Technical Indicators

What is a Technical Indicator? 


A technical indicator is a series of data points that are derived by applying a formula to the price data of a security. Price data includes any combination of the open, high, low or close over a period of time. Some indicators may use only the closing prices, while others incorporate volume and open interest into their formulas. The price data is entered into the formula and a data point is produced. 

For example, the average of 3 closing prices is one data point ( (51+56+54) / 3 = 53.66 ). However, one data point does not offer much information. A series of data points over a period of time is required to create valid reference points to enable technical analysis. By creating a time series of data points, a comparison can be made between present and past levels. 


Why are Technical Indicators used?

Indicators serve three broad functions: to alert, to confirm and to predict.

• An indicator can act as an alert to study price action a little more closely. If momentum is waning, it may be a signal to watch for a break of support. Or, if there is a large positive divergence building, it may serve as an alert to watch for a resistance breakout.

• Indicators can be used to confirm other technical analysis tools. If there is a breakout on the price chart, a corresponding moving average crossover could serve to confirm the breakout. 

• Some investors and traders use indicators to predict the direction of future prices.

Tips for using Indicators -

• When using Technical Indicators in the analysis of Stock Markets, the first requirement is to identify the trend. Once the trend has been identified, the trader can then apply some of the commonly used Indicators mentioned above: Moving Averages, MACD, the RSI, the Stochastic and Bollinger Bands. Technical indicators are used to know when to enter or exit a trade. If you know how to enter and exit a trade, you can easily make profits. That is why choosing good stock indicators are important. 

• Indicators indicate. This may sound straightforward, but sometimes traders ignore the price action of a security and focus solely on an indicator. Indicators filter price action with formulas. As such, they are derivatives and not direct reflections of the price action. This should be taken into consideration when applying analysis. Any analysis of an indicator should be taken with the price action in mind. What is the indicator saying about the price action of a security? Is the price action getting stronger? Weaker?

• Even though it may be obvious when indicators generate buy and sell signals, the signals should be taken in context with other technical analysis tools. An indicator may flash a buy signal, but if the chart pattern shows a descending triangle with a series of declining peaks, it may be a false signal.

Conclusion


When choosing an indicator to use for analysis, choose carefully and moderately. Attempts to cover more than five indicators are usually useless. It is best to focus on two or three indicators and learn their intricacies inside and out. Try to choose indicators that complement each other, instead of those that move in unison and generate the same signals.