Updated: Dec 19, 2020
Technical Indicators are helpful for beginners in the stock market as they bring some discipline by avoiding unnecessary trades. They also help Algo Traders to design a mechanical system to manage their work.
All technical indicators can be broadly classified into two categories: Leading Indicators and Lagging Indicators.
Leading indicators are those who lead the price movement. They give a signal before a new trend or reversal occurs.
Lagging indicators are those who follow the price action. They give a signal after the trend or reversal has started.
Technically all the technical indicators can be divided into four types, as shown below:
Volatility Indicators, and
The traders who use the “Trend following” technique use any Trend indicators to support their trading decisions.
Moving Averages (MA), MACD, Average Directional Index (ADX), Parabolic SAR (PSAR), Linear Regression are some of the examples of Trend Indicators.
These indicators are designed to show the direction and strength of any script. The direction of the trend can be upwards, downwards, or sideways.
These indicators belong to the Lagging Indicator concept.
These indicators are used to measure the speed of a script in a given period.
Short term traders focus on scrips moving significantly in one direction with adequate volume to make quick money. For this reason, they use momentum indicators like RSI, Stochastics, CCI, and Williams %R, etc.
Below are the two widely used essential characteristics of the Momentum Oscillators:
Overbought and Oversold conditions
Bullish and Bearish Divergences
Overbought/oversold conditions are used to predict the end of the trend. Then traders plan to take the trades in the opposite direction of the existing trend.
For example, if a momentum indicator shows an overbought condition for a script, traders will look to sell the stock.
Similarly, divergences are used to pick the end of the trend by identifying its weakness and taking the trades in the opposite direction.
The volatility is the relative rate at which the price of stock moves (up and down).
A high volatility condition is suitable for short-term traders. Hence, many volatility indicators such as Bollinger Band (BB), Average True Range (ATR), Donchin channel, and Volatility Chaikin are used by many traders.
The ‘Volume’ plays a crucial role in trading after ‘Price’ and ‘Time’ parameters.
A trend with high volume indicates the probability of the price moving in the trend direction is high. Hence this can be used to get the confirmation of a trend or reversal of a trend.
Few examples are Volume Profile, Money Flow index, Chaikin money flow, Force Index and On balance volume, etc.
Let us explore the top 10 technical indicators in the stock market.
Top-10 Indicators in Trading
Below are the widely used top-10 indicators in stock market trading:
Moving Average (MA) Indicator
Moving Averages calculate the mean value of a stock’s price movements over a selected period; hence they negate all the short-term spikes or quick moves.
The moving average is a lagging indicator as they are calculated using the past price action. As a lagging indicator, the moving average is the best tool to confirm a stock trend, rather than predicting the future direction or momentum.
There are two types of moving averages:
Simple Moving Averages (SMA) – It takes the candles' closing price, calculates the average over the mentioned period, and plots on the chart.
Exponential Moving Averages (EMA) – It gives more weightage to recent price action and calculates the average of the mentioned period.
SMA is helpful for long-term traders, and EMA is useful for short-term traders. As the swing trade holding period is between 2 days to 3 weeks, it's better to use EMA.
One simple and effective way to use SMA for swing trading is to watch out for a short-term moving average (like 5 SMA) that crosses a long-term moving average (50 SMA).
When a faster-moving average crosses a slower moving average from below, it can indicate a big move on the upside in the coming days.
Similarly, when a faster-moving average crosses a slower moving average from above, it can indicate a big move on the downside in the coming days.
Stochastics is an oscillator that compares the closing price to the range of its prices over a given period in the selected instrument. Then it plots the values within the range of 0-100.
A reading of 80 and above is considered overbought, and a reading of 20 and below indicates oversold.
One should not look for a long trade just because stochastics reached the oversold region. The price can stay in the oversold or overbought zone for more periods in a trending environment.
Hence, one can plan a trade when the price is coming out of that range. For example, you can plan a long trade if the price shows rejection at the support line, and the stochastics moved above 20 from the downside.
Similarly, one can plan a short trade when the price shows rejection at the resistance trend line, and stochastics moved below 80 from the upside.
Relative Strength Index (RSI)
Whenever a person starts learning technical analysis, he will be introduced to RSI. It is an oscillator used to measure the magnitude (both speed and change) of the recent price changes.
