Important Use Of Technical Analysis Indicator (informative)

 

The image above is the perfect example of how a Stock market works. Analyze it properly and you will understand what led to “Buy calls”and “Sell Calls”. It is funny how people can communicate and interpret information! These are the people who do not actually understand how the stock market works. But the people who do know how it works, have tools of their own. They carry out all kinds of analysis to come to a particular decision. One of the tools used by traders and investors all over the world is “Stock market indicator”. So let’s understand what all the fuss is about!

What is a Technical Analysis Indicator?

You certainly need to know that the Technical analysis indicator is the basis of technical analysis. They are used to determine the future trends of stock or economies. Technical analysis indicator helps the investor to know when to enter or exit a trade, in order to make profit. Technical analysis indicator looks at price information and translates it into simple, easy-to-read signals. These signals help the investor determine the correct time to buy or sell.

Technical analysis indicator provides clues to the investor, thus helping them to interpret the market patterns and the future behavior of the price. Thus combinations of price, volume and time sensitive Technical analysis indicator are used to maximize profits.

A technical analysis indicator is nothing but a graphic representation of price action. It consists of series of data points that are derived by applying a formula to the price data of a specific security. Now you must be wondering what price data here means? Price data here is nothing but any combination of the open, high, low or close over a period of time. In some cases the indicators include only the closing prices, while others incorporate volume and open interest into their formulas. And then the price data is entered into the formula and data points are produced.

To clarify your doubts lets understand it by a simple example. Let’s understand how a data point is made or generated. For example, the average of 3 closing prices is one data point. i.e. (41+43+43) / 3 = 42.33, which is the data point here.

However, if you think closely you will understand that a single data point will not make any sense. It does not offer much information and does not indicate anything. For proper analysis, a series of data points over a period of time are required to create valid reference points. Thus by creating a time series of data points, a proper comparison can be made between present and past levels of information. When it comes to analysis, technical indicators are usually shown in a graphical form above or below a security’s price chart. Once a graphical representation is created, an indicator can then be compared with the corresponding price chart of the security.

Also, one point to remember is that the Technical analysis indicator is distinguished by the fact that it does not analyze any part of the fundamental business, like earnings, revenue and profit margins. They are designed primarily for analyzing short-term price movements. If you are a long-term investor, then the Technical analysis indicator may prove to be of little value as they do not cover the fundamentals of what is happening in the Company of interest.

A technical indicator offers a different viewpoint to analyze the price action. Some indicators, such as moving averages, are derived from simple technical analysis indicator formulas and are quite easy to understand. Other indicators like the Stochastic have complex formulas and require more study to fully understand them.

Why use the technical analysis Indicator?

Indicators serve three main functions as shown in the image above.

# Alert

An indicator can act as an alert when the momentum is declining. At such time it may be a signal to watch for a break of support. On the other hand if there is a large positive deviation building, it may serve as an alert to watch for a resistance breakout.

# Confirm

Indicators are also used to confirm other technical analysis tools. They can be used to confirm the breakout or the weakness.

# Predict

Indicators are also used to predict the direction of future prices.

 

 

How is a Technical analysis indicator derived?

Technical analysis indicator is derived from technical charts. These technical charts are the graphical or pictorial representations of the market activity in terms of upward or downward movements in stock prices over a period of time.

If you consider a technical chart as a plot it will be really easy to understand. In such a case the set of price data is found on the Y-axis and a function of time is on the X- axis. This price data here basically include opening price, closing price, the day’s high or low price, average price, or a combination of these. The plotted data points on the chart are then shown as individual points or as small bars.

When all these data points are joined, a wave-like pattern is obtained. And this is what we want for technical analysis in order to arrive at technical indicators. From this we can predict the future market price of a stock or its market trend.

Two major types of Technical analysis indicator are:

1. Leading Indicators

Leading indicators are used to signal future events. A simple example of it would be how the amber traffic light indicates the coming of the red light. Leading indicators are used for predicting price moments. Some examples of leading indicators are Relative Strength Index (RSI), Stochastic Oscillator and Williams %R, Commodity Channel Index (CCI), Momentum.

Momentum Oscillators- Leading indicators generally come in the form of momentum oscillators. Momentum measures the rate-of-change of a security’s price. As the price of a security rises, price momentum increases. The faster the security rises the larger the increase in momentum. Once there is slowdown in the rise the momentum automatically slows down too.

Example- RSI

The relative strength index (RSI) is one of the most popular technical indicators. It is computed on the basis of the speed and direction of the price movement of the stock. The RSI scale ranges from 0 to 100. When the RSI approaches 70 it means that the asset or the security is overbought and hence it is getting overvalued. Hence it is better to get out of that security at such time.

Whereas on the other hand when the RSI approaches 30, it is an indication that the security may be getting oversold and therefore likely to become undervalued. ( Click on the image besides to understand it better).

RSI Buy Signal:

Buy when the RSI crosses above the oversold line i.e. 30.

RSI Sell Signal:

Sell when the RSI crosses below the overbought line i.e. 70

Benefits and Drawbacks of Leading Indicators

• It helps in early signaling for entry and exit.
• These indicators generate more signals and allow more opportunities to trade.
• Early signals can act as an alert against a potential strength or weakness.
• Since the leading indicators generate more signals, the Technical analysis indicator is highly used in trading markets.
• More signals and earlier signals mean that there can be chances of false signals.
• False signals will increase the potential for losses.

