Introduction To Indicators

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Indicators
by Chad Langager and Casey Murphy - Investopedia

Technical analysis is broken into two main categories, chart patterns and indicators. Indicators are essentially calculations based on the price and the volume of a security and measures factors such as money flow, trends, volatility and momentum.

Within technical analysis, indicators are used as a measure to gain further insight into to the supply and demand of securities. Indicators, such as volume, are used to confirm price movement and the probability that the given move will continue. Along with using indicators as secondary confirmation tools, they can also be used as a basis for trading as they can form buy-and-sell signals.

Indicators can be separated into two main types - leading and lagging - both differing in what they show users.

Leading Indicators

Leading indicators are those created to proceed the price movements of a security giving predictive qualities.

Two of the most well-known leading indicators are the Relative Strength Index (RSI) and the Stochastics Oscillator.

A leading indicator is thought to be the strongest during periods of sideways or non-trending trading ranges, while the lagging indicators are regarded as more useful during trending periods. Users need to be careful to make sure the indicator is heading in the same direction as the trend.

The leading indicators will create many buy and sell signals that make it better for choppy non-trending markets instead of trending markets where it is better to have less entry and exit points.

The majority of leading indicators are oscillators. This means that these indicators are plotted within a bounded range. The oscillator will fluctuate into overbought and oversold conditions based on set levels based on the specific oscillator.

Note: An example of an oscillator is the RSI, which varies between zero and 100. A security is traditionally regarded as overvalued when the RSI is above 70.

Lagging Indicators

A lagging indicator is one that follows price movements and has less predictive qualities. The most well-known lagging indicators are the moving averages and Bollinger bands. The usefulness of these indicators tends to be lower during non-trending periods but highly useful during trending periods. This is due to the fact that lagging indicators tend to focus more on the trend and produce fewer buy-and-sell signals. This allows the trader to capture more of the trend instead of being forced out of their position based on the volatile nature of the leading indicators.

How Indicators Are Used

The two main ways that indicators are used to form buy and sell signals are through crossovers and divergence.

Crossovers occur when the indicator moves through an important level or a moving average of the indicator. It signals that the trend in the indicator is shifting and that this trend shift will lead to a certain movement in the price of the underlying security.

For example, if the relative strength index crosses below the 70-level it signals that security is moving away from an overbought situation, which only will occur when the security declines.

The second way indicators are used is through divergence, which occurs when the direction of the price trend and the direction of the indicator trend are moving in the opposite direction. This signals that the direction of the price trend may be weakening as the underlying momentum is changing.

There are two types of divergence - positive and negative. Positive divergence occurs when the indicator is trending upward while the security is trending downward. This bullish signal suggests that the underlying momentum is starting to reverse and that traders may soon start to see the result of the change in the price of the security. Negative divergence gives a bearish signal as the underlying momentum is weakening during an uptrend.

On the other hand, assume that the relative strength index is trending upward while the security's price is trending downward. This negative divergence can be used to suggest that even though the price is lagging the underlying strength, shown by the RSI, traders could still expect to see bulls regain control of the asset's direction and have it conform to the momentum predicted by the indicator.

Indicators that are used in technical analysis provide an extremely useful source of additional information. These indicators help identify momentum, trends, volatility and various other aspects in a security to aid traders when making decisions. It is important to note that while some traders use a single indicator solely for buy and sell signals they are best used in conjunction with price movement, chart patterns, and other indicators.