A lot of information can be derived from the price trend alone in order to make a trading decision. Indicators are often used to support this. There are a number of technical indicators for trading which you can use for your trading. In the following we have listed the most popular ones.
- Moving averages
- Bollinger Bands
- RSI & Parabolic SAR
- Ichimoku Cloud
- Momentum Indicator
- Stochastic Oscillator
- ATR Indicator
Moving averages serve as a technical indicator to show how the price of an underlying has developed on average over a certain period of time. Moving averages are often used to show trends, detect trend reversals, and provide trading signals. There are several different types of moving averages, but they all create a single line that can show you in which direction a price has moved.
Calculating the Moving Average
The Simple Moving Average (SMA) calculates an average of the last “n” (n = number) prices, where n represents the number of periods (candles) for which you want the average:
Simple moving average = (P1 + P2 + P3 + P3 + P4 + …. + Pn) / “n
For example, a four period SMA with prices of 1,2640, 1,2641, 1,2642 and 1,2641 gives a moving average of 1,2641 using the calculation [(1,2640 + 1,2641 + 1,2642 + 1,2641) / 4 = 1,2641].
The SMA value corresponds to the average price for the number of periods in the SMA calculation. Common SMA settings are 8, 20, 50, 100, and 200. For example, if you use an SMA with 100 periods, the current value of the SMA in the graph is the average price of the last 100 candles. An intersection of the 100 and 200 average lines is also called a `Golden Cross`.
Exponential calculation of the moving average
The exponential moving average (EMA) is a weighted average of the last “n” prices, with the weighting decreasing exponentially with each previous price/period. In other words, the formula gives the current price more weight than the past prices.
Exponential moving average = [Closing price – previous EMA] * (2 / n+1) + previous EMA
For example, a four-period EMA with prices of 1.5554, 1.5555, 1.5558 and 1.5560, the last value being the most recent, gives a current value of 1.5558 using the calculation [(1.5560 – 1.5558) x (2/5) + 1.5558 = 1.55588].
As with SMA, the chart platform performs all EMA calculations. Select EMA from the list of indicators on a chart platform and apply it to the chart. Then you select how large the calculation period should be, e.g. 15, 50 or 100 candles.
The EMA adapts faster to price changes than the SMA. For example, if a price changes direction, the EMA reverses direction faster than the SMA. This happens because the EMA formula gives more weight to the most recent prices and less weight to the prices that have occurred in the past.
Calculating the Weighted Moving Average
The weighted moving average (WMA) gives you a weighted average of the last “n” prices, with the weighting decreasing with each previous price. This works similar to the EMA, but the calculation of the WMA is different.
Calculation of the weighted moving average = (price * weighting factor) + (price previous period * weighting factor-1)…..
WMAs can be assigned different weights depending on the number of periods used in the calculation. If you want a weighted moving average of four different prices, the last weight can be 4/10, the period before that could have a weight of 3/10, the period before that could have a weight of 2/10, and so on.
The 10 is a random number, and a weight of 4/10, for example, means that the most recent price is 40 percent of the value of the WMA. The price three periods ago is only 10 percent of the WMA value.
In the following example, prices are assumed to be 90, 89, 88, 89, 89, 89, with the most recent price occurring first. This is calculated as follows: ((90 x (4/10)) + (89 x (3/10)) + (88 x (2/10))) + (89 x (1/10)) = 36 + 26.7 + 17.6 + 8.9 = 89.2
You can adjust the weighted moving average more than SMA and EMA. The latest prices usually get more weight, but it might work the other way around if you give more weight to historical prices.
Using and interpreting the moving average
Moving averages can be used for both analysis and trading signals. For analysis, all moving averages help to highlight the trend. If the price is above its MA (Moving Average), it shows that the price is trading higher than it has done on average over the period considered.
This confirms an upward trend. If the price is below its MA, it shows that the price is traded lower than the average of the period under consideration, which helps to confirm a downward trend.
If the price is above its MA, this shows that the price becomes stronger compared to what it was in the past, as the most recent price is now above average. If the price is below its MA, it shows that the price is getting weaker compared to what it was in the past.
