Types of Indicators
Indicators represent a statistical approach to technical analysis. They provide a secondary measure to actual price movements. Indicators can help confirm the quality of chart patterns or form their own buy or sell signals.
There are two primary types of indicators: Leading Indicators and Lagging Indicators.
Leading indicators precede price movements and try to predict the future.
- Most helpful during periods of sideways or non-trending price movements
- Help identify breakouts or breakdowns.
Lagging indicators follow price movements and act as a confirmation tool.
- Most useful during trending periods, confirm that a trend is still in placing or if it’s weakening.
Indicators can be further divided into two categories based on how they’re built:
- Oscillator. Generally bound within a range 0-100. zero represents oversold conditions and 100 represents overbought conditions.
- Non–bounded. Help in identifying buy and sell signals, strength or weakness of trends.
Indicators generate buy and sell signals through crossovers or divergence.
- When price moves through a moving average or when two moving averages cross, crossover occurs.
- When price trend and indicator move in opposite directions, divergence occurs. It means the price trend is weakening.
The accumulation/distribution line is one of the most popular volume indicators that measures money flow in a security. The indicator attempts to measure the ratio of buying and selling by comparing the price movement of a period to the volume for that period.
The indicator reflects the amount of buying compared to selling in a given security. If the accumulation/distribution line is trending upward, it’s a sign that there is more buying than selling and vice versa.
The Aroon indicator measures whether a security is trending higher or lower as well as the magnitude of that trend. In addition, the indicator can be used to predict when a trend is just beginning to help traders capitalize on the movement.
The indicator is comprised of the ‘Aroon Up’ (green line) and the ‘Aroon Down’ (red line). The Aroon Up line measures the amount of time that has passed since the highest price during the time period. The Aroon Down line, on the other hand, measures the time that has passed since the lowest price during the time period. The number of periods used in the calculation depends on the timeframe that the trader wants to analyze.
Moving Average Convergence Divergence
The MACD, is short for moving average convergence divergence. It is one of the most popular lagging indicators among traders. Lagging indicators confirm the existence of a trend.
So, MACD strategy must be used along with other trading strategies and identification of support and resistance levels is essential. The right combination of lagging and leading indicators can provide you with a real edge in the market.
MACD is built using moving averages like simple moving average and exponential moving averages.
How is it calculated?
Different components that make up the MACD indicator are:
- MACD line, arrived by subtracting 26 period EMA from the 12 period EMA.
- 9 period EMA of the MACD line, called the signal line.
- A center horizontal line placed at value zero.
The MACD line is the fast line and the signal line is the slow line. The histogram shows divergence between the MACD line and signal line.
How to interpret it?
The MACD indicates the changes in the strength, momentum, and direction of the current market.
- When MACD line is above zero, it implies 12 period EMA is trading above the 26 period EMA
- MACD line is above zero and rising signifies an increasing bullish momentum build up.
- When the MACD line is below zero, it implies 12 period EMA is below the 26 period EMA.
- MACD line is below zero and falling signifies an increasing bearish momentum build up.
The purpose of the signal is to further confirm the changes.
- Bullish momentum when the MACD crosses above the Signal line.
- Bearish momentum when the MACD crosses below the Signal line.
Histogram represents the distance between the MACD and its signal line. The zero line often acts as an area of support and resistance for the indicator.
- When the MACD histogram is above zero (the MACD line is above the signal line) this is an indication that positive momentum is increasing.
- Conversely when the MACD histogram is below zero this is an indication that negative momentum is increasing.
The higher or lower the histogram goes above or below zero the greater the momentum of the trend is thought to be.
When the MACD line is at or close to the zero line, the indicator fails to give a reliable trend reading. In such situations, other indicators and trading techniques must be used to probably predict the price trends.
Relative Strength Index
The relative strength index (RSI) is another well known momentum indicators that’s widely used in technical analysis. The indicator is commonly used to identify overbought and oversold conditions in a security with a range between 0 (oversold) and 100 (overbought).
