Last Updated on 17 November, 2020 by Samuelsson
There are different approaches to trading; while some traders make use of economic data and fundamental analysis of a security to determine when to buy or sell the security, others technically analyze how the security’s price has moved in the past in order to predict how it might move in the future. Technical analysis, most of the time, involves the use of trading indicators — either alone or in addition to price action — but what exactly are trading indicators?
Trading indicators are the visual representation of mathematical calculations that are based on historical price, volume, or open interest (futures contracts) of a security used by traders to predict future price direction. They are very important in technical analysis.
There are other things you may not know about trading indicators. Read on to learn about them.
What You Should Know About Trading Indicators
A lot of traders base their trading decisions on technical analysis, and technical indicators are useful tools they employ in their daily analysis of price data. Technical traders try to forecast the future direction of price based on past market data.
Depending on the time frame used, the market prints an enormous amount of price data each day. These data can be overwhelming, especially to new traders. So trading indicators are used to simplify the price data and present them in easily recognizable patterns.
Trading indicators can be used in analyzing any asset that has a historical price and volume data, such as currencies, commodities, stocks, futures, bonds, and others. They are very popular with day and swing traders, but position traders also use them on higher timeframes.
What Benefits Do Trading Indicators Offer to Traders?
There are numerous benefits of attaching a few indicators on your chart, and here are some of them:
- Some indicators like the moving averages can help you confirm the direction of the price trend by filtering out the noise
- Volatility indicators can help you adjust your stop loss based on the level of market activity on the security
- Some indicators can help you know when the price momentum is getting weak
And of course, trading indicators can help you with finding entries and exits!
What Are the Drawbacks of Trading Indicators?
Despite their benefits, trading indicators have some well-known drawbacks, such as:
- They are lagging
- Too many of them can make the chart messy
- Using many of them at once may lead to analysis paralysis
Indicator-Based Trading vs Price Action-Based Trading
Although indicator and price action analysis are parts of technical analysis, indicator-based trading is different from price action-based trading in some ways. Indicator-based trading involves making trading decisions based on indicator signals, whereas price action trading relies on candlestick and chart patterns.
While indicators enthusiasts use one or more indicators to elucidate what is happening in the market, price action traders focus solely on price — what it has done in the past and what it’s currently doing. Furthermore, a price action trader doesn’t joke with important price levels and price structures.
Trading Indicators vs Price Action Analysis
|Technical indicators||Price action analysis|
|Basis of analysis||Previous price data and sometimes current volume data||Considers the current price information in relation to previous price movements|
|Signals||Mostly lagging||Occur in real-time|
|Appearance of chart||The chart may be clustered||Clean chart|
|Types||Trend, momentum, volatility, and volume indicators||Candlestick patterns and chart patterns|
|Examples||Moving averages, Stochastic, Average true range, On-balance volume||Candlestick patterns: Doji, Hammer, Shooting star, Engulfing, Morning star, Evening star
Chart patterns: Triangles, Flags, Pennants, Wedges, Head and shoulder, Double top and Double bottoms
Trading Indicators Types
There are hundreds, if not thousands, of trading indicators available to traders, and more complex ones are still being developed every day as traders continue searching for ways to improve their trading results. These indicators can be classified in various ways, and here are some of them:
Overlays and Separate Window Indicators
Depending on where the indicator is placed on the price chart, there are indicators that are placed on the main price chart, which follow the price movement. These are called overlays, and often include the moving averages, zigzag lines, Fibonacci tools, Bollinger band, parabolic SAR, Ichimoku clouds, chandelier channels, pivot lines, Donchian channels, and others.
There are others which are placed on a separate window from the main price chart, and they are simply known as separate window indicators. They often include stochastic, MACD, RSI, ADX, On-balance volume, accumulation distribution index, etc.
Leading and Lagging Indicators
Trading indicators can also be classified based on when they give signals in reference to the current price movement. Indicators that give signals about price reversals before price changes direction are called leading indicators, and they include oscillators or momentum indicators like RSI and some volume indicators like accumulation distribution index.
Some indicators signal change in price direction after the price has already reversed, and they are known as lagging indicators. Examples of lagging indicators are trend indicators (moving averages), volatility indicators (Bollinger bands), and some volume indicators like Chaikan money flow index.
