Technical indicators are accepted by most technicians, which are essentially mathematical calculations to help interpret market movement.
Newer traders commonly make the mistake of overloading charts with different indicators. This ‘more is better’ method often results in what’s known as ‘analysis paralysis’.
Its imperative traders have a deep understanding of each indicator used to frame trading decisions.
Technical indicators fall under the umbrella of two groups: Leading and Lagging.
Leading indicators are designed to forecast or anticipate price. However, like all technical indicators, leading indicators are prone to false signals.
Lagging indicators, as their name implies, LAG market action. Lagging indicators are in place to confirm a market move, effectively providing delayed feedback. Think of this as an indicator that follows price.
So, if a leading indicator correctly forecasts a price trend, a trader can jump in before the market movement and potentially ride a large portion of the move. As for lagging indicators, these are commonly adopted by trend traders as they don’t show upcoming price movement, but do confirm that a trend is underway.
It’s important to realize that technical indicators are not designed to offer 100 percent accuracy; they’re designed to help put the odds in your favor.
Technical indicators can be further subdivided into trend following, relative strength, momentum, mean reversion and volume.
Trend following indicators, for example, are often lagging—a classic trend following method is composed of two moving averages that generate signals when they cross each other.
Momentum indicators, on the other hand, are generally considered leading. The Relative Strength Index, or RSI, is a good example of a momentum-based indicator.
Three indicators newer traders often begin with are moving averages, the relative strength index and Bollinger bands.
Simple Moving Averages, or SMAs, generally follow trends.
The SMA is derived from taking the average closing price over a number of periods.
The more periods used, the less sensitive the indicator is to market movements, meaning the trend has to be stronger before a signal develops.
The 200-day simple moving average is a common value used amongst longer-term traders, while the 50-day simple moving average is often employed by swing traders, which is more of a medium-term approach.
Moving average crossovers are popular methods, as are acting on a price close beyond the moving average value.
Next up is the Relative Strength Index, or RSI, usually taken as a leading indicator, and is represented by a number between zero and one hundred.
The indicator’s primary uses are identifying overbought and oversold conditions, periods of divergence as well as failure swing tops and bottoms.
Generally, the RSI value over 70 is considered overbought, signalling a bearish reversal, and under 30 is regarded as oversold, which highlights a possible bullish reversal.
In addition, the RSI can be used as a trend confirmation tool by looking at the 50.00 centreline. When the RSI value moves above 50, this can be seen as validation of a bullish trend, namely average gains exceeding average losses.
And finally, we have Bollinger bands, a lagging indicator that measures market volatility.
Bollinger bands consist of a middle band—usually a 20-period simple moving average—and upper and lower bands.
These upper and lower bands are set above and below the moving average by a certain number of standard deviations—usually by 2 standard deviations.
Traders use this indicator in a number of ways, but the two most familiar strategies are the Bollinger Squeeze and Bollinger Bounce.
Aaron Hill was introduced to financial trading, specifically foreign exchange, over a decade ago. Since then, Aaron caught the trading bug and has amassed substantial knowledge, obtaining CMT (Chartered Market Technician) levels 1 & 2. He has since been awarded the CFTe (Certified Financial Technician) and member of the CMT Association!
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