The first technical indicators were introduced in the 18th century in Japan. Ever since then, technical analysis hasn’t stopped evolving. Today, we have hundreds of basic and advanced indicators to help enhance price action prediction accuracy. While this abundance of technical trading tools opens plenty of opportunities for traders, it also makes them experience the fear of missing out (FOMO). Alternatively, they start doubting whether they aren’t missing out on some tools that can predict the market’s behavior better than those in their arsenal. This article helps deal with this conundrum and figure out the best technical indicators to include in your strategy.
The first step to choosing the most suitable indicators to include in your strategy is to get familiar with the options you can choose from. We can divide technical indicators into different categories based on their nature and the subject of their analysis.
Based on their Nature
There are two main types of technical trading indicators based on their nature – lagging and leading.
As their name suggests, lagging indicators follow the price. Their signals come after the price has already changed. You are probably wondering what the point of these tools is then. And rightly so.
However, lagging indicators play a significant role in traders’ arsenal. Traders use them to confirm the signals from other indicators.
Popular lagging indicators include moving averages, Bollinger Bands, moving average convergence divergence (MACD), and more.
On the other hand, leading indicators help you predict the future price movement. Alternatively, they try to forecast the next price move by looking into historical data. Because of their predictive power, traders commonly use these indicators to identify potential price reversals ahead of time.
Examples of leading indicators include the relative strength index (RSI) and on-balance volume (OBV).
Traders usually consider leading indicators superior to the lagging ones because of their ability to give you heads-up information.
Based on the Subject of Analysis
For simplicity, we can divide trading indicators into different categories based on their function. This categorization can vary based on where you are getting your information from. You can often see them divided into categories and sub-categories like oscillators, volatility, volume, support/resistance, trend-following, leading, etc. While this categorization is accurate, distinguishing so many types and sub-categories makes traders’ tasks way more complicated.
That is why it is essential to remember that there are four basic categories of indicators based on the subject of their analysis.
As their name suggests, volume indicators measure the volume level dynamics for the underlying asset. Since they track the level of interest for a specific asset through the buying and selling activity, volume indicators are a great reflection of the indication of the trend strength.
Some of the most popular volume indicators are the on-balance volume (OBV), Chaikin oscillator, and money flow volume.
Trend indicators help traders determine the direction of the price based on historical data. By taking into account different price-specific factors, trend indicators help traders predict whether the market will continue its momentum or reverse and generate buying and selling signals.
Among the most popular trend indicators are the different types of moving averages, MACD, average directional index (ADX), supertrend indicator, and more.
Momentum indicators help traders evaluate the strength of the trend. Based on whether the trend is getting stronger or weaker, chartists can predict whether it will reverse or continue its movement.
Some of the most popular momentum indicators are the RSI, MACD, ADX, stochastic oscillator, and more.
By analyzing the price changes within a certain period, volatility indicators help traders evaluate the state of the market. Scalpers and more active traders employ volatility indicators as the sole basis of their trading strategies.
Among the most popular volatility indicators are Bollinger Bands, Donchian channel, average true range, and more.
What Indicators You Should Include in Your Trading Strategy
To figure out which of these tools will best fit your needs, it is essential to understand their primary functions. Technical indicators can help you in three aspects – generate trading signals, confirm an alert or predict price behavior.
Although some of them can be applied as a standalone indicator, it is essential to enhance your strategy with indicators from different categories. You shouldn’t employ only leading or lagging indicators but instead combine tools that complement each other’s signals.
For example, relying solely on leading indicators can generate false signals. The reason is they are trying to predict the price level ahead of time, which is a challenging task. On the other hand, if you use only lagging indicators, you risk not catching an opportunity earlier and as soon as it arises. However, if you use a combination of both, you can get a more accurate prediction of where the price will head next.
Also, bear in mind that indicators aren’t strictly locked in a particular category. Based on the way they are applied, some tools can work both as leading and lagging indicators, for example. That is why it is essential to also think of the capacity you want to employ the indicators in.
When combining indicators, make sure that they cover different aspects of a price analysis so that you can confirm the trading signals. Having the right combination of indicators in your strategy can be the difference between a profitable and losing strategy.
Also, bear in mind the risk of “overfilling” your strategy with trading indicators. Some traders think the more, the merrier, which, when it comes to trading strategies, is a recipe for disaster. Putting too many indicators on your chart will not increase your chance of finding a profitable position. It might also lead you to incur losses. The result of a strategy saturated with technical indicators can be а hard to read chart with too much information of little to no value. Make sure to familiarize yourself with the way different indicators work. It is crucial to know what exactly they measure. The first part of this article is a good start. Knowing this will help you choose the right combination of technical trading tools.
