5 Essential Indicators Used in Technical Analysis
Indicators are the weapons of choice for professional technical analysts who have battle-tested their analytical abilities. In order for each player to master their craft, they will be provided with the tools that most suit their own unique play style. Some investors are interested in market momentum, while others are interested in separating out market noise and measuring market volatility.
The question is: what are the best indicators in terms of technical analysis? Traders will each tell you something that they consider to be effective. The indicator that one analyst insists is the ultimate indicator will be dismissed by another analyst. In addition to these, there are some very popular indicators, such as those we've listed below (RSI, MA, MACD, StochRSI, and BB).
Introduction
A technical indicator is one that is used by traders to gain an understanding of how a specific asset will perform over time. With the use of these indicators, it will be easier to determine patterns and identify the best time to buy or sell in the current market environment. A wide variety of indicators are available, and they are commonly used by day traders, swing traders, and sometimes even long-term investors. In fact, some professionals and advanced traders have created their own indicators. Our objective here is to provide a brief introduction to some of the most popular technical analysis indicators that can be helpful for any trader's market analysis toolkit.
1. Relative Strength Index (RSI)
The Relative Strength Index is used to determine if an asset is overbought or oversold based on its momentum. It works by measuring the magnitude of recent changes in price (the standard method is to use the previous 14 periods, so 14 days, 14 hours, etc.). The information will then then be displayed as an oscillator with a value that can range from 0 to 100.
The RSI, since it is a momentum indicator, shows the rate (momentum) of the price changing in relation to the RSI. Accordingly, if the momentum increases while the price increases, this means that the uptrend is strong, and it is encouraging more and more potential buyers to invest. However, if momentum is decreasing in conjunction with a rising price, then this may indicate that the seller is about to take control of the market.
Traditional interpretations of the RSI suggest that when it exceeds 70, then the asset is overbought, and when it falls below 30, then it is oversold. Due to this, extreme values can be an indicator of upcoming reversals or pullbacks of the trend. In spite of this, it is best not to view these values as direct indicators of buying or selling. It is always advisable to consider other factors before entering a trade, as the RSI may provide false or misleading signals, just like many other technical analysis (TA) techniques.
2. Moving Average (MA)
Moving averages smooth out price movement by eliminating noise in the market and highlighting the direction of the trend. The underlying price is based on past prices, so it is a lagging indicator.
Two of the most common moving averages used to calculate moving averages are the simple moving average (SMA or MA) and the exponential moving average (EMA). SMA's are plotted using the price data from the defined period in order to produce a calculated average. The SMA for 10 days is calculated by averaging the price over the last 10 days. EMAs are calculated in such a way that the most recent price data is given more weight than older data. In other words, it has a greater ability to react to recent price movements.
Moving averages are generally perceived as lagging indicators, as was mentioned above. Longer the period, the greater the lag. As a result, the 200-day SMA will react to recent price activity more slowly than its 50-day sma. In order to gauge the current market trends, traders often look at the relationship between the price and specific moving averages. It is possible that many traders may consider the asset to be in a bull market if the price stays above the 200-day SMA for a prolonged period of time.
The cross-over of moving averages can also be used as a buy/sell signal by traders. As an example, if the 100-day moving average crosses below the 200-day moving average, it may be considered a signal to sell. However, what is exactly the meaning of this cross? This indicates that the average price for the last 100 days has fallen below the average price for the last 200 days. We are selling in this situation because it seems short-term price movements are not following the uptrend, and can therefore be interpreted as a trend reversal.
3. Moving Average Convergence Divergence (MACD)
In the MACD, the relationship between two moving averages is used to determine the momentum of an asset. This indicator consists of two lines - a MACD line and a signal line. In order to calculate the MACD line, the 26 EMA is subtracted from the 12 EMA. On top of this, we plot the 9 EMA of the MACD line, which is the signal line. The MACD line and the signal line are separated by a histogram, which is often incorporated in many charting tools to display the distance between the two lines.
The traders might gain insight into the strength of the current trend by looking for divergences between the MACD and the price action. It might be that the market is about to reverse if, for example, the price is making higher highs while the MACD is making lower highs. But what is the signal from the MACD in this case? There is a high probability of the price reversing or pulling back when momentum decreases, as price is increasing while momentum is decreasing.
A trader may also use this indicator to identify crossovers between the MACD line and the signal line of the MACD. A cross of the MACD line over the signal line may be interpreted as a buying signal. A MACD cross below the signal line, on the other hand, may indicate a sell signal. As both the MACD and the RSI measure momentum in different ways, it is sometimes used in conjunction with each other. The assumption is that when taken together they will provide a more comprehensive technical outlook for the market.
4. Stochastic RSI (StochRSI)
The Stochastic RSI is a momentum oscillator that is used to determine whether an asset has gone from overbought to oversold at a given moment in time. Since it is derived from RSI values rather than price data, it is a derivative of the RSI. A stochastic oscillator is derived from the ordinary RSI values by applying a formula called the stochastic oscillator formula. It is generally accepted that the RSI values for Stochastics range from 0 to 1 (or 0 to 100).
The StochRSI can be tricky to interpret because of its greater speed and sensitivity, causing a lot of trading signals to be generated. It is generally more useful near the extremes of its range - the upper or lower ends of its range.
In general, a value above 0.8 on the StochRSI is considered overbought, and a value below 0.2 is considered oversold. By default, the RSI is set to 14 (a default value), which means it is at its lowest value since the measurement period started. For example, if the RSI is set to 1, it means that the RSI is at its highest value within the period being measured.
It should be noted that overbought or oversold StochRSI values do not necessarily indicate that prices will reverse immediately. This is similar to how RSI should be used. For instance, when the StochRSI is used, it simply means that the RSI values (from which the StochRSI values derive) are at the extremes of their recent readings. Additionally, it's important to keep in mind that the StochRSI indicator is more sensitive than the RSI indicator, so it tends to generate a larger number of false signals.
5. Bollinger Bands (BB)
This measure of market volatility, as well as illustrating the overbought and oversold conditions of the market, is known as Bollinger Bands. These lines are made up of three lines namely, an SMA (the middle band), and an upper and lower band. While the settings may vary, typically the upper and lower bands will be separated by approximately two standard deviations from the middle band. The distance between the bands will be increasing or decreasing in accordance with the volatility in the market.
the closer the price is to the upper band, the more likely it is that the asset is in overbought conditions. In the opposite situation, if a price is very close to the lower band, it may be very close to being in oversold conditions. It is most likely that the price will stay within the bands, but there may be occasions where it breaks above or below the bands. It is important to note that while this event may not necessarily be viewed as a trading signal in itself, it can indicate the extreme conditions of the market.
In addition to BBs, squeezes are an important concept to understand. It describes a period of low volatility, in which all bands are very close to one another. In general, this could be considered as a sign of potential future volatility.