What is a Technical Indicator?
A technical indicator is a mathematical pattern derived from historical data used by technical traders or investors to predict future price trends and make trading decisions. It uses a mathematical formula to derive a series of data points from past price, volume, and open interest data.
A technical indicator is usually shown graphically and compared with the corresponding price chart for analysis. The mechanics of a technical indicator captures the behavior and sometimes the investors’ psychology to provide a clue of future trends of price activity.
Technical indicators offered in technical analysis to predict future price movements include cycle volumes, momentum readings, volume patterns, price trends, Bollinger Bands, moving average, Elliot waves, oscillators, and sentiment indicators. Besides providing valuable insight into the price structure, a technical indicator also shows how to reap potential profits from price movements.
- In technical analysis, a technical indicator is mathematically derived from price, trading volume, investor sentiments, or open interest data and applied to interpret stock market trends and investment decisions using past price and volume trends.
- Technical analysts use technical indicators to determine market entry and exit points.
- Technical indicators can be used for trading decisions by analyzing them either on a stand-alone basis or when combined.
Understanding Technical Indicators
A technical indicator is generally a mathematically derived representation of data, such as price, volume, or open interest, to detect stock movement. The indicator is weighed based on historically-adjusted returns, common sense, an investor’s objective, and logic to evaluate investments and identify trading opportunities.
Some technical indicators generate signals as stand-alone, while others supplement each other. As elements of technical analysis, they are used to evaluate a security’s strength or weakness by focusing on trading signals, patterns or price movements, and other analytical charting tools. Although there are non-specific technical indicators with regard to the market, some technical indicators are meant to be used for a specific financial market.
Types of Technical Indicators
Oscillators are a special subset of technical indicators that oscillates between a local minimum and maximum and focuses on market momentum. They are best used to provide readings of overbought and oversold price movements. Traders and investors define price turns and reversals within ranging markets using oscillators because they swing within a generally defined range.
In many cases, technical analysts consider using multiple oscillators on a single chart as redundant because they bear a striking similarity in their mathematical formulas, function, and appearance. Technical analysis uses oscillators, such as relative strength.
Overlays are special types of technical indicators used by traders and investors to identify overbought and oversold levels. They provide insight into the supply and demand of a stock. Commonly used overlays include Bollinger Bands and moving average.
Other than giving the overbought and oversold conditions, Bollinger Bands measure the impending market volatility. On the other hand, moving averages are used to determine and measure the strength of a market trend.
Common Technical Indicators
1. Accumulation/Distribution Line (A/D Line)
The Accumulation/Distribution Line is commonly used to determine a security’s money flow. The A/D line focuses only on the security’s closing price and trading range for the period. A buying interest is shown when the indicator line is trending up, while a falling indicator line shows a downtrend.
2. On-Balance-Volume (OBV)
On-Balance-Volume (OBV) applies to securities over time, where it measures the flow of trading volume. A rising OBV suggests the buyers’ willingness to enter the market. Conversely, a falling OBV suggests lower prices when selling volume outpaces buying volume. OBV is, therefore, a confirmation indicator for a continuous trend.
3. Average Direction indicator (ADX)
Traders and investors use the Average Direction indicator (ADX) to measure a trend’s strength and momentum. A robust direction strength, either up or down, is in the offing when the ADX is above 40. A weak trend or non-trending is suggestive when the indicator is below 20.
4. Moving Average Convergence Divergence (MACD)
Traders use Moving Average Convergence Divergence (MACD) to see the direction and momentum of a trend that provides different trade signals. When the price is on an upward phase, the MACD is above zero, while a below-zero MACD is suggestive of a bearish period.
Combining Multiple Technical Indicators
Technical analysts analyze technical indicators independently to perceive possible changes in the behavior of each indicator. The structural changes within the various financial markets render the behavior of some technical indicators substantial.
For this reason, there are overwhelming combinations of technical indicators. Some combinations are complex to understand and work with, while other combinations prove easy, especially when weights are assigned to each indicator.
An example of a technical indicator combination is the Commodex Trend Index. The Commodex Trend Index incorporates other subjective forms of technical analysis, such as crossovers of a fast and slow-moving average, liquidation, open interest, and volume momentum.
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