Technical indicators are designed to arm traders with information about the direction and sustainability of price action, and the trends within it.
What are technical indicators?
They're often automated as studies and applied to charts to help add extra information about the direction or prospects of an instrument's price.
Indicators may be displayed on the main body of a chart, in a separate chart attached to it or as values independent of any chart.
When used with a chart, indicators are often displayed as lines, and the interaction between those lines, or between them along with the underlying price can be used to determine what the next moves in price may be.
Types of indicators
We've listed the most commonly used types of indicators our clients use below:
1. Support and Resistance
Support and resistance levels are barriers to progress in price action. That is, they're levels at which price can't move above or below based on its current momentum.
When price approaches a support or resistance level and bounces off of those levels, it often starts to move in the opposite direction. Support and resistance levels act like floors and ceilings, by containing the price action and defining its boundaries.
However, if those boundaries are broken by a price move to the upside, then the prior resistance levels become potential support levels for the new trend. On the other hand, a price move to the downside breaks through the support level, the previous support level assumes the role of potential resistance.
Historical support and resistance levels and the price action can be used to identify possible turning points in the market as well as entry and exit points within a trade.
This information is essential to help traders make profitable trades and to minimise losses on losing ones.
2. Moving Average
Moving Averages are the average values of an instrument's price over a defined period.
They're calculated by adding together a given number of closing prices recorded within a specific timeframe.
That total figure is then divided by the number of prices used in the calculation.
For example, to calculate a 10-day moving average, the last ten daily closing prices are added together and then divided by 10.
There are four main types of moving averages:
The difference between each of these comes down to the weightings that are assigned to the latest data in the series and calculations.
Moving averages are used to:
- Define areas of support and resistance
- Identify entry and exit points
- Emphasise the direction of a trend
- Smooth out price fluctuations or market noise.
The direction of the moving average shows whether a bullish or bearish trend is present in the market.
Multiple moving averages, calculated over different durations, can be used on a chart to compare price trends over time.
If these moving averages intersect, it can confirm a change in trend. This is because indicators lag behind the changes seen in the underlying price.
Oscillators are designed to indicate an imminent change in the current price trend of an instrument. They do this by highlighting its proximity to overbought or oversold boundaries that are independent of the price itself.
Oscillators indicate the potential for a trend change, rather than identifying an outright change in trend. It's important to note that prices can ignore these indicators and continue to trend, becoming overextended in either direction.
The relative strength index (RSI) is one particular indicator which identifies whether an instrument is looking overbought or oversold in comparison to its historical price performance. The indicator ranges between 0 and 100, with oversold and overbought boundaries set at 30 and 70 respectively.
- If the RSI indicator moves to readings of 70 or higher and then tops out, it can indicate that a current uptrend is due to follow the same trend, which could be a selling opportunity.
- Alternatively, if the indicator moves to 30 or below and bounces, it can suggest a loss of momentum in an existing downtrend, which could be a buying opportunity.
In other words, the price and the RSI movement correlate.
The Stochastic oscillator is made up of two lines that oscillate in a range between 0 and 100%. Traders monitor the behaviour of these lines, their interaction with each other and their reaction at the overbought and oversold boundaries of 20% and 80%.
- If the lines in the indicator top out, at or around the 80% level, and head lower this can be seen as a sell signal.
- If the lines hit a bottom at 20% or lower and rebound, this can be interpreted as a buy signal.
Divergence between the stochastic lines themselves, or the current price trend, are also of great interest to traders, as are the actual points where the two stochastic lines intersect.
Technical analysts believe that markets are mean reverting and often like to retrace their previous price gains or losses. Retracement indicators are used to identify and measure these potential moves that occur when an existing trend comes to an end and a new and opposing trend begins.
The most well-known of these tools is the Fibonacci retracement, which captures the high and low prices of a prior move and plots specific price points, or retracement levels, for traders to monitor.
These levels are calculated through the use of a mathematical sequence developed by the Italian mathematician, Leonardo Fibonacci.
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