Technical analysis is a popular trading method and one of the cornerstones of day trading. Unlike fundamental analysis, technical analysis is easy to interpret, and trades are executed faster. Numerous trading indicators are available that can assist a trader in technical analysis.
While first-time traders can opt for simple techniques like moving averages, several technical indicators are based on more complex computations. Thanks to advanced trading platforms, the information is ready on most trading platforms. The article will discuss some of the most popular trading indicators used.
The first trading indicator in the list is the Moving Average or Simple Moving Average. It is simply the average of the prices taken over a period of time. Mathematically it is expressed as:
Moving Average = (P1 + P2 + ….. +Pn)/n
Where P is the price and n is the number of periods in consideration.
For a 60-day moving average, n would be 60, and the price for 60 days would be needed to compute the moving average.
The simple average is a basic tool to determine if the stock is experiencing an uptrend or downtrend. A trader uses a long-term moving average along with a short-term moving average to make a comparison. If the shorter-term moving average is above the longer-term moving average, the stock is experiencing an upward trend.
Exponential Moving Average
A drawback of the Simple Moving Average indicator is that it places equal weightage on all the price points. This means that the weight of the oldest data point is the same as the latest price point. This can lead to redundancy in the indicator. Bring in the Exponential Moving Average. The Exponential Moving Average places more weight on the most recent data and is calculated as:
EMAt = Closing price x multiplier + EMAt-1 x (1-multiplier)
The higher the value of the multiplier, the greater is the weightage attached to the most recent price. The interpretation of EMA is similar to the Simple Moving Average, i.e., if the long-term line is below the short-term line, it is an indication of an uptrend.
Moving Average Convergence Divergence (MACD)
Moving Average Convergence Divergence or MACD can be considered as a more advanced version of the EMA line. The MACD line is computed by subtracting the longer-term EMA from the shorter-term EMA. A baseline is also used as a reference.
A common version of MACD used 26-period EMA as the long-term reference and the 12-period EMA as the short-term reference.
MACD = 26-day EMA – 12-day EMA
The line used for a signal line is often the 9-day EMA. When the MACD crosses over the signal line, it is an indication to buy, and when it crosses below, it is an indication to sell.
Sometimes, these signals can be false, and it is advisable to use MACD with other technical indicators for better results.
This is another momentum indicator that compares the current price to a set of historical prices. It is expressed in percentage terms, and the formula for Stochastic Oscillator is given as:
K = (closing price – lowest trading price for the period)/(highest trading price for the period – lowest trading price for the period) * 100%
When the value of K is above 80%, it is considered to be overbought, and the price can be expected to drop. Similarly, K is below 20%, the price can be expected to rise due to an oversold scenario.
The oscillator may not give an accurate result in case of a strong uptrend or downtrend. In these cases, the market can sustain such prices even if it is considered overbought or oversold by the indicator.
On-Balance Volume (OBV)
The OBV is an indicator that uses both price and volume to determine the trend. There are three scenarios for determining the OBV of a particular day.
When the price at t is greater than the price at t-1, add the volume at t to OBVt-1
When the price at t is lesser than the price at t-1, subtract the volume at t to OBVt-1
When the price at t is equal to the price at t-1, OBVt is equal to OBVt-1
This can be illustrated with an example
OBV1 = 0
OBV2 = 0 + 800 = 800 (since price has increased, volume is added to previous OBV)
OBV3 = 800 + 600 = 1,400
OBV4 = OBV3 = 1,400 (since the price has not changed, there is no change in OBV)
OBV5 = 1,400 – 200 = 1,200 (since price has decreased the volume is subtracted)
The OBV indicator can be used to determine if the price movement is backed up by volume. However, it must be noted that certain events like earnings call can trigger OBVs to an inflated level leading to outcomes that may not be reliable for future trades.
Relative Strength Index (RSI)
The RSI is another momentum indicator and tells if the current price signals an overbought or oversold situation. The Index can have values between 0 and 100. The mathematical formula to calculate RSI is given as:
RSI = 100 – (100/(1 + average gain/average loss))
For calculating the RSI, one must first define the time period. Suppose a 10-day period is used during which the average gain has been 2%, and the average loss has been 1%, then RSI is given as;
RSI = 100 – (100/(1 + (2%/1%)) = 66.67
Generally, the default setting considers an RSI for a 14-day period. When the RSI rises above 70, the stock is considered to be in an overbought zone. This is an indication to sell the stock.
An RSI of 30 or below signifies that the stock is oversold and the trader should buy it.
A Bollinger Band comprises three lines. The reference line comprises of a Simple Moving Average, and the other two lines above and below it are determined using the following expression:
Bollinger Band = Moving Average +/- k*standard deviation
Where k is the coefficient and 2 is the most commonly used value since it encompasses 95% of all possible price points.
The time frame can range between 14 to 28, and 20 is commonly used for a Bollinger Band.
When the price crosses above the simple average line, it can be an indication to buy. The upper Bollinger Band can be considered as a resistance level.
When the price crosses below the simple average line, it can be an indication to sell. The upper Bollinger Band can be considered as a support level.
Fibonacci Retracement levels are essentially ways to determine support and resistance levels. A trader selects a couple of price points and determines a resistance or support level by assigning a fixed percentage. It would be easier to demonstrate this with the help of an example. Suppose the two price points are 150 and 200. A trader can use a retracement level (some commonly used levels are 23.6%, 38.25, 50%, etc.)
So, for the 23.6% retracement, the value would be 200 minus 23.6% of (200 minus 150) or 188.2. Likewise, for a 50% retracement, the price would be 200 – 50% of 50 or 175. The price 188.2 or 175 can be interpreted as those levels from which the price can be expected to rebound after it has fallen from 200.
Fibonacci Retracement can convey wrong signals when the trend is strong, and the resistance or support can no longer cause a reversal in trend.
Commodity Channel Index (CCI)
The CCI compares the current price to the average price over a certain period. The mathematical expression for computing CCI is:
CCI = (P – Average(P)/(0.015*Mean Deviation)
P is defined as a typical price and is the average of high, low, and close prices.
Mean Deviation = Average of modulus (P – Average(P))
A CCI value of above 100 is a sign that the stock is overbought, and when it is below -100, the stock is oversold. CCI can be highly volatile when the typical price of a short period is considered.
While most indicators are used to detect a signal, the Aroon indicator helps a trader find out how strong the trend is. It comprises two lines: Aroon Up and Aroon Down. When the Up line is above the Down line, it indicates a bullish pattern. When Aroon Down is above, it is a bearish pattern. A crossover in these two lines can indicate a reversal in trend.
Aroon Up = (n – Periods since n-period high)/n * 100%
Aroon Down = (n – Periods since n-period low)/n * 100%
When the value is above 50, it means that a high/low was witnessed in the last 12 days, and when it is below 50, the high/low was witnessed before 12 days. Higher the value of an Aroon line, the stronger the trend.
Putting It All Into Practice
The article has mentioned only the most commonly used indicators. The variety of such indicators can be overwhelming to a person looking to become a trader. It is advisable to gain expertise first using online platforms like Finamark, as the trading platform offers a seamless experience in placing trades using these indicators. It also allows a trader to operate in a simulated environment so that actual capital is not required. A trader can experiment on the vast array of available indicators and shortlist the one that suits him to make actual trades.