Reviewing the building blocks of technical analysis and how to interpret them
Technical indicators are quite often referred to as traders best friends and can be an invaluable toolset, just like the control panel of an airplane. They can help in deciphering exactly what is going on in a market and why a price is behaving the way it is, but can also blur the picture due to their inherent weaknesses. In this article we will be going over the different types of indicators and what they aim to display, as well as the most popular examples among them.
The indicators themselves are mathematical calculations that take the historical price variations (often combined with the volume) of the instrument. Based on this they generate a certain type of visual representation of these prices, different from the one on the charts. The aim of this different representation is to provide more layers of information than the simple movement of the price and possibly provide entry and exit points. This comes with the warning that no indicator claims 100% accuracy, leaving the final decision and execution to the trader.
One way to categorise them is as lagging, leading and confirming indicators. Lagging indicators are best utilised as filters for determining trend direction, an example of which are moving averages. Each one of them provides a single line on the chart itself and in this way splits the chart in two, placing the current price above or below said line.
Leading indicators are most often used for finding good entry points, Stochastic and MACD are the prime examples among them. As the name suggests they are designed to show how and where momentum changes, even providing a direction for the future with relatively clear cut points for an entry or exit. Both of the indicators are displayed below the price chart and can be used with the crosshair function to combine the actual price levels, with the values of the indicators.
The third type of indicator is the confirming one. It’s usually an indirect dataset, not directly changed by big price movements. It can be a volatility index such as the VIX, or a volume indicator that gives clues to the strength of price movements.
Generally using one of each type of indicator is enough to determine what trades should be, but the challenge remains to find the exact indicator that best suits the instrument AND the timeframe you’ve selected.
It’s not uncommon for one indicator to give different signals for the same instrument if you switch to a different timeframe. So many traders check many of them and pick their entry and exit points to coincide with periods when all timeframes show similar indicator values.
Using indicators presents risks to traders, some of them quite veiled. Over-reliance on multiple indicators and adopting the notion that many of them have to be followed to have perfect trades can lead to some heavy mistakes and losses. There is a point of too much information being displayed on the screen, so much so that the price chart itself is just one of many lines, figures and graphs. All you need are three indicators for the currency, stock or commodity of your choice and that is usually more than enough to make a decision on the direction and good moment for the trade.
Emotions play a large part in trading, more often as something negative. With indicators you can limit them to a minimum and you’ll just have to remain disciplined to enter and exit at the points specified by them.
However this doesn’t mean that they can’t be misinterpreted or used incorrectly for patterns or whole instruments. By remembering that technical analysis isn’t an exact science and that no single indicator, or even a combination with more, won’t make all your trades winners, you’ll be able to look at them as valuable tools, but not a crystal ball.