A longer-term and a short-term moving average, e.g. 20 and 50 periods, can be added to a chart at the same time. If the 20-period MA rises above 50, this indicates that the short-term price momentum is moving upwards. If the 20-period MA falls below the 50, this indicates that the short-term price momentum is moving down.
MAs can also be integrated into other indicators to provide trading signals. An EMA can provide buy signals when combined with e.g. Keltner channels. A strategy may involve buying near the EMA when the trend rises and the price falls back from the top of the Keltner channel.
One type of MA is no better than another; they just calculate the average price differently. Depending on which strategy you use, one type of MA may work better than another.
It is recommended that you slightly adjust the settings for each market. A 50 period SMA can give great signals for one market, but doesn’t work well for another. Or a 20 period EMA can help to see the trend in one currency pair but not in another. All MAs are just tools, and the trader is responsible for interpretation, as no indicator works well all the time or under all market conditions.
The MACD line is the 12-day Exponential Moving Average (EMA) minus the 26-day EMA. Closing prices are used for these moving averages. A 9-day EMA of the MACD line is recorded with the indicator as the signal line to identify curves. The MACD histogram represents the difference between the MACD and its 9-day EMA, the signal line. The histogram found in some indicator settings is positive if the MACD line is above its signal line and negative if the MACD line is below its signal line. Values 12, 26 and 9 are the typical MACD settings, but other values can be replaced depending on your trading style and goals.
The Bollinger Bands developed by John Bollinger are volatility bands that are above and below a moving average. Volatility is based on the standard deviation that changes with increasing and decreasing volatility. The bandwidths widen automatically as volatility increases and contract as volatility decreases. This dynamic of the Bollinger Bands also means that they can be applied with the default settings to various securities among other Forex currency pairs. For signals, Bollinger Bands can be used to identify M-Tops and W-Bottoms or to determine the strength of the trend.
Bollinger ribbons consist of a middle ribbon with two outer ribbons. The middle band is a simple moving average that is usually fixed at 20 periods. A simple moving average is used because the standard deviation formula also uses a simple moving average. The review time for the standard deviation is the same as for the simple moving average. The outer bands are usually set with 2 standard deviations above and below the center band.
The settings can be adapted to the characteristics of certain securities or trading styles. Bollinger recommends making small adjustments to the standard deviation multiplier. Changing the number of periods for the moving average also affects the number of periods used to calculate the standard deviation. Therefore, only small adjustments are required for the standard deviation multiplier. Increasing the moving average period would automatically increase the number of periods used to calculate the standard deviation and justify increasing the standard deviation multiplier.
Bollinger suggests increasing the standard deviation multiplier to 2.1 for a 50-period SMA and reducing the stand deviation multiplier to 1.9 for a 10-period SMA.
Signal: Walking the bands
Movements above or below the bands are not signals in themselves. As Bollinger puts it, movements touching or crossing the bands are not signals, but “tags”. At first glance, a movement to the upper band indicates strength, while a strong movement to the lower band indicates weakness. Momentum oscillators work similarly. Overbuying is not necessarily bullish. It takes strength to reach overbought values, and overbought conditions can expand in a strong uptrend.
Similarly, prices can walk the band with numerous accents during a strong uptrend. The upper band is 2 standard deviations above the simple moving average of 20 periods. It takes a fairly strong price movement to cross this upper band. Touching the upper band after a Bollinger band has confirmed W-Bottom would signal the beginning of an upward trend.
Just as a strong uptrend produces numerous upper band tags, it is also common for prices never to reach the lower band during an uptrend. The 20-day SMA sometimes serves as support. In fact, dips below the 20-day SMA sometimes offer buying opportunities before the next day of the upper band.
The Relative Strength Index – RSI, like the MACD, is a momentum indicator that measures the extent of recent price changes to analyze overbought or oversold conditions.
The RSI provides a relative assessment of the strength of a stock’s recent price performance. The RSI values range from 0 to 100. The default period for comparing up and down periods is 14, as in 14 trading days.
