Technical indicators are ubiquitous in the world of trading, and for good reason – they can be powerful tools for predicting future changes in a stock’s price. Technical indicators are best for short-term forecasts and so are most frequently used by active traders, but they also offer important information to long-term investors looking to buy or sell a stock. This article will cover everything needed to get started with using technical indicators, from what they are, to commonly used indicators, to how to incorporate them into a trading strategy.
What is a Technical Indicator?
A technical indicator is a mathematical formula that, when applied to a stock’s historical trading data, yields a forecast trend for how that stock will trade into the future. The historical data typically includes data such as closing prices, past gains and losses, and trading volume, but can incorporate additional data such as volatility, rates of price change, and more. Critically, technical indicators require multiple data points to work effectively, meaning that the formula is applied iteratively to a stock’s data for multiple days or periods to generate a trendline.
How a technical indicator is calculated depends on the indicator, and thus the mathematical formula, being applied. For most indicators, the required data is derived either from a single day or from a continuous stretch of days. For example, in the case of a simple 10-day moving average, data for the technical indicator is derived from a stock’s price for the last 10 days, and the previous point in the trendline from the 10 days before yesterday, and so on.
The ultimate goal of a technical indicator should be to provide information about whether a stock will go up or down in price in the near future. There are a number of benefits to using technical indicators over simply eyeballing price data, the most important of which is that indicators can give a more holistic view of the momentum and past behavior of a stock’s price. However, technical indicators vary widely in complexity and interpretation, so it is important to use technical indicators cautiously and with awareness of what an indicator is intended to signal.
Types of Technical Indicators
There are two main types of technical indicators: overlays and oscillators.
Overlays describe technical indicators that output a value in dollars. They are known as overlays because they can be plotted on the same price vs. time chart as the stock price for which the technical indicator was calculated. A common example of an overlay is a moving average, which can be plotted on top of a stock’s price data.
Oscillators output a value that is anything other than a price point, and that varies between minimum and maximum values. Since oscillators cannot be plotted on the same price vs. time chart as the stock price, they are typically plotted on their own axes above or below the price chart and share the time axis with the price chart.
Goals of Using Technical Indicators
There are three key reasons to use technical indicators in stock price analysis.
The first is that technical indicators have the effect of smoothing out fluctuations in stock price data, which is particularly helpful for volatile stocks that have messy and complex price charts. Visualizing smoothed price data, for example by using a moving average overlay, provides a different perspective on price movements and can make it easier to identify trends within the noisier price data.
The second is that technical indicators make it easy to identify key price levels. These price levels can include floors and ceilings past which the price of a stock can rise or fall rapidly. These price levels can be invisible or hard to visualize when looking directly at historical stock price data, but can be easy to identify once changes in stock prices are analyzed with respect to specific overlays.
The third reason to use technical indicators is to gauge a stock’s momentum – that is, to determine whether a stock is overbought or oversold. This is extremely important when deciding whether to buy or sell a stock that is rising or falling in price, and assessing momentum depends on factors beyond simply the stock’s current price. Momentum oscillators, which are a class of indicators that measure the rate of change of a stock’s price, can be valuable tools for determining whether and how the price of a stock is likely to continue to change.
Common Technical Indicators
One of the simplest and most widely used classes of indicators are moving average indicators. Although there are many different types of moving average indicators, indicators in this class typically function as overlays and serve to smooth price data by averaging a set number of days worth of prices for a security.
Simple moving averages achieve this smoothing by weighting the closing price of a stock over a period of interest equally – more recent closing prices are not given additional weight in a simple moving average. So, for a 3-day moving average, the current day’s average would just be the past three days’ closing prices divided by 3.
Weighted moving averages are slightly more involved because they take into account factors in addition to price, such as changes in the volume traded over the calculation period or how recently each price occurred. In this case, it is possible to assign more importance to larger-volume price actions or to more recent stock prices when calculating the moving average.
Exponential similarly assign greater weight to more recent price data. However, they are more popular than weighted moving averages because they take into account a stock’s entire historical value, rather than just the value over the period of interest. Although this makes the mathematical formula involved more complex, the exponential moving average offers a balance between smoothing and price history tracking that many traders prefer.
Momentum oscillators are, as the name indicates, a class of oscillators that typically use information about a stock’s recent rate of price change to provide a metric of how likely current movements in price are to continue.
The RSI, or relative strength index, is one of the most commonly used momentum oscillators among active traders and provides information about whether a stock is overbought or oversold. The index calculates a value from 0 to 100 by counting the size of gains and losses over a specified historical price period. Values less than 30 indicate that a stock may be gaining momentum and may be poised for a breakout, while values over 70 indicate that a stock may be overbought and is likely to dip in price.
Another common momentum oscillator is the stochastic oscillator, which compares a stock’s current price to the range of its prices over a specified time period. In practice, the value output by the stochastic oscillator is a measure of how the stock’s current price compares to its recent high and recent low and can indicate that a stock is overbought or oversold. Values less than 20 indicate that a stock is nearing its recent low value and may be oversold, while values greater than 80 indicate that a stock is nearing its recent high value and may be overbought.
Moving Average Convergence Divergence (MACD)
The moving average convergence divergence, or MACD, is a widely used technical indicator that offers easy to interpret buy and sell signals. The MACD, is calculated by subtracting the 26-day exponential moving average for a stock from its 12-day exponential moving average. As such, when the MACD is positive it indicates positive momentum as the short-term average is greater than the longer-term average. Conversely, when the MACD is negative, it indicates a downward momentum as the longer-term average is greater than the shorter-term average.
The MACD can be used to forecast changes in price when it is plotted against the same stock’s 9-day exponential moving average. In this case, the 9-day exponential moving average is known as the “signal” line. When the MACD crosses the signal line on either an up or down trend, that is known as a crossover. A downward crossover indicates that the price of the stock is likely to fall, while an upward crossover indicates that the price is likely to rise. Crosses can be misleading, however, as it is possible for the MACD to cross the signal line only briefly before returning to an existing trend.
Another situation to watch for in the MACD is when the stock price and the MACD are trending in opposite directions. This is known as a divergence and signals the end of the stock price’s current trend. For example, if the stock price is rising while the MACD is falling, this indicates that the stock’s price may be nearing the end of its rise.
A third situation in which the MACD may be used to forecast stock price activity is when the MACD rises sharply upward, indicating a recent upward momentum in the stock’s price. This signal can be combined with information from the RSI to determine whether the stock may be overbought.
How to Apply Technical Indicators in your Trading
The most important rule in applying technical indicators is to keep it simple. Technical indicators are designed to provide different perspectives on potential stock price movement and shouldn’t define a trading strategy. When in doubt, remember that price and volume are the basis for most technical indicators and should be the primary data used to make decisions.
In addition, technical indicators should be used parsimoniously – they are intended to make trading more efficient and fact-based, and checking the hundreds of possible indicators is likely to result in uninterpretable data and less efficient trading. With that in mind, it is also important to consider which technical indicators best fit the needs of a particular trading strategy. For example, active traders may be best served by momentum oscillators, while long-term traders may be better served by long-term moving averages. Developing a strategy that is flexible when incorporating indicators is key to using them successfully.
Technical indicators can be extremely useful analytical assets for informing buying and selling decisions for both short- and long-term traders. While the sheer variety of indicators can seem overwhelming, they can be broken down into two main classes and many of the most popular indicators are popular for good reason. Most of all, it is important to remember that technical indicators are there to inform and enhance a trading strategy and should not replace or take over trading decisions.