The Five Categories of Indicators
Another way of categorizing trading indicators is based on the story they tell about price and volume. As a matter of fact, this is the most common way of classifying these indicators, and the main categories are as follows:
Mean Reversion Indicators
Mean reversion indicators aim to identify oversold and overbought conditions, where the market is likely to revert to its mean. Mean reversion is a market tendency that is especially prevalent in equities.
Some common mean reversion indicators are the Relative Strenght Index and the Stochastic Indicator.
These indicators are designed to show traders how the price of a security is behaving: if it’s trending or range-bound. Some of them even show the direction of the trend, which may be upward (bullish trend), downwards (bearish trend) or sideways (range-bound).
Some of the examples of trend indicators are moving averages, average directional index (ADX), parabolic SAR, and linear regression. Moving average convergence divergence (MACD) may also be seen as a trend indicator, but most times, it is taken as a momentum indicator.
The indicators here are also called oscillators because they oscillate between two extremes or about a midpoint. They show the speed at which the price is moving over a given time.
The ones that oscillate between two extremes often show overbought and oversold regions, and they include stochastic, relative price index (RSI), commodity channel index (CCI), advance/decline ratio (ADR), and William %R indicator. Momentum indicators that oscillate about a midpoint include Chande’s momentum indicator, oscillatory moving average (OsMA), and MACD.
These indicators help traders to measure the level of market activity in a security. They indicate the relative magnitude price moves in the upward and downward directions. When the price moves up or down very quickly, the asset is said to have high volatility, and when the opposite is the case, the asset is said to have low volatility.
Examples of volatility indicators include average true range, Bollinger bands, standard deviation indicator, envelopes, volatility channels indicator, Garman-Klass volatility estimator, etc.
Apart from the asset’s price, there are indicators that measure the volume of transactions. These indicators help traders to confirm whether the price movement or change in direction is supported by a genuine interest in the asset or not — as indicated by the volume of the asset transacted.
Some of the indicators in this group are on-balance volume, accumulation distribution index, money flow index, demand index, and force index.
Common Trading Indicators
Indicators are just tools to help you analyze the market and make your trading decisions. They don’t tell you what will happen, instead, they help you assess the likelihood of an outcome.
Traders use these indicators in different ways to suit their style of trading. The way one trader uses RSI, for example, may be different from another trader. Here are some common indicators and how traders use them in making trading decisions:
This is one of the most common indicators on any trading platform. It is a trend indicator, and it lags.
A moving average indicator displays the average price of a security over a chosen number of periods. Based on how the average is calculated, there are different types of moving averages — simple moving average (SMA), exponential moving average (EMA), and linear-weighted moving average (LWMA).
Moving averages help to smooth out price fluctuations and make the price trend clearer. They are calculated by taking the average close (or open or high or median) price over the last ‘X’ number of periods. If you choose longer ‘X’ value, the indicator will appear smoother but will react more slowly to changes in price movement.
On the other hand, if you set shorter ‘X’ value, the indicator will appear choppier, as it tends to follow price movements more closely.
The most common use of moving averages is to identify trend direction. An up-sloping moving average indicates an upward trend, while a down-sloping moving average shows a downward trend. When the moving average is flat, the trend is sideways.
Some traders take price crossing above an up-sloping moving average as an indication to buy the security and a cross below a down-sloping line as an indication to sell. Also, traders use the long-period (100-day or 200-day) moving averages as dynamic support and resistance. Some may use two moving averages crossing each other as an indication for a trade.
Furthermore, two or more moving averages can be used to indicate what is happening in the market in the long-term, medium-term, and short-term periods. For example, a trader may have 2000-day, 100-day, and 50-day moving averages on the chart.
If you want to learn more about moving averages, you should check out our pillar article on moving averages!
This is a momentum indicator that oscillates between 0 and 100. Sometimes, its signals occur before there’s a change in the price direction, so it’s a leading indicator. The indicator is gotten by comparing the most recent closing price of a security to its price range over an ‘X’ period of time and then, taking a moving average of the result.
So, the indicator has two lines: the %K line, which shows the position of the recent closing price in reference to the ‘X’-period range, and the %D line, which is a moving average of %K. Another slower stochastic is gotten by taking another moving average of the result. You can adjust the sensitivity of the indicator by increasing or decreasing the value of ‘X’ or the moving average.