The traditional interpretation and use of RSI is that RSI values of 70 or above indicate that a value is overbought or overvalued and can therefore be prepared for a trend reversal or corrective price loss. An RSI of 30 or less is commonly interpreted as an indication of an oversold or undervalued condition that may imply an upward trend reversal or corrective price reversal.
Sudden large price movements can lead to false buy or sell signals in the RSI. Therefore, it is best to use it with refinements of its application or in conjunction with other technical indicators.
Some traders use more extreme RSI values such as buy or sell signals such as RSI values above 80 to indicate overbought conditions and RSI values below 20 to indicate oversold conditions.
The RSI is often used in conjunction with trend lines, as the support or resistance of the trend line often matches the support or resistance values in the RSI.
Divergences with the RSI Indicator
According to Wilder, divergences signal a potential reversal point since directional momentum does not confirm the price. A bullish divergence occurs when the underlying reaches a lower low and the RSI a higher low. The RSI does not confirm the low and shows increasing momentum. A bearish divergence occurs when safety shows a higher high and the RSI a lower high. The RSI does not confirm the new high and shows a declining momentum.
Before getting too excited about divergences as big trading signals, you have to realize that divergences in a strong trend are misleading. A strong uptrend can be accompanied by numerous bearish divergences before a top actually occurs. Conversely, a strong downtrend can result in bullish divergences – and yet the downtrend continues.
The parabolic SAR is a technical indicator used to determine the price direction of a value and to indicate when the price direction changes. The parabolic SAR was developed by Welles Wilder, the inventor of the Relative Strength Index (RSI) and is sometimes known as the Stop and Reverse System.
In a chart, the indicator appears as a series of points placed either above or below the candles. A point below the price is considered a bullish signal. Conversely, a point above the price is used to show that the bears are in control and that momentum is likely to stay down. If the points turn around, this indicates that a possible change in price direction is in progress. For example, if the points are higher than the price, if they fall below the price, this could indicate another price increase.
If the price of a value rises, the points will also rise, first slowly and then faster and faster with the trend. The SAR starts to move slightly faster as the trend develops, and the points soon catch up with the price.
The parabolic SAR is also a method of setting stop-loss orders. If a value rises, move the stop loss to adjust it to the parabolic SAR indicator. The same concept applies to short trading – as the price falls, so does the indicator. Move the stop loss so that it corresponds to the level of the indicator after each candle.
This indicator is mechanical and will always give new signals to trade long or short. It is up to the trader to decide which trades to accept and which to leave alone. For example, in a downtrend, it is better to only take the short sell, as shown in the chart above, as well as the buy signals.
Indicators to complement the Parabolic SAR
In trading, it is better to have several indicators confirm a certain signal than to rely on only one indicator. Supplement the SAR trading signals with other indicators such as a stochastic moving average or the ADX.
For example, SAR sell signals are much more convincing when the price is below a long-term moving average. The price below a long-term moving average indicates that sellers are in control of the direction and that the current SAR sell signal could be the beginning of another wave.
Similarly, if the price is above the moving average, focus on taking over the buy signals (points move from top to bottom).
The Ichimoku Cloud is an indicator that tells you everything you need to know about a price trend, including direction, momentum, dynamic support and resistance levels, and even trading signals. The Japanese name – Ichimoku Kinko Hyo- means “a look (or look) at the equilibrium chart”. This indicator was developed by Goichi Hosoda, a Japanese journalist who published it in the late 1960s. Ichimoku offers a trader more information than a standard candle chart.
It is designed to provide relevant information at a glance by using moving averages (tenkan-sen and kijun-sen) to display bullish and bearish crossover lines. The “clouds” (kumo, in Japanese) form between the ranges of the average of the Tenkan-sen and Kijun-sen charts six months in advance (senkou span A) and the midpoint of the 52-periods in the high and low points (senkou span B) six months in advance (senkou span B).
