Technical Indicators in Stock Trading

About Technical Indicators
With price volatility at an all-time high, it is becoming increasingly important for the investor to recognize patterns in the movements of the stocks they own or are interested in purchasing. The interpretation of market activity using technical analysis provides clues to the investor as to the future behavior of the price. Generally speaking, the technical investor will use a combination of price, volume and time-sensitive technical indicators to maximize their profits.

Listing of Technical Indicators
An indicator is a result of mathematical calculation, based on prices and/or volume. The figures received are used for forecasting price changes. There are many of elaborated technical indicators. Some of them are presented below:

Technical Indicators Significance

Indicators are simply mathematical models which are derived directly from price and its related derivatives. Many new technical analysts typically get confused between the use of trading systems and technical indicators and frequently use the two interchangeably, which usually leads them into poor decision making and financial loss. Furthermore, new analysts tend to regard indicators as superior tool compared to looking at price directly - a fundamental and often misunderstood error.

Indicators should only ever be used to solidify a decision that is already clearly apparent on the price chart. If a technical analyst uses indicators in any other way than this, they will most likely find themselves in both a disastrous situation and a consequential failed trade. The more experienced technical analyst will only ever use indicators as a secondary tool to confirm decisions they have already made in their chart examination. Furthermore, they also realize the importance of relying on price as the ‘primary trading signal’ and any resulting indicator analysis as a secondary confirming tool.

Remember, the price chart will detail the direction of trading movement and the indicator will either support or oppose this movement - deciding on whether or not to execute a trade on this basis, is a decision that comes with experience and skill.

Leading and Lagging Indicators

There are two main types of indicators - leading and lagging.

Leading Indicators

Leading, or momentum, indicators are designed with purpose of leading price movement and therefore producing signals ahead of the price chart. Most leading indicators measure the speed, or rate-of-change, at which price is changing and therefore are of the momentum oscillator indicator group. The faster the change of price movement, then the greater the increase in momentum that will be observed. For example, as a securities price begins to increase rapidly, then momentum will be dually reflected; conversely, if the securities price rise beings to slow down, then momentum will equally decrease to reflect the slower price movement. If a security begins to trade square (or flat) and enter a sideways trading channel after a price increase, then momentum will decrease from its previous level to indicate that momentum is stabilizing at this new price level. Leading Indicators are mainly used when trading in swings or ranges, as lagging indicators are too slow to accurately detect shorter trending patterns. Only use leading indicators in these periods to use the indicators correctly. Some typical leading or momentum indicators include Relative Strength Index (RSI), Momentum Indicator, Commodity Channel Index and Stochastic Oscillator.

We have found that many sites do not discuss the negative aspects, or weaknesses of leading indicators. While they are a lot of benefits from using leading indicators to formulate trading strategies, there are also many downfalls that you must be aware of as well. The well published advantages for leading indicators include the formation of early trading signals for entry and exit points, as well as the generation of more signals and opportunities to trade. Although this sounds fantastic, there are many traps that revolve around using leading indicators in their entirety and these pitfalls are not usually explained fully to new technical analysts.

It is important to note that leading indicators can sometimes be a double edged sword. The more risk you take in adopting an early position, then the greater the chance you are taking of price moving against you. Although leading indicators allow for more trading signals, they also create a higher probability of executing trades on false signals and whipsaws. Thus, it is important to realise that when you are trading with leading (and lagging for that matter) indicators, you adopt of degree of cautiousness. Keep the age old adage in the back of your mind - “If it’s too good to be true, then it usually always is”.

Lagging Indicators

Lagging or trend following, indicators are designed with the purpose of lagging price movement and therefore producing signals that follow price action. Lagging indicators tend to smooth price action and generate trending lines from this effect. They keep traders active within a trending period and then alert them when to close, or reverse, these positions due to a trend failure. These indicators are not intended to be used in square, flat or sideways trading movement as they lag price and therefore cannot generate accurate signals in these highly volatile trading periods. The most popular lagging indicator is the moving average indicator system which is outlined in our Technical Analysis Indicator List.

A lot of new technical traders complain of not having enough literature on the positives and negatives of lagging indicators and as a result, we thought that we would include it into this tutorial. Firstly, let us consider that classical technical analysis incorporates the use of highs and lows as well as peaks and troughs in order to form the most basic of trending patterns - more commonly known as trend lines. Trend lines are a very simple form of developing trending analysis and basic patterns.

Although trends lines were covered in an earlier tutorial, it is suggested that trend following, or lagging, indicators are similar in their ease of use to more classical trending systems. Thus, if you are new to technical analysis, it would be sensible to start mastering both classical trending system in combination with lagging indicators before moving onto the more advanced leading indicator analysis.

In saying this, you are probably wondering why we are discussing classical trending analysis when we are supposed to be reviewing lagging indicators. Quite simply, to master the art of lagging indicators you must be fluent in your understanding of classical technical analysis. This will allow you to understand that lagging indicators actually allow you to capture a basic move, and then remain in this move until the trend has finished. If you are trading a security or index that continues in the direction of your move, then a trend following indicator can be extremely profitable and very easy to use. Basically, the longer the trend continues, the less the amount of trading signals that will be generated and the smaller the degree of trading involved.
So what are the pitfalls and traps? The main drawbacks of lagging indicators are that they are generally quite late. By the time you are comfortable to trade on a move, the majority of profit has already occurred and you miss out on a large portion of it. This implies that the bulk of the clear trades occur when the trend is almost completed, and therefore profits are limited. It is important to be aware that lagging indicators are precisely that - lagging - and all trades entered using these indicators can distort the risk-to-reward ratio.
In summary, it is important to identify how you want to trade, and what your trading objectives are in order to determine which type of indicator analysis is best for you. A prudent technical analyst would use a combination of both leading and lagging analysis in order to determine the appropriate trading action - not only would this be a sensible rule-of-thumb to develop early on in your trading handbook, but one that should remain a constant focus throughout your entire technical trading life.

Guidelines for Indicators:

  • Indicators aren’t the be all to end all. You need to ensure that you remove the subjective component of your analysis and remain completely objective. Rely on price movement and what your chart is telling you. Remember that this is the solid quantitative data.
  • Never use one indicator by itself, and equally don’t overuse too many indicators to the point that you become confused. Develop your trading strategies with a group of indicators that you believe work well together. Remember to keep it simple and straightforward - complexity is not correlated to trading success. There is no magical trading strategy, and there is no perfect indicator - if you do find one, remember to tell us!
  • Cut your losses and move on to the next trade if things don’t work out. Remember, mental toughness is part of technical trading and you have to be prepared to endure trading losses - not every trade will go according to plan.
  • Always ensure you plan your trading time period. Swing trading involves very different trading strategies to longer term yearly trading. All Technical Analysts seek to develop an indicator that is extremely sensitive to price movement, while equally predicting early signals and reducing the amount of whipsaws - few, if any, have actually achieved it. It should always be your choice how you will chose a trading time period that is appropriate to your risk-return ratio and personal objectives - make sure it stays this way!

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