If you are untrained, then day trading in stocks is very risky. But if you have an eye for spotting market trends, then you make profits. Learning about the technical analysis indicators will help you in doing so.
There was a time long ago when trading in stocks was a simple game of buying and selling. But now it is not. Technical analysis is an art and science of predicting future prices from past price movements that have given investors new technical analysis indicators.
“Technical analysis is a skill that improves with experience and study. Always be a student and keep learning.” – John Murphy
Technical indicators, collectively called "technicals", are distinguished by the fact that they do not analyze any part of the fundamental business, like earnings, revenue and profit margins. The most effective uses of technicals for a long-term investor are to help identify good entry and exit points for the stock by analyzing the long-term trend.
What is a 'Technical Indicator'
In technical analysis of stocks, a technical indicator is a mathematical calculation based on historic price, volume, or (in the case of futures contracts) open interest information that aims to forecast financial market direction. Technical indicators are fundamental part of technical analysis and are typically plotted as a chart pattern to try to predict the market trend. Indicators generally overlay on price chart data to indicate where the price is going, or whether the price is in an "overbought" condition or an "oversold" condition.
Many technical indicators have been developed and new variants continue to be developed by traders with the aim of getting better results. New technical indicators are often back tested on historic price and volume data to see how effective they would have been to predict future events. Technical indicators look to predict the future price levels, or simply the general price direction of a security, by looking at past patterns.
So let's discuss About Most Impact full Trading Tools and Indicators and how to use them well.
Tools of the Trade
The tools of the trade for day traders and technical analysts consist of charting tools that generate signals to buy or sell, or which indicate trends or patterns in the market. Broadly speaking, there are two basic types of technical indicators:
- Overlays: Technical indicators that use the same scale as prices are plotted over the top of the prices on a stock chart. Examples include moving averages and Bollinger Bands® or Fibonacci lines.
- Oscillators: Rather than being overlayed on a price chart, technical indicators that oscillate between a local minimum and maximum are plotted above or below a price chart. Examples include the stochastic oscillator, MACD, or RSI. It will mainly be these second kind of technical indicators that we consider in this article.
Traders often use several different technical indicators in tandem when analyzing a security. With literally thousands of different options, traders must choose the indicators that work best for them and familiarize themselves with how they work. Traders may also combine technical indicators with more subjective forms of technical analysis, such as looking at chart patterns, to come up with trade ideas. Technical indicators can also be incorporated into automated trading systems given their quantitative nature.
1. On-Balance Volume
- The On-Balance-Volume is a technical analysis indicator used to measure the positive and negative flow of volume in a security over time. It is a momentum indicator that measures positive and negative volume flow.
- This indicator was developed by Joseph Granville. According to him, when volume increases sharply without a significant change in the stock’s price then the price will eventually jump up and when volume decreases sharply without a significant change in the stock’s price then the price will eventually jump down.
- Calculation:
There are three rules implemented when calculating on-balance volume (OBV):
- If today’s closing price is higher than yesterday’s closing price
Current OBV = Previous OBV + today’s volume
- If today’s closing price is lower than yesterday’s closing price
Current OBV = Previous OBV – today’s volume
- If today’s closing price equals yesterday’s closing price
Current OBV = Previous OBV
According to Granville’s theory, a rising OBV reflects positive volume pressure which can lead to higher prices. Whereas falling OBV reflects negative volume pressure which can lead to lower prices. OBV will often move before prices. One can expect prices to move higher if OBV is rising while prices are either flat or moving down. Similarly one can expect prices to move lower if OBV is falling while prices are either flat or moving up.
2. Accumulation/Distribution Line
- The accumulation distribution indicator (AD) or accumulation distribution line is a volume-based indicator used to determine the trend of a stock, using the relation between the stock’s price and volume flow. The term “accumulation” denotes the level of buying (demand), and “distribution” denotes the level of selling (supply) of a stock. Hence, based on the supply and demand pressure of a stock, one can predict the stock’s future price trend.
- The above figure represents the accumulation/distribution (A/D) comparison chart of a stock for a period. The orange line is the stock price variation over the period, and the grey line is the A/D line for the same period. As you can see, the A/D line is relative to the stock price. When the stock price was low, the A/D indicator was low, and when the stock price was high, the A/D indicator was high.
- How the Accumulation/Distribution (A/D) Indicator Works?
The primary rule of the A/D indicator is that stock volume precedes stock price. The number of shares traded is relative to the rise and fall of its stock price. The A/D indicator, like other volume indicators, predicts the direction of the volume flow. It helps determine future stock price movements and hence provides an edge.
- When the stock price and A/D indicator both make high peaks and high troughs, the upward trend is likely to continue.
- When the stock price and A/D indicator both make low peaks and low troughs, the downward trend is likely to continue.
For a given period, if the A/D indicator is rising, then accumulation (buying pressure) may be higher and is a sign of the future upward breakout.
For a given period, if the A/D indicator is falling, then distribution (selling pressure) may be higher and is a sign of the future downward breakout.
When the stock price continues to rise while accumulation distribution falls, the upward trend is likely to stall. It is called negative divergence.
When stock price continues to fall while accumulation distribution rises, the downward trend is likely to stall. It is called positive divergen
3. Average Directional Index
- The Average Directional Index (ADX), Minus Directional Indicator (-DI) and Plus Directional Indicator (+DI) represent a group of directional movement indicators that form a trading system developed by Welles Wilder. Although Wilder designed his Directional Movement System with commodities and daily prices in mind, these indicators can also be applied to stocks.