There are five calculations that generate the Ichimoku Cloud:
– Tenkan-sen = (9-day high + 9-day low) / 2
– Kijun-sen = (26-day high + 26-day low) / 2
– Senkou span A = (Tenkan-sen + Kijun-sen) / 2
– Senkou span B = (52-day high + 52-day low) / 2
– Chiku spread = closing price of 26 days from the past
– Ichimoku Cloud Signals
The general trend is upwards when prices are above the cloud, downwards when prices are below the cloud, and downwards when they are in the cloud itself. If the Senkou spread A rises above the Senkou spread B, the trend is stronger upwards and is typically green. If the Senkou span B rises above the Senkou span A, the trend is stronger downwards and is marked with a red cloud.
Traders will often use the Senkou “cloud” as an area of support and resistance, depending on the relative position of the price. The Senkou “Cloud” provides support levels that can be projected into the future. This distinguishes the Ichimoku Cloud from many other technical indicators that only provide support and resistance levels for the current date and time.
Trend strength or weakness:
If the range A (green cloud) moves up and away from the range B (red cloud), this indicates that the uptrend is gaining momentum. If span A moves downwards and away from span B, this indicates that the downward trend is accelerating. In other words, a thickening cloud helps to confirm the current trend. A very thin cloud indicates indecision and a potentially weak or weaker trend.
Support and resistance:
The cloud is projected from 26 candles to the right of the current price and gives an idea of where support and resistance could develop in the future. During an uptrend, the price will often bounce off the cloud in pullbacks and then resume the uptrend. During a downtrend, the price will often go down into the cloud and then continue to fall. Therefore, the cloud offers opportunities to enter the trend.
If the trend goes up (price above cloud and spread A above spread B) and the conversion line falls below the baseline and then recovers above it again, this signals a long entry. If the trend points down (price below the cloud and spread A below spread B), and the conversion line collects above the baseline and then falls below it again, this signals a short entry.
The strength of the Ichimoku trading signals can be judged by three factors:
– How far away is the price movement from the cloud?
– How far away is the chiku spread from the cloud?
– How far away is the crossover from the cloud?
Traders should use the Ichimoku cloud in conjunction with other technical indicators to minimize risk. For example, the indicator is often linked to the Relative Strength Index (RSI), which can be used to confirm or refute impulses in a particular direction. It is also important to look at the larger trends to see how the smaller trends fit into them.
Momentum is perhaps the simplest and easiest oscillator to understand and use; it is the measurement of the speed or velocity of price changes. In “Technical Analysis of the Financial Markets” John J. Murphy explains:
“Market dynamics are measured by continuously taking into account price differences for a fixed time interval. To construct a 10-day impulse line, simply subtract the closing price 10 days ago from the last closing price. This positive or negative value is then drawn around a zero line.
Momentum measures the rate of increase or decrease of a value. From a trend perspective, momentum is a very useful indicator of strength or weakness. History has shown that dynamics are much more useful in rising markets than in falling markets; the fact that markets rise more often than fall is the reason for this. In other words, bull markets typically last longer than bear markets.
Traders use a 10-day timeframe to measure the momentum. You will see the zero line in the table below. If the most recent closing price of the value, e.g. stock, index, or currency pair, is more than the closing price 10 trading days ago, the positive number (from the equation) is displayed above the zero line. However, if the last closing price is below the closing price 10 days ago, the negative measurement is displayed below the zero line.
By measuring price differences over a period of time, we can begin to see the prices at which the price rises or falls. Momentum will help you identify trend lines. As the stock price rises, clear trend lines develop; a rising Momentum plot line above zero indicates that an upward trend is solidly developing. A signal line that begins to balance indicates to traders that the latest price of a security is about the same as 10 days ago, slowing the speed of the trend.
It is important to understand that if the momentum indicator slides below the zero line and then reverses in an upward direction, this does not mean that the downward trend has ended. It just means that the downtrend is slowing down. The same applies to the applied impulse above the zero line.
