5 Technical Indicators Every Trader Should Understand
Fundamental analysis is a terrific aide in helping you make investment decisions based on a company’s financial records, the strength of its management, and other important information, but it doesn’t help you determine the best time to buy, hold, or sell. As a result, while fundamental analysis may be important, it alone is not sufficient to guide your investment decisions. On the other hand, technical analysis, which is the study of price trends and movements, can be invaluable in helping you determine the best times to enter and exit a trade.
What is Technical Analysis?
Technical analysis became popular with the advent of the Dow Theory in the late 1800s. Based upon the beliefs of Charles Dow, technical analysis involves the use of a myriad of technical indicators or the price chart movement of a security over a specified period of time.
Indicators are simply calculations based on the current and historical volume and price of a security, measuring the volatility, trends, and momentum of its price. Indicators are primarily used in two ways: to confirm chart patterns and price movement, and to provide traders with distinct buy and sell signals.
While some indicators are more complex than others, they all seek to create visual patterns that make the interpretation of confusing price data much easier to digest and understand. Indictors can be applied to a wide range of securities, including indexes, stocks, futures contracts, currencies, and any other instruments that react to supply and demand.
Although each indicator depicts certain price patterns and provides valuable insight into the price trajectory of a security, studying a single indicator will not provide you with a comprehensive view of a security's price direction.
For example, a false signal, or whipsaw, may be made by an indicator. Therefore, examining more than one indicator will help you avoid false signals and provide you with a true signal of a security’s price movement. By studying multiple indicators, you will gain a balanced perspective on the current and future price target of a security.
There are literally hundreds of charting tools and indicators available for you to use, but the following tools and indicators have stood the test of time and are by far the most popular indicators used by successful investors around the globe.
There is a substantial variation of price movement on most chart patterns, making it rather difficult for traders to determine the overall trend of a security. Moving averages combat this and allow traders to clearly identify price trends. A moving average is simply a security’s average price over a specific period of time. By removing a security’s day-to-day price fluctuations, moving averages smooth out price movement, enabling traders to determine the true trend and allowing them to make more knowledgeable investment decisions.
There are many different types of moving averages, such as simple, exponential, and linear, all of which differ in the way they are calculated. However, the interpretation of each average remains the same; when a moving average line is going upward on a chart, the security is trending upward, and vice versa.
Two moving averages of different time frames can also be used to determine entry and exit points. Known as moving average crossovers, when the two lines cross over or under each other, they signal a trend reversal, which is an ideal time to enter or exit a trade.
Similar to moving averages, the MACD indicator, which stands for moving average convergence/divergence, is another popular indicator used frequently in the field of technical analysis. The indicator uses two exponential moving averages, or EMAs, to measure the momentum of a security.
If this indicator is above the center line and in positive territory, the price of the security is experiencing upward momentum. Conversely, when it is below the center line, it suggests that the price of a security is experiencing downward momentum. A crossing of the moving averages mentioned above is signaled if the MACD line moves across the center line, which takes it from positive to negative territory, and vice versa.
The Stochastic Oscillator is another popular momentum indicator used by technical analysts. With this indicator, the price of a security will close near the top or bottom of the trading range, signaling that the security is experiencing upward or downward momentum. Thus, you can use the Stochastic Oscillator to determine whether the security is in an uptrend or downtrend.
The Fibonacci Retracement Tool is quite popular amongst technical traders. Fibonacci trading techniques are based on specific naturally occurring number sequences identified by Leonardo Fibonacci, a 13th century mathematician. However, these number sequences are not nearly as important as the ratios or mathematical relationships between the numbers that make up the series.
Fibonacci retracements are used in technical analysis by dividing the vertical distance of two extreme points on a price chart, such as a peak and a trough, by the 23.6 percent, 38.2 percent, 50 percent, 61.8 percent, and 100 percent Fibonacci ratios. The Fibonacci Retracement Tool can be used to identify these levels and draw horizontal support and resistance lines.
For unknown reasons, the ratios listed above play a vital role in both nature and the stock market, allowing them to be used to determine important price reversal points. When the price of an asset retraces to one of these ratios, it’s safe to assume the direction of the previous trend will likely continue.
Relative Strength Index
Another popular indicator, the Relative Strength Index, or RSI, is an additional tool to gauge momentum. Technical analysts use the RSI indicator to signal when a security is experiencing overbought or oversold conditions. The popular indicator plots the price of a security between a range of zero to 100. If the price of a security is above 70, this suggests that it is overbought, signaling prime selling conditions. A price that is below 30, on the other hand, suggests that it may be oversold, signaling ideal buying conditions.
Technical analysis revolves around market psychology and the forces of supply and demand. Since these forces are the inherent drivers of the price of all securities, technical analysis is used by successful traders around the globe. By using Fibonacci retracements to identify support and resistance along with the right combination of technical indicators in conjunction with fundamental analysis, you will be poised to identify key entry and exit points for any security in any market. With practice and patience, you can use technical analysis to profit regardless of the market conditions and finally achieve trading success.
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