J. Welles Wilder developed RSI, and it was first introduced in the book “New Concepts in Technical Systems” in 1978.
The RSI oscillates between zero and 100, and traditionally people consider that the stock is in an overbought situation when the RSI is above 70 and oversold when RSI is below 30. Many systems generate trading ideas by looking for divergences and failure swings.
Below are the two traditional characteristics of RSI which are used by many Traders to take the trades:
1. Bullish and Bearish Divergences
2. Overbought and Oversold conditions (30 and 70 rule)
The basic formula for RSI is below:
RSI = 100 – [100 / ( 1 + (Average gain / Average loss ) ) ]
The average gain or loss used in the above formula is the average percentage gain or loss during a look-back period.
RSI uses 14-days as the standard period to calculate its value. Anyone can change these settings.
Traditional RSI usage will not provide better results as it always suggests taking the trades against the trend and attempting to catch the Tops and Bottoms.
RSI Hidden Divergence
RSI Hidden Divergences (Bullish and Bearish) are the best ways to use RSI because of the below reasons:
Trades will be in the direction of the trend
The success ratio is better as compared to conventional RSI divergence
Good Risk-Reward as a trend can continue at higher levels.
Andrew Cardwell and John Hayden first propose RSI hidden divergences. In the book “RSI – The Complete Guide,” John Hayden has explained these hidden divergences in detail.
The above image shows the formation of both Hidden Bullish and Hidden Bearish Divergences.
Some examples of both bullish hidden divergence and bearish hidden divergence are shown below.
To know more about RSI Indicator, please read this article.
Average Directional Index (ADX)
ADX indicator has three components: ADX line, +DMI, and –DMI. An ADX line above 25 is considered a strong trend (either uptrend or downtrend), and if the +DMI line is above –DMI, then it is considered bulls are in control, and similarly, if –DMI is above +DMI, the bears are in control over Bulls.
A trader can plan a long trade only if the ADX line is above 25 and if +DMI is above –DMI, and if the price takes support at the trend line. Similarly, he can plan a short trade only if the ADX line is above 25 and if –DMI is above +DMI and if price resistance at the trend line.
Traders should know ADX works well as a trend following system. Hence, holding successful stocks until the end of their trend is essential to maximizing profits. Besides, it’s better to note that it doesn’t work well in a sideways market.
John Bollinger develops Bollinger Bands in the mid-1980s, and it consists of 3 different lines :
A 20 period SMA as midline
Two lines as two standard deviations above and below the midline
The distance between bands is based on the standard deviation; hence they contrast and expand based on the price fluctuations, which is nothing but volatility.
If the volatility is high, then the band will expand, and if the volatility is less, then the band would contrast. Hence, these bands also can be used to identify the overbought and oversold condition in any scrip.
When the band squeezes due to low volatility, there is a high probability of a sharp and quick price move in any direction. It is recognized as the ‘Bollinger Band Squeeze Breakout’ trading method. Some traders use methods for their trading. As the price moves in any direction, the bands will expand slowly.
The price keeps on hugging any band (upper or lower) in a robust trending environment. In case of a sideways move, the price keeps on rotating between upper and lower bands.
Moving Average Convergence Divergence MACD
MACD acts as both trend following and momentum oscillator. Technically it belongs to the momentum oscillator category. However, it is not typically used to identify overbought and oversold situations like any other oscillator.
The MACD fluctuates above and below the zero line based on whether the two MA converge or diverge.
MACD indicator consists of 3 components:
1. MACD line
2. Signal line
3. MACD Histogram
MACD line is drawn after subtracting 26 days EMA from 12 days EMA (MACD line = 12 days EMA – 26 day EMA).
A signal line is nothing but 9 days EMA.
MACD Histogram is drawn using the difference between the MACD line and the Signal line. It is positive when the MACD line crosses above the signal line, and it turns negative when the MACD line crosses below the signal line.
As the name suggests, MACD is all about ‘convergence’ and ‘divergence’ of the two moving averages on the chart. Convergence occurs when the moving averages are close to each other. When the moving averages move away from each other, divergence occurs.
Traders use MACD is in different ways. Some of the methods are below:
When the MACD line crosses above zero is considered Bullish, and when the MACD crosses below zero, it is viewed as Bearish.
When the MACD line crosses above the signal line, it is considered bullish. When the MACD crosses below the signal line is bearish.
Image-13 and image-14 show the examples for both the methods.
