Technical Indicator

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Technical Indicator Definition

Technical indicators refer to technical analysis tools used by investors to make investment decisions based on future price movements derived primarily from historical prices. Influenced by the signals produced by the indicators, investors determine the entry and exit points.

Investors always prioritize using indicators to time their investments and make the most profitable decisions. Indicators range from simple to complex ones, and their incorrect usage can lead to losses. Hence, almost every user studies indicators before investing; even amateur traders use simple indicators to trade.

Table of contents
  • Technical indicators refer to techniques used by entities during technical analysis to make investment decisions. It largely uses previous prices to forecast future price changes.
  • Its application generates buy or sell signals, and traders decide entry and exit points based on the signals generated.
  • The basic types are overlays and oscillators. Examples are On-Balance-Volume (OBV), Moving Average Convergence Divergence (MACD), and Average Direction indicator (ADX).
  • Traders use a combination of various indicators to reach a plausible conclusion.

Technical Indicator Explained

Technical indicators are widely used in financial markets to analyze and predict price movements based on previous price movements. It is the core of many trading methods. A trading system is strengthened by applying indicators or pattern-based methodologies that provide buy/sell signals for trading. Combining different indicators can form a single trading rule and the trading system.

Technical indicators in stock trading are an important element that assists the investment decision-making process. Its application is unavoidable in creating profitable and successful short-term and long-term trading strategies. At the same time, any calculation error in indicators may lead to wrong decisions and result in financial losses. Moreover, it is more apt for stock trading than other streams like forex trading and crypto trading. If the indicator selected is not apt, it can deliver the wrong signals.

Indicators in stock trading use the stock movement chart as the prime input element. Indicator development is not limited to the use of objective mathematical models; it can also include subjective variables. It aids in expressing the decision-making logic in a more "human" way. Such an indicator takes broad market information as additional input, such as profitability and volatility of stock prices, and produces signals.

Types of Technical Indicators

There are different types of classifications of indicators. The basic types are oscillators and overlays. Another important classification is segregating the technical indicators into momentum, trend, volume, and volatility indicator classes. Furthermore, it is also classified as lagging indicators and leading indicators. Lagging indicators are usually employed to measure trends, whereas leading indicators are typically used to detect overbought or oversold conditions.

Technical Indicator

Oscillators

Oscillators focus on the market momentum and shift. It is called oscillators because it presents a trend indicator oscillating within the bounds of higher and lower bands. Oscillators point to overbought and oversold conditions. Most of the data comes from charts, and traders often apply multiple oscillators on one chart to get clarity. Relative Strength Index (RSI), Commodity Channel Index (CCI), Moving Average Convergence Divergence (MACD) and Awesome Oscillator (AO) are some of the examples.

Overlays

Overlays are formed over the main or source price chart. The name signifies that they are represented on the reference price chart itself. Support, Resistance, Trendline, Moving average, Channel, and Bollinger Bands are common overlays.

List of Technical Indicators (Most Common)

The apt indicators to use varies with various factors like asset classes, goals, and strategies followed by the investors. For example, popular technical indicators for day-trading are Relative Strength Index (RSI), Moving Average Convergence Divergence (MACD), Average Directional Index, On-Balance-Volume, etc. At the same time, popular technical indicators for swing trading are Moving Average, Volume, Bollinger Band, Stochastic, etc.

On-Balance-Volume (OBV)

On-Balance Volume focus on trading volume to predict price movements. OBV value fluctuates based on the trading volume. An increasing OBV indicates buyers' behavior toward the market entry, positive volume pressure, and upward price movement. Conversely, a declining On-Balance-Volume showcases lower prices.

Let us look at the following US Dollar/Japanese Yen chart to understand the concept of On-Balance Volume better.

Source

The blue line in the above chart represents the On-Balance Volume or OBV. As one can observe, the decline in OBV from August 22, 2023, to August 23, 2023, showed that sellers were dominating the market, pushing down the price. On the other hand, an increase in the OBV on August 29, 2023, shows that buyers were entering the market.

If individuals wish to look at more OBV charts to improve their understanding concerning the indicator, they may choose to visit the TradingView website. It has various charts explaining how different indicators in technical analysis work.

Moving Average Convergence Divergence (MACD)

Moving Average Convergence Divergence (MACD) uses two moving averages. If the two averages are meeting or converging, the scenario is considered convergence, and the momentum decreases. Whereas if the averages are diverging, the scenario is divergence, and the momentum increases. The strategy starts with creating a MACD line and the signal line. If the MACD crosses and moves above the signal line, it is usually a buy signal, and if the MACD crosses below the signal line, it is a sell or short signal.

Average Direction Indicator (ADX)

The technical analyst, Welles Wilder, developed the ADX representing the strength of a price trend. ADX value moves from 0 to 100. A reading below 20 indicates a weak trend, between 20 to 40 indicates a strong trend, and above 40 indicates an extreme trend. When the ADX line is rising, the strength also increases, and the price is expected to move in the direction of the trend. Whereas, if the ADX falls, the strength decreases and may cause a shift in the primary trend.

Frequently Asked Questions (FAQs)

What is a technical indicator?

Technical indicators refer to techniques used by investors to make investment decisions with the help of buy or sell signals. It largely uses previous prices to forecast future price changes, and investors decide entry and exit points based on the signals generated.

What are the 4 types of indicators?

There are various classifications of indicators. Oscillators and overlays are the basic types. Segregating the indicators into classes like trend (Example: ADX, and Moving Averages), momentum (Example: RSI and Stochastic), volume (Example: On Balance Volume), and volatility (Bollinger Bands and Standard Deviation) indicators is another important classification.

Give examples of technical indicators?

Examples are Moving Average Indicator (MA), On-Balance-Volume Indicator (OBV), Exponential Moving Average Indicator (EMA), Moving Average Convergence Divergence (MACD), Relative Strength Index (RSI), Percentage Price Oscillator indicator (PPO), Parabolic SAR Indicator (PSAR), Average Directional Index (ADX), Accumulation/Distribution Line Indicator (A/D), Stochastic Oscillator Indicator, Bollinger Bands Indicators, Aroon Oscillator (AO), Standard Deviation Indicator, Fibonacci Retracement Indicators, and Commodity Channel Index (CCI).