A reading above 70 suggests that a security is overbought, while a reading below 30 suggests that a security is oversold. Often times, the indicator is used by traders to determine if the price has been pushed to unreasonably higher or low levels after a snap reaction to news.
RSI helps us identify overbought and oversold conditions in the market. It is also scaled from 0 to 100. Typically, readings below 30 indicate oversold, while readings over 70 indicate overbought. Typically, readings below 30 indicate oversold market conditions. Readings over 70 indicate overbought conditions.
The standard RSI calculation uses 14 trading days as a basis, although this figure can be adjusted based on a trader’s individual needs.
We can use RSI to pick potential tops and bottoms depending on whether the market is overbought or oversold.
Determining the Trend using RSI
RSI is a very popular tool because it can also be used to confirm trend formations. If you think a trend is forming, take a quick look at the RSI and look at whether it is above or below 50. For an Uptrend, make sure RSI is above 50. For a Downtrend, make sure RSI is below 50.
As RSI passes above 50, it is a good confirmation that a uptrend has actually formed.
The On-Balance Volume (OBV) indicator is a simple volume-based indicator that’s used to understand changes in volume over time.
The OBV indicator is calculated by taking the total volume for a trading period and assigning it a positive or negative value depending on whether the price increased or decreased over the period.
When the price increased, the volume is assigned a positive value and a negative value is assigned when the price decreased. The positive or negative volume total for the period is then added up to a total that is accumulated from the start of the measure.
OBV rises when volume on up days outpaces volume on down days. OBV falls when volume on down days is stronger.
- A rising OBV reflects positive volume pressure that can lead to higher prices.
- Conversely, falling OBV reflects negative volume pressure that can foreshadow lower prices.
Granville noted in his research that OBV would often move before price. Expect prices to move higher if OBV is rising while prices are either flat or moving down. Expect prices to move lower if OBV is falling while prices are either flat or moving up.
The Stochastic oscillator is another forex chart analysis indicator that helps us determine where a trend might be ending.
It is most recognized as a momentum indicators in technical analysis. The indicator works on the premise that prices should be closing near the highs of a trading range during upswings and toward the lower end of a trading range during downswings.
The Stochastic is scaled from 0 to 100. Readings above 80 are considered overbought while readings below 20 are considered oversold.
As a rule of thumb, we buy when the market is oversold, and we sell when the market is overbought. The oscillator has two lines, the %K (Blue) and %D (Orange). %K measures momentum and %D measures the moving average of %K.
The %D (Orange) line is more important of the two and tends to produce better trading signals. The stochastic oscillator generally uses the past 14 trading days in its calculations, but as with any indicator, can be adjusted by traders to meet their needs.
Average Directional Index (ADX)
The average directional index (ADX) is a trend indicator that’s used to measure the strength of the current trend – although it has limited use identifying the direction of the current trend.
The ADX fluctuates from 0 to 100, with readings below 20 indicating a weak trend and readings above 40 signaling a strong trend.
Unlike the stochastic, ADX doesn’t determine whether the trend is bullish or bearish. Rather, it merely measures the strength of the current trend.
Because of that, ADX is typically used to identify whether the market is ranging or starting a new trend. Once ADX starts dropping below 40 again, it could mean that the uptrend or downtrend is starting to weaken and that it might be a good time to lock in profits.
Parabolic SAR (Stop And Reversal)
Parabolic SAR (Stop And Reversal) can help us determine where a trend might be ending.
A Parabolic SAR places dots on a chart that indicate potential reversals in price movement.
Dots are below the candles during the uptrend and above the candles when it is a downtrend.
- When the dots are below the candles, it is a BUY signal.
- When the dots are above the candles, it is a SELL signal.
This tool is best used in markets that are trending, and that have long rallies and downturns. Might not be the right tool for market where the price movement is sideways.
Indicators can be extremely helpful in identifying momentum, trends, volatility, and other aspects of a security. But, it’s important to note that indicators work best when combined with other forms of technical analysis to maximize the odds of success.