The stochastic oscillator is a momentum indicator that compares the closing price of a value with the range of its prices over a certain period of time. The oscillator’s sensitivity to market movements can be reduced by adjusting this period or by a moving average of the result. The general theory that serves as the basis for this indicator is that in an uptrending market, prices close to the peak and in a downtrending market, prices close to the bottom will close. Trading signals are generated when the %K traverses a moving average (period 3) called the %D. History of the Stochastic Oscillator The stochastic oscillator was developed by George Lane in the late 1950s. As designed by Lane, the stochastic oscillator represents the location of the closing price of a value relative to the upper and lower range of the price over a period of usually 14 days. Lane has said in numerous interviews that the stochastic oscillator does not follow price, volume or the like. It indicates that the oscillator follows the speed or the moment of the price. Lane also shows in interviews that, as a rule, the dynamics or speed of the price of a value changes before the price changes. In this way, the stochastic oscillator can be used to anticipate reversals when the indicator detects bullish or bearish divergences. This signal is the first and probably most important trading signal that Lane has identified. Overbought vs. oversold: Lange also expressed the important role the stochastic oscillator can play in identifying overbought and oversold levels as it is tied to the range. This range – from 0 to 100 – remains constant no matter how fast or slow a value rises or falls. Given the most traditional settings for the oscillator, 20 is typically considered an oversold limit and 80 an oversold limit. However, the settings are customizable. Values above 80 indicate that a value is trading near the top of its high/low range; values below 20 indicate that the value is trading near the bottom of its high/low range.
The Average True Range (ATR) is a technical analysis indicator that measures volatility by breaking down the entire range of a value for that period. Specifically, the ATR is a measure of volatility introduced by Welles Wilder in his book New Concepts in Technical Trading Systems.
Wilder originally developed the Average True Range (ATR) indicator for commodities, but the indicator can also be used for equities, forex and indices. Simply put, a value with high volatility has a higher ATR, and a value with low volatility has a lower ATR. The ATR can be used by traders to enter and exit trades, and it is a useful tool to expand a trading system. It is designed to allow traders to more accurately measure the daily volatility of an underlying through simple calculations. The indicator does not indicate the price direction but serves primarily to measure the volatility caused by gaps and to limit upward or downward movements. The ATR is relatively simple to calculate and requires only historical price data.
ATR Calculation Traders can use shorter periods to generate more trading signals, while longer periods are more likely to generate fewer trading signals. For example, assuming a short-term trader only wants to analyze the volatility of an underlying, such as the Dax Index or EURUSD, over a period of five trading days, the trader can calculate the five-day ATR (5). The ATR indicator moves up and down as the price movements in an asset increase or decrease. The indicator is based on price movements, so the value is a dollar amount. For example, an ATR value of 0.23 means that the price moves an average of $0.23 per price bar. In the Forex market, the indicator shows pips, where a value of 0.0025 means 25 pips. A new ATR value is calculated as each time period passes. On a one-minute chart, a new ATR is calculated every minute. On a daily chart, a new ATR is calculated every day. All these readings are recorded to a continuous line so traders can see how the volatility has changed over time.
Because the ATR indicator is based on how much each underlying is moving, the value for an underlying is not compared to other underlyings in isolation. For example, an ATR of 0.50 may appear high if the stock price is $10, but if the stock price is $100, an ATR of 0.50 may be considered low. This is because if the price moves by $0.50 to a $10 share, this corresponds to a 5% price movement. A move of $0.50 to a $100 share represents a price change of 0.5 percent.
The ADX Indicator (Average Directional Index) is a trend strength indicator developed by J. Welles Wilder. The ADX is actually a set of technical indicators developed by Wilder, so some trading platforms split the indicators and offer Directional Movement as one indicator and ADX as another. Typically, these indicators are used together to form the ADX.
The ADX is calculated by comparing the current price with the previous price range. The DMI then displays the result as an upward (+DI) and downward (-DI) direction index. The DMI also calculates the strength of the upward or downward movement and displays the result as a trend strength line called the Average Directional Index or ADX.
The +DI and -DI appear as two separate lines, each colored green and red. If the red line is above the green line, this means that the price is falling. If the green line is above the red line, it means that the price is rising. If the -DI and the +DI cross back and forth, there is probably no price trend and the price moves sideways.
An ADX above 25 (20) signals that a strong trend exists. If the ADX fluctuates below 25 (20), this usually means that there is no strong trend and the price is moving sideways or within a weak trend. Some traders only use the ADX to see trend strength, while others prefer to look at directional movement lines to confirm price direction.