The stochastic indicator has overbought and oversold regions. When the indicator is above the 80% line, it’s said to be overbought, and when it is below the 20% line, it’s oversold. But being overbought or oversold doesn’t always indicate a potential price reversal; when a trend is very strong, the indicator may remain in the overbought or oversold region for a long time.
For some traders, when the fast line crosses the slow line, it’s an indication of a change in price momentum and a possible price reversal. Other traders may wait until the indicator crosses the 20% line from below to confirm an upward reversal or crosses the 80% line from above for a downward reversal.
Another important reversal signal is a divergence between the indicator and the price action at key price levels. If price makes a higher high and the indicator makes a lower high, there’s a high chance of price reversal to the downside. Similarly, when price makes a lower low and stochastic makes a higher low, the odds are in favor of an upward price reversal.
Average True Range (ATR)
The ATR is a trading indicator that measures the degree of volatility in the price of a security. It is an ‘x’-period smoothed moving average of the true range values. The true range is the greatest of the following: most recent high minus most recent low; the absolute value of the most recent high minus the previous close; and the absolute value of the most recent low minus the previous close.
Most traders use the 14-day moving average of the true ranges. Although it doesn’t show price direction, the ATR is very important to traders. This trading indicator helps traders to accurately measure the daily volatility of a security.
The indicator moves up and down as the magnitude of price movement becomes larger or smaller. Since the indicator is based on price moves, its reading is in the same unit as the asset. So if an ATR reads 0.45 for a stock, it means that the stock moves $0.45 per price bar on average.
Generally, the higher the volatility of an asset, the greater the risk. But volatility may mean different things to different traders. While some traders — especially day traders and swing traders — may love highly volatile assets because they present greater price movements to profit from, others (position traders) may prefer assets with lower intraday volatility for their low risk.
The On-Balance Volume (OBV)
This is a trading indicator that uses volume flow to predict changes in the price of a security in advance. Being a volume indicator, it is useful for securities that trade on exchanges, such as stocks and futures, whose daily volume of transactions are known. It isn’t useful for securities that trade in the OTC market.
OBV relates the cumulative volume of transaction in an asset to its price changes. If the volume increases sharply without a reasonable change in the asset’s price, the price will potentially rise or fall significantly soonest. It tends to show when an asset is getting the attention of institutional investors.
The indicator is a cumulative total volume calculated by adding the current volume to the previous OBV if the asset’s price closed higher or subtracting the current volume from the previous OBV if the asset closed lower. When the asset’s price closed unchanged, the day’s volume is not added, and the OBV remains the same as the previous value.
A divergence between the volume and price of the asset may indicate the activities of institutional investors who may be accumulating or distributing their position in the asset. If the price of the asset is rising but the volume isn’t increasing, that may be a fakeout, and the price may be about to fall. On the other hand, if the volume is rising but the price is relatively unchanged, a significant price move may be on the horizon.
Tips on How to Use Trading Indicators
Many traders learn about a trading indicator, and then immediately try to implement what they have learned in their trading. However, the truth is that very little of what you read online will make any money for you. Most concepts of how indicators should be used describe patterns that are since long gone, or that never have worked. Sometimes the instructions you read simply are conclusions derived from some rationale that makes sense intuitively, but does not work in the markets.
The latter possibility is an example of what most traders do wrong.
The markets are not rational, and therefore, you cannot necessarily use rationale thinking in your trading. If anything was true, it would be the opposite. It is the irrationality of the markets that makes trading possible. If everything was rational, then the market would be priced right all the time, and there would be no market inefficiencies for us to employ in our trading.
Essentially, if the markets were completely rational trading would turn into betting!
Here are some more tips that may help you use trading indicators better:
- Learn the basics about the indicator you’re about to use and know the story it tells about the asset — not all indicators are suitable for every asset
- Avoid using multiple indicators from the same category if it does not add any clear
- Beware of important support and resistant levels in the market
- And last but not least, do never try to trade an indicator right away! Backtest the idea before, and see how it works!
Trading indicators are tools traders use to analyze the market. They are numerous and can be categorized in different ways. On their own, they don’t mean much, but in the hands of someone with the right skills and experience, they can make a lot of difference. It is important to learn the process of trading before and use the indicators for what they are — tools!