Technical indicators are visual drawing (lines/bars/dots/arrows/digits and/or alarms) of math. calculations based on the price and the volume of an instrument that measure money flow, trends, volatility and momentum. Indicators are used as a secondary measure to the actual price movements and add additional information to the analysis of instruments. Indicators are used in two main ways: to confirm price movement and the quality of chart patterns, and to form buy and sell signals.
There are two main types of indicators: leading and lagging. A leading indicator precedes price movements, giving them a predictive quality, while a lagging indicator is a confirmation tool because it follows price movement. A leading indicator is thought to be the strongest during periods of sideways or non-trending trading ranges, while the lagging indicators are still useful during trending periods.
There are also two types of indicator constructions: those that fall in a bounded range and those that do not. The ones that are bound within a range are called oscillators – these are the most common type of indicators. Oscillator indicators have a range, for example between zero and 100, and signal periods where the instrument is overbought (near 100) or oversold (near zero). Non-bounded indicators still form buy and sell signals along with displaying strength or weakness, but they vary in the way they do this.
There are many different types of technical indicators, however for understanding the concept, here is a brief description of the most commonly used technical indicators :
Moving averages are trend indicators and are used by traders as a tool to verify existing trends, identify emerging trends and signify the end of trends. Moving averages are smooth lines that enable the trader to view long-term price movements without the short-term fluctuations. Of the three types of moving averages, the most common is the simple moving average; the other two are the weighted and exponential moving averages.
All the moving averages are calculated as the average of a specified number of either low, high or closing prices of the period. The difference between the three types is the weighting or importance placed on each particular period. For example, the weighted and exponential moving averages give greater importance to the latest prices, whereas the simple moving average gives equal importance to all the periods chosen.
Each new point of the moving average drops off the oldest period and brings in the newest period. A moving average line will change depending on the number of periods chosen – the greater the number the slower the average. Some traders will play with a different number of moving averages, all with different periods, until they find a series of moving averages that they feel best indicates the behavior of the particular instrument being studied.
When choosing a moving average to work with, ideally in an upward trending market the current price should not fall beneath the moving average line chosen more than once. The moving average should form a support line during upward trends and a resistance line during downward trends. If the upward trend continues, yet it breaks the moving average line on more than one occasion, then it is a good indication that the moving average line chosen is too fast, and has not been smoothed out enough. If, for example, a 30-day moving average was used, then a 45-day moving average may be more appropriate for this particular instrument.
Once a trader is content with the behavior of the moving average line against the actual prices, he may use the line to signify the continuation of a trend or the end of a trend. If the price closes below the moving average line on two occasions in an upward trending market, it is an indication of the end of the trend and time to exit a long position. The same logic follows in a downward trending market except in reverse: the current price needs to close above the moving average on two occasions to indicate that the downtrend is over.
Another way of using moving averages is in pairs. Many traders will first find the long-term moving average as described above and add a faster moving average (smaller period) as an even earlier indication of the end of a trend. If the shorter moving average crosses the slower moving average, it may signal an earlier exit point for a trend.
Overview of different moving averages for technical analysis:
Simple Moving Average (SMA)
A Moving average simply measure the average price or exchange rate of a security over a specific time frame. For example, 5 day Simple Moving Average is the sum of last 5 days closing/opening price divided by the number of time periods (5).
Exponential Moving Average (EMA)
While the simple moving average is a lagging indicator, we may find a way to reduce the lag.To do this, it is better to use another kind of Moving average which called Exponential Moving Averages. Exponential moving averages reduce the lag by applying more weight to most recent prices relative to older prices or In other words it is a weighted simple moving average putting more weight on the today’s closing price. The weighting applied to the most recent price fully depends on the period of the moving average. That means if you apply a shorter period to exponential moving average then you actually placed more weight to the most recent price. So we should take this into consideration that an exponential moving average (EMA) react much quicker to most recent price movements. Also remember, a 10 day EMA is in fact more than 10 day moving average as it could include data from the entire life of a security. It can smooth the price changes and at the same time react to price changes very quickly .Therefore Exponential Moving Average often identified as the best kind of moving averages among short term traders in Forex and Futures market day traders.