2. Lagging Indicators

A lagging indicator gives a signal after the trend has started. It basically informs you that “Hey buddy, pay attention, the trend has started and you’re missing on it.” If we consider our example of traffic light, the amber light is a lagging indicator telling that the Green light has occurred before. In Finance terms the lagging indicators can be Profit or losses made by a company. But the main challenge with the lagging indicators is that they do not measure the current activity.
Lagging indicators follow the price action and hence they are commonly referred to as trend-following indicators. Such types of technical analysis indicators work best when markets or securities develop strong trends. Some popular examples of lagging indicators are moving averages (exponential, simple, weighted, variable) and MACD.

Example- MACD

MACD is a short for moving average convergence/divergence. It is a trading indicator created by Gerald Appel in the late 1970s. It reveals changes in the strength, direction, momentum, and duration of a trend in a stock’s price.

The MACD indicator is a collection of three time series calculated from historical closing price data. These three series are:

1. The MACD series proper. It is the difference between a “fast” (short period) exponential moving average (EMA), and a “slow” (longer period) EMA of the price series.
2.  The “signal” or “average” series. This is an EMA of the MACD series itself.
3. The “divergence” series. It is the difference between the above two series.

Remember the below calculations:

• MACD: (12-day EMA – 26-day EMA)
• Signal Line: 9-day EMA of MACD
• MACD Histogram: MACD – Signal Line

Benefits and Drawbacks of Lagging Indicators

• When the market or security in question develops a constant move, lagging indicators can be enormously profitable and easy to use.
• But the main disadvantage is that the lagging indicators are not predictive.
• Another drawback of these indicators is that the signals tend to be late.
• What we want from an indicator is sensitivity and consistency. We want that the indicator should give early signals and at the same time there should be few false signals (termed as whipsaws). If we increase the sensitivity by reducing the number of periods, we would get an early signal, but at the same time number of false signals will also increase.
• If we decrease sensitivity by increasing the number of periods, then the number of false signals will decrease, but at the same time the signals will also lag.
• The longer the moving average, slower the reactions and fewer the signals.
• But if the moving average is shortened, it becomes faster but also increases the number of false signals.

The Challenge of Indicators

• What we want from an indicator is sensitivity and consistency. We want that the indicator should give early signals and at the same time there should be few false signals (termed as whipsaws). If we increase the sensitivity by reducing the number of periods, we would get an early signal, but at the same time number of false signals will also increase.
• If we decrease sensitivity by increasing the number of periods, then the number of false signals will decrease, but at the same time the signals will also lag.
• The longer the moving average, slower the reactions and fewer the signals.
• But if the moving average is shortened, it becomes faster but also increases the number of false signals.

List of Technical analysis indicator

Volume Indicators

Volume indicators help in confirming the strength of the trend.

Momentum Indicators

Momentum indicators help in determining the speed at which price is changing.

Common Oscillators

Oscillators are computed from prices and tend to oscillate within a fixed or a limited range.

Trend Indicators

Trend indicators help in determining future direction and trend.

Volatility Indicators

Volatility indicators help in judging the strength of the trend and breakouts.

The Benefits of a Technical Indicator

• Technical analysis indicator provides a viewpoint on the strength and direction of the price action of the stock. As discussed earlier, their main function is to alert, confirm and predict.
• Stock prices fluctuate continuously and hence it can become cumbersome to make a track. But here is when the Technical analysis indicator comes handy. These Technical analysis indicators smooth out the data and make it easier to understand. They help in plotting the movements of the stock on a chart.
• Technical analysis indicator determines the support and resistance levels. This indicates whether the price has dropped lower (support) or has climbed higher (resistance).
• Also some indicators help to determine the future price of a share.
• Technical indicators help in establishing upward and downward trends. This is critical for both traders and investors.
• Technical analysis indicator can act as an alarm, alerting a technical analyst of any major price action or volatility.

Key Tips for using Technical analysis indicator

• Sometimes traders forget how indicators are derivatives and not the direct reflection of the price actions. Sometimes they tend to ignore the price action of a security and focus solely on an indicator.
• Hence any analysis of an indicator should be taken with the price action in mind.
• Sometimes the same indicator may show different behavioral technical analysis indicator patterns when applied to different stocks.
• Your Buy or Sell call decision should not be solely based on the indicator. Make sure that you take help of other tools as well.
• You may find that the process of choosing an indicator is quite difficult. There are hundreds of indicators in use today, and more are created every week.
• Choose indicators that complement each other. You may avoid using the Technical analysis indicator that move in unison and generate the same signals. Two or three indicators are usually sufficient to come at the right decision.

Conclusion

• Make a note that the best Technical analysis indicator are those that have been tried and tested in the past and have proven to be successful.
• Do not become the “Jack of all Trades and Master of None!” Nothing will come your way if you attempt to master all Technical analysis indicator and oscillators.
• Use the indicators which best complements your trading style.
• Use two or three indicators, as using just one may give you a false signal.
• Remember that each technical indicator provides unique information. Identify it and grab the opportunity.
• Be aware of the weakness associated with most Technical analysis indicator.

Always Remember….

“Success is simple. Do what’s right, the right way, at the right time”.

Technical Analysis Indicator Infograph

Learn the juice of this article in a minute through Technical Analysis Indicator Infograph

First Image Source- binary-option-trading-guide.com

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