Important Technical Indicators To Watch While Trading

Technical indicators are useful in understanding where the prices are going, what do the current and past price movements mean and what position can be taken. Indicators can be leading (ahead of the market price) or lagging (behind the market price). While leading indicators usually help in deciding the positions, lagging indicators help in confirmation of the trend. However, that may not be the case in all scenarios. Here are some of the most basic and common indicators used by traders for short-term as well as long-term trading and investment in the stock market.

1. Moving Averages – Simple Moving Average (SMA) and Exponential Moving Average (EMA)

A moving average is simply an average of the past prices. It is therefore a lagging indicator. It is used to smooth out the prices from ‘noise’ (unimportant and temporarily extreme price fluctuations) in the market. Two most common moving averages are Simple Moving Average (SMA) that is simply an average of the prices during a specified time interval and Exponential Moving Average (EMA) which is similar to SMA but gives more weight to the most recent prices. Moving averages usually are used for price trend confirmation (eg.: when a shorter term Moving Average crosses a longer term Moving Average from below upwards an uptrend is confirmed and a downtrend is confirmed when the shorter term moving average crosses the longer term moving average from above downwards). A combination of two or more types of averages of varied period is sometimes used to decide the entry and exit levels.

2. Moving Average Convergence Divergence (MACD)

MACD gets its base from Moving Averages since it is calculated by subtracting a 26 period EMA from a 12 period EMA and hence it is also a lagging indicator. A 9 period EMA line is plotted alongside MACD line to act as a trigger to buy and sell. It is called the signal line. MACD is usually represented along with a histogram that indicates the distance between MACD and signal line. It helps to identify the trend in the market. When the MACD is above the signal line, the histogram will be above base line and vice versa. This is used to identify the bullish and bearish momentum in the market.

3. Relative Strength Indicator (RSI)

RSI is essentially an oscillator i.e. a line that moves between two extreme points, here 0 and 100. It is used to understand if the security or the market price is in the overbought or oversold zone in order to take buy or sell position. When the line touches or crosses 70, the stock or market is considered to be overbought and a sell position may be taken. When the line touches or crosses 30, the stock or market is oversold and a long (buy) position may be taken. Usually a standard one used majorly is the 14 period RSI. RSI uses the closing prices in its calculation.

Another similar oscillator is Stochastic oscillator. Again between 0 to 100, traditionally, if the line goes beyond 80, the stock is overbought and if the line goes below 20, the stock is oversold. Even for stochastic a standard 14-day period is used.

The only difference between the two is that the stochastic oscillator assumes that the closing prices will go in the same direction as the current trend.

4. Parabolic Stop and Reverse (Parabolic SAR)

Parabolic SAR is a lagging indicator used to understand the current price trend and decide on potential exit points. Parabolic SAR dots are shown above the prices in a downtrend and below the prices in an uptrend. However, Parabolic SAR is useful in steady markets. In volatile markets the dots keep appearing back and forth a lot of times creating false indicators.

5. Bollinger Bands

Ballinger Bands combine moving averages with standard deviation of the stock’s prices. It includes a centerline which is an EMA and two price bands, one above and one below the centerline. The band expands when volatility increases and contracts in the opposite scenario. Usually when the prices continually keep touching the upper price band, the stock is considered overbought and when price keeps touching the lower price band, it is oversold.

6. Fibonacci Retracement

Fibonacci Retracement is a trading tool that uses fibonacci ratios i.e. 23.6%, 38.2%, 50%, 61.8% and 100% for its calculation. Two extreme points of the stock are taken. The difference between the two points is divided by the fibonacci ratio derived from the fibonacci sequence. The result is used to identify support, resistance, stop-loss and target price while taking a position.

The above are only a few most commonly used indicators for trading and/or investing in stock market. All indicators come with their set of limitations and none are 100% accurate. A combination of two or more indicators must be used to reduce the impact of the limitations.

*The common strategy is to buy when the stock is in oversold zone and sell when the stock is in overbought zone.