Which Indicators to Include in Your Trading Strategy
Before we dive into some indicator suggestions, we should again highlight the need to curate tools that can fulfill the three core tasks.These are generating alerts, confirming signals, and predicting price behavior. With that said, you should make sure to enhance your trading strategy with indicators that complement each other. They need to handle all of the tasks mentioned above.
Now that you are familiar with what to do and avoid, it’s time to get practical with some examples.
Moving Average Convergence Divergence (MACD)
The different types of moving averages (simple, exponential, smoothed, and weighted) are good basic tools for beginners. However, we will jump right on to the MACD – a powerful momentum indicator and a more advanced version of the exponential moving average.
The MACD is an oscillator that appears on a chart as two lines floating without boundaries and a signal line. The indicator is mainly used for trading trends and generating buy and sell signals by looking for crossovers (types and direction), convergence, and divergence movements. It also helps get a sense of the trend’s strength.
The MACD is one of the go-to indicators for traders since it can be used both as a momentum and a trend-following indicator. It has been around since the 1970s and has established itself as one of the simplest and most effective technical analysis tools.
The RSI is an invaluable part of the trading arsenal of virtually all traders since it can be used both as a leading and a lagging indicator. This simple yet highly-effective momentum indicator helps identify overbought and oversold market conditions.
The indicator has values between 0 and 100, and the trader can get a sense of the trend’s potential direction solely by looking at them. If the RSI is above 70, it is considered in overbought territory. If it is below 30, the market is oversold, and the trader can expect mounting buying pressure.
RSI is useful for understanding the trend’s strength – whether the momentum is growing or slowing down. However, bear in mind that while the RSI can help you find out the trend’s likely direction, it can’t tell you when exactly a reversal will take place.
Find out more about the RSI and how to incorporate it into your trading strategy in our in-depth guide.
Bollinger Bands is the number one indicator in the toolbox of traders interested in small and continuous gains. It is the most popular volatility-measuring indicator and one of the most complete ones. At the same time, it is very simple to interpret.
Bollinger Bands give you a range within which the price of the asset typically trades. Based on the recent volatility, the width of the band increases and decreases. The wider the bands are, the bigger the volatility. And vice-versa – if the bands are close to each other, the volatility is lower.
So, how can this help you? The indicator is useful for recognizing when an asset is trading outside its usual levels. It can help predict long-term price movements. For example, when a price continually moves outside the upper band, the market can be overbought and vice-versa.
Thanks to this, you can timely spot looming breakouts and identify when the current trend is running out of steam simply by monitoring the distance between the upper and lower bands.
The OBV is another widely-popular and very powerful momentum indicator. While some technical trading tools monitor the price behavior alone, the OBV takes into account the trading volume as well to give you a more accurate signal.
The OBV’s idea, in a nutshell, is that the price of the instrument should always follow the trading volume. For example, if the volume changes, the price will too as well – if not immediately, then shortly after.
The interpretation of OBV’s signals is simple – an increasing OBV indicates growing buying pressure while decreasing OBV signals that the selling pressure is piling up.
Traders use the OBV for several reasons, including identifying trend confirmations, trend reversals (divergence), and oversold and overbought markets.
The indicator is ideal for pinpointing the extent to which the market might reverse and start moving against the current trend. The Fibonacci Retracement is one of the most powerful tools for accurately identifying support and resistance levels and the perfect price levels for placing stop-loss orders and limits. Furthermore, it allows traders to spot pullbacks timely, thus take advantage of arising trading opportunities.
Traders also use the Fibonacci retracements as a source of buy/sell signals. These signals surface when looking at the price action. More specifically – the gradual retracements between the swing low and swing high points. Once the support is broken, for example, it is an indication of selling pressure and vice-versa.
Find out more about the Fibonacci Retracement indicator here.
The indicators featured in this article are just a small part of all the possible tools you can use to enhance your trading strategy. Trading platforms such as NinjaTrader® and Finamark offer users an incredible variety of them. There isn’t a silver bullet combination – the indicators to include in your strategy depend on your trading style and risk tolerance. For example, if you seek long-term moves with large profits, you might opt for a trend-following system. If you prefer short-term opportunities, more active trading, and a higher volume of small gains, then a volatility-based strategy might be a better choice.
The basic rule of thumb is that no indicator is a sufficient solution on its own. It is critical to combine indicators from different categories to create a robust and well-performing strategy. Bear in mind that you should avoid using too many indicators since it can backfire and make the generated signals less reliable. Make sure to always test your technical analysis setup on a demo account before applying it in real life.
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