One of the most basic and easy to understand technical indicators is the moving average. It is used to emphasize the direction of a trend. It takes the prices for a specific number of periods, sums them and then divides them by the number of periods. Each day, the oldest price drops off and a new one is added. Because prices constantly change, the moving average moves with each new input.
While the most commonly used timeframes are 10-, 20-, 40- and 50-day averages, you can choose any period you wish. The longer the time span, the less sensitive the moving average will be to daily price changes.
There are three main types of moving averages: simple, weighted and exponential. The last two place more emphasis on recent prices. Whichever type you choose, you end up with a single smoothed line that when laid over a price chart, gives you a picture of the trend (see “Spotting trends,” above).
As long as prices remain above the average, there is strength in the market. If prices cross below the average, the market no longer expects prices to continue to move higher.
Moving Average Convergence Divergence (MACD) is an indicator that can help you decide when you might want to get in on a potential trend. MACD uses three moving averages. Two of them are based on the number of price periods used and a third is an average of the difference between the two moving averages. These indicators are turned into a momentum oscillator (a measure of how much prices have changed over a given time period) by subtracting the longer moving average from the shorter moving average. The resulting plot forms a trigger line that oscillates above and below zero, without any upper or lower limits.
When the line is above zero, the market may be considered to be in an uptrend. Below the line, a downtrend may be at hand. The zero line also can act as an area of support and resistance (see “Finding trends early,” page 45).
Traders watch how the MACD’s movements compare with price movements. When prices make a high and then another high, while MACD makes a high and a lower high, they are diverging. The two are going in different directions. Divergence can signal underlying weakness in the market.
Average Directional Movement Index (ADX) measures the strength of a trend, whether it is up or down. This indicator has two directional movement indicators, one for upward movement (+DMI) and the other for downward movement (-DMI). ADX represents the average difference between the two DMIs.
Rising values suggest that the trend’s strength is increasing. An ADX value crossing above 25 is in a strong trend. As long as price is trending, ADX should remain above 25.
ADX is an objective measure of trend strength. This can help traders know when to let profits run.
THE END OF THE TREND
Relative Strength Index (RSI) measures the velocity of price movements by comparing the magnitude of recent gains to recent losses to determine overbought and oversold conditions.
RSI ranges from 0-100. A market is considered to be overbought if the RSI approaches the 70 level, meaning that it may be getting overvalued and is a good candidate for a pullback. Jeff Friedman, senior market strategist with Lind-Waldock, says, “This number isn’t written in stone, because some believe that in a bull market 80 is a better level to indicate an overbought price, since prices often trade at higher valuations during bull markets. Likewise, if the RSI approaches 30, it’s usually an indication that the market may be getting oversold and may become undervalued. But some traders adjust to 20 in a
The shorter the number of days used, the more volatile the RSI, and the more often it can hit extremes. A longer-term RSI fluctuates a lot less.
Many markets will remain overbought or oversold for extended periods of time, so RSI is best used as a complement to other tools and not a stand-alone indicator.
Bollinger Bands measure market volatility. The bands are lines plotted two standard deviations from a simple moving average, typically a 20-day, although other time frames can be used. The bands adjust themselves to the market conditions. When the markets become more volatile, the bands widen and when they become less volatile, the bands contract. A tightening of the bands is often seen as an early indication that volatility is about to increase sharply.
This is one of the most popular technical analysis techniques. The closer the prices move to the upper band, the more overbought the market is and the closer the prices move to the lower band, the more oversold it is.
There are other indicators you may wish to try or may already favor. You can learn more about them by picking up any text on technical analysis. Whichever indicators you choose, remember that they are just one piece of the puzzle; your trading discipline is what will underpin your success.
Laura Oatney is a freelance writer with more than 20 years of industry experience. She can be contacted at firstname.lastname@example.org.