Indicators are data points that indicate the direction in which an instrument will move. They are used extensively by investors to optimize their trading strategies. The right mix of a variety of indicators may help one formulate an effective trading strategy that succeeds in a dynamic and fast-moving market.
Broadly speaking, indicators can be classified into two categories:
Leading technical indicators: These suggest the probability of what is likely to happen in the market with respect to the direction in which a particular currency or CFD is headed or the level at which a price could reach.
Lagging technical indicators: These indicators keep traders abreast of what has already happened in the market. These indicators are useful in identifying whether the market is moving sideways or is trending up or down.
The study of technical analysis, which analyzes past price action to predict future price movements, incorporates a number of methodologies used to evaluate price movements. One of the most useful is the ability to define momentum, and the rate of change a security is experiencing. An oscillator is a calculation of past prices changing to reflect the rate of change and whether prices have reached extreme levels. The most commonly use oscillators studied to analyze the markets are the stochastic oscillator, and the relative strength index (RSI)
The stochastic oscillator is a momentum technical indicator that measures extremes and momentum by creating an index based on the high/low range of prices over a specific period. The goal of the oscillator is to follow the acceleration in prices. The theory is predicated on the idea that prices follow momentum. An example would be to think of the momentum you have when you are driving a car, as momentum accelerates the likelihood of continued follow-through in your direction increases. Stochastics can also represent pivot points that reflect extreme values where prices are likely to revert.
The most common setting for the Stochastic Oscillator is 14 periods, which can be any time frame from months to intra-day. The highest high over the last 14 periods and the lowest low over the last 14 periods, are compared to the current period. A 3-day moving average of the relative period is then compared to the current period.
The chart above, of the full stochastic, identifies crossover periods when the fast stochastic crosses above (or below) the slow stochastic, as well as the absolute value of both stochastics. When the fast stochastic crosses above the slow stochastic, it generates a buy signal that identifies increasing positive momentum (the red line crossing above the green line). The reverse is true when the fast stochastic crosses below the slow stochastic reflecting a period of increasing negative momentum.
The absolute value of the stochastic can also be helpful in finding periods when a security is overbought or oversold. A stochastic level above 70 is considered overbought and a stochastic level below 30 is considered oversold.
By combining the extreme readings of the stochastic with the crossover signal, you can find levels where momentum is accelerating when the index was recently oversold, or where negative momentum is increasing when the index was recently overbought (black arrows).
Another oscillator is the relative strength index (RSI). Generally the RSI is used more exclusively in determining overbought and oversold levels rather than depicting periods where there is a change in momentum. The RSI is an index that is derived from subtracting 1/the average gain for a period minus the average loss from 100. RSI readings above 70 are considered overbought and RSI reading below 30 are considered oversold. The RSI helps find price levels where a change in direction is likely, but it may be best used in conjunction with other indicators that will be more specific about an entry level.
Other Indicator Tools: the ones to look out for
Some of the key indicators are:
One of the most efficient tools a trader may use is a moving average. Traders use moving averages to smooth price action. A moving average removes some of the daily volatility associated with financial markets and is generally calculated based on the daily closing price of a financial instrument. The end result is a trend following indicator that necessarily lags the instrument’s movement and is therefore a reactive tool. Even so, moving averages are very useful tools and are perhaps the most widely used indicators.
Moving averages represent the fair price of a market when averaged across a specific period. Many of the widely used moving averages reflect specific benchmarks. A short term moving average, such as a 5-day moving average, represents a week of trading action, and helps represent a smoothing of price action. The 10-day moving average is half a monthly reporting period, while the 20-day moving average represents a full monthly reporting period. The 50-day moving average reflects a quarterly reporting period, while the 200-day moving average reflects 80% of the year’s report card.
The longer the moving average, the less volatile the price action as it appears on a chart. Moving averages help an investor determine the longer term trend of a financial instrument by removing much of the noise associated with price charts.
As a trader you have to determine the best moving average to use to meet your goals. For example, a short term moving average helps determine short term trends, but will hold on to some of the noise of the daily movements of a market.
Advanced Moving Averages
Exponential moving averages reduce the lag by applying more weight to recent prices. The simple moving average weighs each period equally and therefore it is a lagging gauge of market sentiment. The weighting applied to the most recent price depends on the number of periods in the moving average. The first step in calculating an exponential moving average is to generate a simple moving average. For a 10-day moving average you would calculate the average of the last 10-days and on the 11th day you would drop the first day from the calculation. The next step would be to multiply the exponent you are looking to use to reduce the lag.
Moving average Crossover
There are a number of strategies you may employ when using a moving average. One of the simplest and very effective is the moving average crossover strategy. This strategy entails finding a short term moving average that fits your criteria and evaluating when it crosses either above or below a longer term moving average.
The goal is to analyze the market using this crossover strategy to find the middle of a trend. When you are using short term moving average, for example the 5-day moving average and the 20-day moving average your analysis is geared to finding a short term trend. The longer the tenor of your moving averages, the deeper the trend you are planning on evaluating. One of the most prolific tenors is the 50-day moving average and the 200-day moving average.
When the 50-day moving average crosses above the 200-day moving average, a long term uptrend is in place. This is referred to as the “golden cross”. When the 50-day moving average crosses below the 200-day moving average, a long term downtrend is in place. This is known as the “death cross”
Moving average can be used in many ways including finding momentum. Momentum measures the acceleration in price movements. You may determine this be evaluating the change between 2 or more moving average which tells you the change in momentum.
Both the MACD (moving average convergence divergence index), created by Gerald Appel is a momentum indicator that may be used to capture momentum. Momentum reflects acceleration and may be used as a trading signal to either enter or exit a trade.
MACD – Moving Average Convergence Divergence Index
This indicator creates an index level by calculating the change in 2-moving averages (the spread) relative to the 9-day moving average of the spread. The 2-moving averages that are used as defaults are the 12-day moving average and the 26-day moving average. If the spread is less than the 9-day moving average of the spread, the index is negative and therefore momentum is negative. If the spread is above the 9-day moving average of the spread, the index is positive and therefore momentum is positive.
The most common way to use moving average as they relate to momentum is to generate buy and sell signals from the MACD. When the spread of the MACD crosses above or below the 9-day moving average of the spread, a signal is generated. A buy signal occurs when the spread crosses above the 9-day moving average of the spread. A sell signal is generated when the spread crosses below the 9-day moving average of the spread.
Although this is not an exhaustive read, it does include some of the main indicators that could help a trader formulate better trading strategies.