Average True Range (ATR)
The Average True Range (ATR) indicator measures Volatility. It shows how much the price moves on average during the selected timeframe. It was developed by J. Welles Wilder Jr and was first mentioned in the book 'New Concepts in Technical Systems' in 1978.
Current ATR = ((prior ATR x 13) + current TR) / 14)
A simple way to understand ATR is the larger the candles' range, the greater the ATR value, and the smaller the range of the candles, the ATR value is smaller.
ATR doesn’t indicate the trend and it was created to measure the volatility of a stock on any trading day.
Many traders feel bad when the price takes their stop-loss and then moves in the expected direction. ATR is a useful indicator to avoid this terrible situation to trail your stop-losses. One can trail the stop-loss adding the ATR value to their technical stop-loss on the chart.
As most traders know, Volume plays a crucial role in the price rally. Traditional ‘Volume’ details are plotted along with the ‘Time’ on X-axis, and traders can see the available Volume for the selected period. However, they will not come to know at what price level these volumes occurred.
For example, on a daily chart, a traditional volume on X-axis shows how many transactions occurred on that day. However, it doesn’t show at what price levels those transactions occurred. Volume Profile solves this problem.
Volume Profile is an indicator in which traded volume details is plotted against the Price levels, i.e., on Y-axis (as a histogram). Hence, useful price references can be identified from the volume profile chart, and many profitable trading strategies can be developed using this data.
High Volume Node (HVN) is a price level on the volume profile chart, which indicates a volume spike at a particular price level.
Low Volume Node (LVN) is a price level on volume profile that shows less volume than the average volume.
To know more about Volume Profile, visit here.
Parabolic SAR (PSAR) Indicator
J. Willes Wilder first introduced the PSAR indicator in 1978 with his book ‘New Concepts in Technical Trading Systems.’
This indicator is nothing but a series of dots above or below the price candles. It will appear below the price candle if the stock is in an uptrend and above the price candle if it is in a downtrend.
When the PSAR dots are moved from above to below the price candle, this is considered the reversal point (end of downtrend), and hence a few traders plan their ‘Long’ trades. They trail their stop-loss along with the PSAR dots until it stops out.
PSAR indicator is helpful to identify the price direction and trail the stop-loss. Hence, it gives good results in a trending environment. However, it produces false signals in the sideways zone of the market. Traders can avoid these false signals by picking only strong trending scenarios with momentum oscillators such as RSI or Stochastics.
Ichimoku Cloud Indicator
Ichimoku Cloud is also known as ‘Ichimoku Kinki Hyo’ is a technical indicator developed by Goichi Hosoda in the late 1960s. It is a group of a few technical indicators which aim to indicate support & resistance levels, and along with momentum and direction.
It does this by placing five plots on the chart. Below are the five plots:
TenkanSen (also called as Conversion Line) = (High + Low) /2 default period = 9
KijunSen (also called as Base Line) = (high + Low) /2 default period = 26
Chiku Span (also called a Lagging Span) = Price Close shifted back to 26 bars
Senkou A (also called as Leading Span A) = (TenkanSen + KijunSen) / 2 (Senkou A is shifted forward to 26 bars)
Senkou B (also called as Leading Span B) = (High + Low) / 2 using period = 52 (Senkou B is shifted forward to 26 bars)
When TenkanSen and KijunSen placed above the Cloud, the trend is bullish.
When TenkanSen and KijunSen placed below the Cloud, the trend is bearish.
Traders look for a ‘Long’ trade when the Tenkan Sen crosses above the Kijun Sen + the Tenkan Sen, Kijun Sen, and price are all above the cloud.
Similarly, traders look for a short trade when the TenKan Sen crosses below the Kijun Sen + the Tenkan Sen, Kijun Sen, and price are all below the cloud.
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All the technical indicators are unique and show different behavior in different market conditions. An indicator's behavior is unique in an uptrend; the same indicator shows other distinctive characteristics in a downtrend; and again, the same indicator behaves differently in a sideways market.
Intelligent traders study the indicator's behavior in uptrend, downtrend, sideways, and random market conditions, and they use this information while making their trading decisions.
But traders should remember one thing. Almost all the indicators are derived from the price. Any changes in the price will bring changes in indicators.
In simple words, the price dictates indicators and not vice-versa. Hence, it's always better to learn Price Action Trading if you want to evolve as a trader.