As a newcomer to the trading realm, you’ve likely come across terms like RSI, MACD, and stochastic – the formidable technical trading indicators. But what exactly are these indicators, and how do they work?
In this post, we go beyond the basics of trading indicators. We delve into a systematic classification of these indicators, enabling you to gain a clearer understanding of their functionality.
We will also empower you to navigate the trading landscape with confidence and make better-informed decisions.
What are indicators in trading?
Trading indicators are tools used to analyze the price movements of an asset in a market. These tools help us identify trends, patterns, and relevant information that may affect market value.
In other words, technical indicators are mathematical and statistical formulas applied to price and volume series with the intention of helping to make investment decisions.
There are several types of indicators that traders must know:
- Trend or oscillator indicators
- Volatility indicators
- Momentum indicators
Before continuing, I remind you that trading indicators are a fundamental part of the interpretation of price within all technical analysis theories.
If you want to take a look from a more global perspective, I leave you with the following article: Understanding Chartist Figures
Now, let’s see what these different groups are and how they are classified:
Trend or Technical Oscillator Indicators
The trend indicators are the most commonly used by traders and allow them to define the direction of a trend. In this way, they can be interpreted in the following ways:
- Rule: Some analyze the direction of the trend (bullish or bearish)
- Change of direction: Others provide information on when it is likely that the current trend will change direction through divergences
- Strength: Others focus on reflecting the strength of a trend.
We highlight the following indicators:
- RSI Indicator: The RSI indicator Also known as the Relative Strength Index, it is a technical indicator that measures the strength of a trend by comparing recent gains and losses in the price of an asset.
It is used to identify possible changes in the direction of a trend or to confirm the strength of an existing trend. It meets the following characteristics:
- It is represented as a line between 0 and 100,
- A value above 70 indicates overbought,
- A value below 30 indicates that the market is oversold.
- MACD (Moving Average Convergence Divergence): MACD is an indicator used to identify the direction of the trend and its strength. It consists of a signal line and a MACD line that moves above and below the signal line.
It stands out for being able to eliminate part of the delay that carries with it the moving averages
- Moving Averages: it is an indicator that shows the average of the prices in a given period of time. It is used to identify the direction of the long-term trend. And by the way, two very common strategies are
- ADX (Average Directional Index): This is an indicator used to measure the strength of the trend. It is used to identify the trend’s strength and determine if the market is in a trending or consolidation phase. It consists of three lines:
- the ADX line
- the DI+ line
- the DI- line.
- Ichimoku: This is an indicator that shows the direction of the trend and the support and resistance levels. It consists of several lines, including the cloud, the conversion line, and the baseline. It is used to identify buying and selling opportunities and determine the direction of the trend.
Volatility is the measure that indicates the strength and intensity with which prices change for an asset. So situations of volatility are classified as follows:
- High volatility: If the price has very abrupt fluctuations and constantly changes direction, we are facing a very volatile asset or moment.
- Low volatility: If the changes are milder it indicates low volatility.
Let’s see the three most popular volatility indicators:
- ATR: The Average True Range is a technical indicator of volatility used to measure the amplitude of price movements. The ATR is a measure of the distance between the maximum and minimum price of an asset during a given period, so the more significant the price range, the higher the ATR value.
Traders use ATR to determine the size of their positions and set stop-losses and profit targets based on market volatility.
- Bollinger Bands: are a volatility indicator created by John Bollinger. They are composed of a simple moving average and two standard deviation lines.
- The upper band represents two standard deviations above the moving average
- The lower band represents two standard deviations below the moving average.
- Bollinger Bands expand and contract according to market volatility. Traders use Bollinger Bands to identify overbought and oversold levels of an asset and to set possible entry and exit points.
- Keltner Channels: are a volatility indicator that uses an exponential moving average and two channel lines calculated above and below the moving average. Keltner Channels automatically adjust to reflect market volatility.
- When volatility is high, the channels expand.
- When volatility is low, the channels contract.
Traders use Keltner channels to identify the direction of the trend and to set possible entry and exit points.
Momentum indicators are a technical analysis tool used to evaluate the momentum of an asset’s price. In some way, they are a subcategory of oscillators.
These indicators measure the speed and direction of price changes. And therefore, they can be used to identify trends, determine support and resistance levels, confirm trend reversals, and provide information about the strength of the trend.
Let’s look at some of the main momentum indicators:
- Stochastic: It is an indicator that measures price momentum and helps to identify trend inflection points. It is based on a comparison between the current closing price and the highest and lowest prices of a given period.
- Volume: It is an indicator that shows the number of financial assets traded in a given period of time. It is used to confirm trends and market patterns and to identify possible changes in the direction of the price.
- Volume Profile: It is an indicator that represents the trading volume in relation to the price during a given period of time. It helps traders identify areas of greater interest in the market, which can be useful to determine support and resistance levels.
- Williams Oscillator: It is an impulse indicator that helps to identify the direction and strength of a trend. It is based on the relationship between the current closing price and the highest and lowest prices of a given period.
- RSC Mansfield: It is an indicator that measures the relative performance of a value compared to a reference index. It helps traders to identify stocks that have better performance compared to the market in general.
- VWAP: It is an indicator that shows the volume-weighted average price of a value over a given period of time. It is used to determine the average price at which the shares have been traded and to identify possible support and resistance levels.
- In this classification we should also indicate the MSCD and the RSI, since they can be used either to measure the strength of a trend, and therefore the momentum, or to establish a strategy of possible changes of trend.
In any case, the indicators have a variety of uses, from identifying trends and patterns to measuring the risk of an investment. To help you in this task, we leave you, in addition to the articles of each of the indicators, with this more complete guide.
Can I create my own customized trading indicators to suit my unique trading strategy?
Absolutely! Some trading platforms let you create your own indicators using coding languages like Python or MQL. This way, you can customize indicators to suit your style and groove with your personal criteria.
Are there any limitations or drawbacks to relying solely on trading indicators for decision-making?
Yes, trading indicators have their limits. They might not always keep up with price moves or give false signals. To be on the safe side, combine them with other analysis tricks and consider fundamental factors.
Can trading indicators be used effectively in volatile markets, or are they more suitable for stable market conditions?
Trading indicators can handle both wild and calm markets. Just make sure to pick indicators that match the market vibe and tweak their settings accordingly.