Eager to discover more about charts and indicators? In this article, we will delve deeper into trading indicators, chart patterns, and how you can maximise your trading experience by applying technical analysis techniques correctly. Let’s take a look at indicators!
(Read the Part I of the Technical Analysis article here).
Indicators
Generally, traders and analysts use technical tools or indicators to help them determine an asset’s price movements. Let’s take a look at some of the most widely used indicators.
Overlays
Indicators that use the same scale as prices are plotted on top of the prices displayed on a chart. Overlays include:
Bollinger Bands
Developed in the 1980s by John Bollinger, Bollinger Bands consist of a simple moving average (SMA) (middle band—yellow, in the example below), generally set to a 20-day period, and an upper and lower band. The distance between these bands widens when volatility is high and narrows when it is low, creating a trending envelope, as shown below.
The width of the bands is determined by standard deviation. Standard deviation refers to the asset’s volatility and is generally set at 2.0.
With this in mind, Bollinger Bands with 20, 2 parameters are calculated as follows:
Upper band = 20-day SMA + (20-day standard deviation x 2)
Lower band = 20-day SMA – (20-day standard deviation x 2)
Bollinger Bands are used to determine when an asset has been overbought and oversold. Typically, if the price breaks below the lower band, it means the asset may have been oversold, and hence, the price may have dropped too much, making a reversal upwards imminent.
Conversely, if the price breaks above the upper band, it means that the asset may have been overbought, and hence, the price may have risen too much, making a downside pullback imminent.
Often, upside and downside reversals are referred to as “price corrections” or “corrective moves” as they re-balance the market after a period of jittery. A typical example of this is the recent spike in cryptocurrency prices due to massive support from high-profile investors like Elon Musk and Mark Cuban, which sparked buying action, leading to a steep rise in crypto prices.
Fibonacci Retracement
The Fibonacci retracement indicator helps determine retracement levels (i.e., support and resistance) based on the Fibonacci number sequence.
Some of the numbers included in the Fibonacci sequence are 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89,144, 233, 377, and others.
The Fibonacci sequence is important because of the so-called golden ratio of 1.618 and its inverse 0.618.
Any number in the Fibonacci sequence is approximately 1.618 times the preceding number, except the first few numbers. Each number is also 0.618 of the number at its right.
Although not typically Fibonacci numbers, many traders use 0.5, 1.0, 2.0. These numbers show how far the price could move following another price movement.
Fibonacci retracement levels include 23.6%, 38.2%, 61.8%, and 78.6%. Traders also use the 50% Fibonacci ratio; however, not officially.
Support and resistance levels are represented as a set of lines, as shown in the chart below.
Example: If a stock’s price moves up US$10 and then drops US$2.36, for example, it means it has retraced 23.6%, which is a Fibonacci number.
Oscillators: These are momentum indicators used to identify when an asset has been overbought or oversold. Oscillators include:
The Moving Average Convergence Divergence (MACD)
This trend-following momentum indicator shows the correlation between two moving averages of an asset’s price. The MACD represents the difference between the 12-period exponential moving average (EMA) and the 26-period EMA.
A 9-day EMA or the “signal line” of the MACD is plotted on top of the MACD line, and it can function as a BUY /SELL indicator. The MACD also includes a histogram (as shown below), which outlines the distance between MACD and the signal line.
When the MACD crosses above, it triggers a BUY signal, and when it crosses below, it triggers a SELL signal.
MACD explained
MACD = 12-period EMA – 26-period EMA
Signal line: 9-day EMA
MACD Histogram: MACD Line – Signal Line
b)
c)
The Relative Strength Index (RSI)
The RSI is a momentum indicator showing the impact of recent price movements to determine if an asset has been overbought or oversold.
Developed in 1978 by J. Welles Wilder, the RSI offers traders an indication of bullish and bearish momentum. The values of the RSI typically range between 0 and 100 but never below 0 or above 100.
Given that it’s a momentum indicator, it measures how fast an asset’s price can move. The quicker the price advances, the higher the RSI value. The faster the price drops, the lower the RSI value. The standard RSI setting is the 14-period. The 5, 7, and 70-periods are also popular among traders.
The most significant values for the RSI are 30 and 70. If the RSI stands above 70%, it means that the asset has been overbought (the price has climbed too much, and, therefore, a trend reversal is imminent). If it is below 30%, it has been oversold (the price has dropped too much, and thus, an upside reversal is coming.)
Nevertheless, even when the RSI indicates that the market faces an overbought or oversold condition, it does not mean that a reversal will occur immediately. Prices may linger in overbought or oversold areas for an extended time while continuing to move upward and downward (divergence). Therefore, to avoid the pitfall of entering a reverse position simply because the RSI indicates an overbought or oversold market condition, it’s best to consider price divergence before entering a trade, as shown in the chart below. Please refer to the Day Trading section for more examples of the RSI.
The Stochastic Oscillator
The Stochastic Oscillator is a type of momentum indicator used to compare a security’s closing price to a range of its prices over a pre-set period. Traders use it to identify overbought or oversold conditions.
Stochastic Oscillators usually vary around a certain mean price level, given that they rely on an asset’s historical price movements.
The default settings for this indicator revolve around 14-based periods, which can vary between 14 days to 14 weeks or even 14 minutes or hours if you want to track intraday momentum fluctuations. Given that momentum changes more rapidly than price, the Stochastic Oscillator helps project reversals.
The Stochastic Oscillator explained
Therefore, a 14-period %K (Stochastic) uses the most recent close price, the highest high reached in the last 14 periods (i.e., days, weeks, minutes), and the lowest low the price reached in the last 14 periods. %D in the above formula is a 3-day simple moving average (i.e., the mean level the price hit in 3 days) of %K. The line is plotted alongside %K, acting as a signal or trigger line.
The Average Directional Movement Index (ADX)
Developed by J. Welles Wilder in 1978, the ADX indicator essentially consists of three indicators that measure a trend’s strength and direction. These indicators are the Direction Movement Index (DMI+), DMI- and the ADX.
The ADX is the average of an asset’s expanding price range values over a 14-period (usually 14 weeks or months, as a longer period is required to assimilate the smoothing calculation techniques involved with this indicator). It is a rather complex technical analysis tool requiring a certain level of expertise. Technical analysts generally use it to determine a trend’s strength.
ADX explained
Smoothing techniques
1)
This technique is used to smooth each period’s +DM1, -DM1, and TR1 values over 14 periods. The calculation has to start at a point so that the first value is the sum of the first 14 periods. In the example above, smoothing starts with the second 14-period calculation.
2)
This technique is used to smooth each period’s DX value to finish with the ADX. We start by calculating the average for the first 14 days. Afterwards, we continue as shown above.
According to Wilder, a strong trend is defined by ADX >25. Conversely, when ADX <25, the market is trendless, he suggests.
Based on the above formula, let’s take a look at the following historical price levels of the NASDAQ 100 QQQQ ETF:
As explained above, a longer period was required to provide a more precise outlook on the security’s price trend. In this case, we’re looking at 119 days. The chart below will likely shed more light on the subject.
Setting up the ADX
That’s about it with the theory; it’s time to put this wealth of knowledge to good use! If you’re new to trading, you can try the TibiGlobe demo account option and test-drive the platform.
Risk Disclaimer:
CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money. Prices can fluctuate rapidly, and past performance is not indicative of future results. Please refer to the full risk disclaimer on our website.
The information provided does not constitute financial advice and should not be relied upon as such. You should seek independent advice before making any investment decision.