Today most of charting applications calculate the Exponential Moving Average automatically, so you don’t actually need to get involved in confusing mathematical formulas to calculate the EMA price. If you are still curious about the way an EMA calculate, so in brief: The EMA Takes today’s price and multiple it by specific percentage as a weighting factor and then add the result to yesterday’s EMA multiplied by 1-EMA multiplied weighting percentage. The weighted percentages will calculated as below: Example: The EMA% for 5 days is 2/ (5 days +1) = 33.3%
Weighted Moving Average (WMA)
Weighted Moving Average is a kind of moving average that put more weight on most recent data and less weight on older data. A weighted moving average is calculated by multiplying each of the previous day’s data by a weight. To calculate this kind of moving average we have to put a weight of 1 to oldest data and then 2 for next data and so on up to the current price. The applying weight is based on the sum of the number of days in the moving average. To calculate 5 day WMA calculates the weight of the first day as below:
Divide the number of each day by sum of the number of days (15) and multiply it by the value of the security (Price). For the last step, you should add all 5 weighted values together (sum).
The sum of the number of days = 1 + 2 + 3 + 4 + 5 = 15
5 day weighted moving average (WMA) = 2.33 + 4 + 8 + 12 + 16.66 = 43
Practical Ways of using Moving Averages:
– Identifying a trend
– Identifying Support & Resistance levels
– Identifying price breakouts
– Measuring price momentum
Using moving averages to identify market trend:
– The moving average is rising
– The price line tend to be above the moving average
– A shorter moving average crossed the longer moving average
(all for identify an up trend , vice versa for down trend identification).
MACD is an enhanced study of the moving averages and behaves as an oscillator. The MACD plots the difference between a 26-day exponential moving average and a 12-day exponential moving average. A 9-day moving average is generally used as a trigger line, meaning that when the MACD crosses below this trigger it is a bearish signal, and when it crosses above it, it”s a bullish signal.
Traders use the MACD for trend reversals. For instance, if the MACD indicator turns higher while prices are still falling, this could be an exit point and a possible reverse trade.
The most commonly used stochastic is the slow stochastic. Stochastic oscillators are also used to determine either the strength of a trend or when the end of a trend is approaching. Stochastics are displayed by two lines known as %K (faster) and %D (slower) that oscillate between a scale ranging from 0 to 100.
The mathematics behind the oscillators is unimportant; what is important is the meaning and placement of the lines. When the lines cross above the 80 line, it represents a strong upward trend; when they cross below the 20 line, it represents a strong downward trend. When the %K line crosses over the %D line it could indicate a change in the trend, and a possible exit point. When prices are fluctuating, a normal appearance for the stochastics will be for them to cross over one another in mid range – which indicates the lack of a trend.
The stochastics give their best signal when both the lines are moving to new ground at the same time as the actual price. This is a good indication of the continuation of a trend. However when the stochastics cross in a different direction of a prolonged trend this could be an indication to either exit or switch directions.
RSI = Relative Strength Index
RSI is another momentum oscillator. RSI attempts to pick reversals in the trend. RSI read on a scale between 0 and 100. reading above 70 indicates an overbought market and readings below 30 indicate an oversold market, reading above/below 50 can confirm rising/dropping strength . Trading on RSIs should occur only when there is a direction change above or below the 70 and 30 lines, as RSI lines can often remain above or below the 70, 30 levels for prolonged periods of time during strong trending markets.
The RSI can be used to identify divergence between price & oscillator formation just as stochastic and macd.
ADX = Average Directional Index
The ADX is a trend indicator that is used to measure the strength of a current trend. The indicator is seldom used to identify the direction of the current trend, but can identify the momentum behind trends.
The ADX is a combination of two price movement measures: the positive directional indicator (+DI) and the negative directional indicator (-DI). The ADX measures the strength of a trend but not the direction. The +DI measures the strength of the upward trend while the -DI measures the strength of the downward trend. These two measures are also plotted along with the ADX line. Measured on a scale between zero and 100, readings below 20 signal a weak trend while readings above 40 signal a strong trend.
Bollinger Bands are volatility indicators and are used to identify extreme highs or lows in relation to the current price.
Bollinger Bands are based on a set number of standard deviations from the moving average. It essentially tries to indicate support and resistance levels or bands of expected trading.
As with the moving average, here too the trader can pick and adjust the moving average on which to base his Bollinger Bands and the number of standard deviations to use. The trader can adjust these over time to suit his individual trading style. The default used is usually a 20-day moving average and two standard deviations from the moving average.
A break above or below the Bollinger Bands may show an exit point or a reversal.
Fibonacci retracement levels are a sequence of numbers that indicate changes in trends from previous peaks or troughs. After a significant price move, prices will often retrace a significant portion of the original move. As prices retrace, support and resistance levels often occur at or near the Fibonacci retracement levels.
In the forex trading markets, the commonly used sequence of ratios is 23.6%, 38.2%, 50% and 61.8%. Fibonacci retracement levels are drawn by joining a trend line from a significant high point to a significant low point. The pullback simply represents a correction in the trend and not an end to the trend. The most significant pullbacks are the 38.2%, and 61.8% levels.