to 100. The underlying currency is considered overbought – and chances of a price pull back are high – when the RSI lies above 70. It is considered oversold when the RSI rates below 30, indicating a probable turn in prices.

Relative Strength Index RSI

Relative Strength Index RSI (bottom panel)

 

3. Moving Averages Convergence and Divergence (MACD)

While the Moving Average and the Relative Strength Index are both lagging indicators which are based on purely historical data, the MACD is a mixed indicator. That means it is based on lagging and leading indicators, which is more useful. The MACD is a momentum indicator defining the strength of the momentum, i.e. whether the current upward or downward trend is getting stronger or weaker. The MACD is comprised of two parts: a histogram – which is a bar chart showing the difference between the two EMAs (Exponential Moving Averages) of two different time periods – and a signal line – which is an SMA (Simple Moving Average) of the MACD for a specified period. The generally preferred time frames for the MACD calculation are 12, 26 and 9. The typical MACD would therefore be a histogram calculation of a 12 units EMA over a 26 units EMA, while the Signal line is the SMA of the MACD for the previous 9 periods.

If the Histogram is in the positive zone, it indicates an uptrend; if it’s in the negative zone, it indicates a downtrend. But the strength of the trend is shown by the size of the histogram which calculates the difference between the signal line and the MACD. Hence, if the signal line crosses under the Histogram-MACD region, it indicates a positive run; while a cross-over will point towards a price correction. But we need to be cautious regarding the strength of the price move.

Moving Average Convergence Divergence MACD

Moving Average Convergence Divergence MACD (bottom panel)

 

4. Stochastic Oscillator

A stochastic oscillator is another momentum indicator, which helps determine peaks and troughs of the current price movement that is the points where the trend is most likely to turn. Unlike the MACD, it shows two lines: The %K period line relates the current price to the price range over a given period of time, while the %D line is the 3-period exponential moving average of the of %K line. It does not plot the histogram as is the case with the MACD. Its value ranges from 0 to 100. Stochastic Indicators tell us when the market is overbought or oversold: Generally, a trade above 80 indicates an overbought market, signaling a price correction, while a level below 20 is an oversold signal and would indicate a price reversal.

Stochastic Oscillator

Stochastic Oscillator (bottom panel)

These indicators are the most common and basic ones. To be useful, however, they have to be read in the context of market trends, and together with other indicators. One single indicator can never be enough to base a trading decision on. But to know the basics of indicators helps investors form more precise ideas about future price movements and therefore contribute to a sound trading strategy.

Content credit goes to Forex Ball, a Trading Competition championship

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