- Positive and negative directional movement form the backbone of the Directional Movement System. Wilder determined directional movement by comparing the difference between two consecutive lows with the difference between their respective highs.
- The Plus Directional Indicator (+DI) and Minus Directional Indicator (-DI) are derived from smoothed averages of these differences and measure trend direction over time. These two indicators are often collectively referred to as the Directional Movement Indicator (DMI).
- The Average Directional Index (ADX) is in turn derived from the smoothed averages of the difference between +DI and -DI; it measures the strength of the trend (regardless of direction) over time.
How this indicator works
Wilder suggests that a strong trend is present when ADX is above 25 and no trend is present when below 20.
- When the ADX turns down from high values, then the trend may be ending. You may want to do additional research to determine if closing open positions is appropriate for you.
- If the ADX is declining, it could be an indication that the market is becoming less directional, and the current trend is weakening. You may want to avoid trading trend systems as the trend changes.
- If after staying low for a lengthy time, the ADX rises by 4 or 5 units, (for example, from 15 to 20), it may be giving a signal to trade the current trend.
- If the ADX is rising then the market is showing a strengthening trend. The value of the ADX is proportional to the slope of the trend. The slope of the ADX line is proportional to the acceleration of the price movement (changing trend slope). If the trend is a constant slope then the ADX value tends to flatten out.
Calculation
ADX is simply the mean, or average, of the values of the DX over the specified Period.
4. Aroon Indicator
- Aroon Indicator is a technical analysis indicator used to measure whether a security is in a trend. It is used to identify when trends are likely to change direction. This indicator measures the time it takes for the price to reach the highest or lowest points over a particular timeframe.
- The indicator consists of the “Aaroon up” line and “Aroon down” line. The Aaron up line measures the strength of the uptrend whereas the “Aaron down” line measures the strength of the downtrend.
Calculation:
Aroon Up – ((N – Days Since N-day High) / N) x 100
Aroon Down – ((N – Days Since N-day Low) / N) x 100
- The “N” indicates the number of periods used for the indicator. By default, many traders use the Aroon indicator over 14 periods.
There are three stages in order to identify an uptrend signal
- Firstly the aroon lines will cross. The upward signal is when Aroon-Up moves above Aroon-Down. This shows that new highs are becoming more recent than new lows.
- Secondly the Aroon lines will cross above or below 50.
- Thirdly one of the lines will reach 100. Aroon up reaches 100 and Aroon down remains at low levels.
Reverse engineering these stages will give you the downward signal.
5. MACD
The Moving Average Convergence Divergence (MACD) is a trend following indicator and momentum indicator which shows the relationship between two moving averages of a security’s price.
Calculation:
- Step 1. Calculate a 12-period exponential moving average of the close price.
- Step 2. Calculate a 26-period exponential moving average of the close price.
- Step 3. Subtract the 26-period moving average from the 12 periods moving average. This is the fast MACD line.
- Step 4. Calculate a 9-period exponential moving average of the fast MACD line calculated above. This is the slow or signal MACD line.
- The indicator is composed of two lines: the MACD line and a signal line, which moves slower. When MACD crosses below the signal line, it indicates that the price is falling. When the MACD line crosses above the signal line, the price is rising.
- As shown on the following chart, when the MACD falls below the signal line, it is a bearish signal line and when the MACD rises above the signal line then the indicator gives a bullish signal.
- Looking at which side of zero the indicator is on aids in determining which signals to follow. For example, if the indicator is above zero, watch for the MACD to cross above the signal line to buy. If the MACD is below zero, the MACD crossing below the signal line may provide the signal for a possible short trade.
6. Relative Strength Index
It is a momentum indicator that measures the magnitude of current price changes to determine whether the stock is overvalued or undervalued. This indicator was originally developed by J. Welles Wilder.
- The most basic use of an RSI is as an overbought and oversold indicator. When RSI moves above 70, the asset is considered overbought and could decline. When the RSI is below 30, the asset is oversold and could rally. However, making this assumption is dangerous; therefore, some traders wait for the indicator to rise above 70 and then drop below before selling, or drop below 30 and then rise back above before buying.
- Divergence is another use of the RSI. When the indicator is moving in a different direction than the price, it shows that the current price trend is weakening and could soon reverse.
- A third use for the RSI is support and resistance levels. During uptrends, a stock will often hold above the 30 level and frequently reach 70 or above. When a stock is in a downtrend, the RSI will typically hold below 70 and frequently reach 30 or below.
7. Stochastic Oscillator
The stochastic oscillator is one of the momentum indicators. The oscillator compares the closing price of a stock to a range of prices over a period of time. The momentum of the stock b=changes before the price, hence, momentum is a useful indicator.
- Plotted between zero and 100, the idea is that, when the trend is up, the price should be making new highs. In a downtrend, the price tends to make new lows. The stochastic tracks whether this is happening.
- The stochastic moves up and down relatively quickly as it is rare for the price to make continual highs, keeping the stochastic near, 100 or continual lows, keeping the stochastic near zero. Therefore, the stochastic is often used as an overbought and oversold indicator. Values above 80 are considered overbought, while levels below 20 are considered oversold.
- Consider the overall price trend when using overbought and oversold levels. For example, during an uptrend, when the indicator drops below 20 and rises back above it, that is a possible buy signal. But rallies above 80 are less consequential because we expect to see the indicator to move to 80 and above regularly during an uptrend. During a downtrend, look for the indicator to move above 80 and then drop back below to signal a possible short trade. The 20 level is less significant in a downtrend.