Technical indicators are trading tools that use historical price data to help investors
identify things like a security’s trend and potential entry and exit signals. There
are hundreds of them, so it can be difficult to determine which to use. Some new traders
add numerous indicators to a chart and get stuck in analysis paralysis. By understanding
the different types of technical indicators and their purposes, you can zero in on a few
indicators to help you make trading decisions or even build a consistent, rules-based trading
system. We’ll discuss four major indicator categories
including trend tracking, oscillators, sentiment, and flow-of-funds. Trend tracking and oscillator
indicators are generally used for creating trading systems, while sentiment and flow-of-funds
indicators are commonly used for determining the strength of the broad market trend. Let’s
break these groups down and determine when you might use them.
We’ll start with trend-tracking indicators. One of the basic tenets of technical analysis
is the trend is your friend. This means a trader should consider using bullish strategies
in uptrends and bearish strategies in downtrends. One of the most common trend-tracking indicators
is moving averages. A moving average tracks a security’s price over a certain time period
and plots it on a graph. For example, the 50-day moving average takes
the average price for the previous 50 days and charts it. If the line is going up, the
trend is up. If the line is going down, then trend is down.
Long-term investors may choose a 200-day moving average while short-term traders may choose
a 20 day. The moving average can also be used to help
determine buy signals. If the trend is up, investors may buy when the stock price moves
above the line and sell when the price moves below the line.
Other common trend-tracking indicators include linear regression, envelops, and Bollinger
Bands®. Often, trend traders look at other indicators
to confirm a buy or sell signal. This is one use for the next group of indicators: oscillators.
Oscillators typically measure how quickly a security’s price is changing and chart
it in a range to identify extreme values. Extreme values may suggest that a security
is overbought or oversold, which could mean it’s ready to reverse direction.
Like watching a ball thrown in the air, you can tell it’s about to start falling when
its rise slows. A commonly used oscillator is the stochastic
indicator. The stochastic measures momentum by comparing a stock’s current price to
its range of movement over a set time. If the stochastic line is rising, then this indicates
that the price has bullish momentum. If the stochastic line is falling, then momentum
is slowing. Some traders identify the extremes of the
stochastic indicator as reversal zones. These reversal zones can suggest the security
is overbought or oversold and can be used as trading signals. For example, the line
crossing above 20 and out of the lower reversal zone could be a bullish signal. The line crossing
below 80 and out of the upper reversal zone would be bearish. These signals can be used
as confirmation with trend indicators like moving averages or as their own entry or exit
signals for trading shorter-term swings. Other common oscillators include the Relative
Strength Index or RSI, moving average convergence divergence or MACD, and the Commodity Channel
Index or CCI. The next type of indicators sentiment indicators aren’t
commonly used to trade specific securities. Instead, they gauge investors’ beliefs about
the direction of the market. They tend to be popular with contrarian investors who are
looking to pick market tops and bottoms. Many sentiment indicators are polls conducted by
private companies to help determine if professional and retail investors are extremely bullish
or bearish. Access to these polls often requires a subscription service.
However, the options market offers some popular sentiment indicators you can access from most
charting platforms. One of these is the put/call ratio. This indicator compares the number
of puts purchased versus the number of calls purchased on stocks in a broad index like
the S&P 500. Puts are commonly purchased when investors are bearish, while calls are commonly
purchased when investors are bullish. If there were an equal number of calls and puts purchased,
the ratio would be one. However, investors tend to be bullish more often, so the ratio
tends to be below one most of the time. Contrarian investors attempting to identify
market extremes may interpret a ratio spike above one as excessive bearishness, suggesting
a market bottom could be near. Often, investors will rely on more than one
indicator to determine tops and bottoms. Other common sentiment indicators include
the Cboe® Volatility Index or VIX, historical P/E ratios, the advance/decline line, and
consumer sentiment. Finally, there are flow-of-funds indicators.
Flow-of-funds analysis attempts to track changes in supply and demand for investments. In other
words, it’s a way to see where people are putting their money.
One widely available flow-of-funds indicator is the Arms Index also known as the Short-Term
Trading Index or TRIN. The Arms Index compares rising stocks, called advancers, to falling
stocks, called decliners in a stock exchange. The first level of comparison is the number
of advancers versus the number of decliners. If advancers outnumber decliners when the
market is uptrending, then it suggests that the rally is broad-based and strong. If the
decliners outnumber the advancers during an uptrend, the uptrend is weakening. Next, the
Arms Index compares the volume for advancers to the volume of decliners. If advancers are
seeing high volume, this means more money is flowing into bullish stocks. If the decliners
are experiencing high volume, then money is flowing out of stocks and into other investments.
A measure of one or less suggests more money is going into advancers. A measure above one
suggests more money is leaving stocks. It’s not uncommon to see the Arms Index bounce
above and below one. Large positive or negative spikes indicate extreme conditions and are
often used by contrarians to signal a final surge before changing directions.
Other common flow-of-funds indicators include Chaikin Money Flow, on-balance volume, and
the Commitment of Traders report. When it comes to selecting which indicator
to use, it starts by defining what it is you want to accomplish. If you’re looking to
build a trading system, you may want to consider focusing on a trend-tracking indicator and
supplement it with an oscillator. If you’re looking to trade short-term swings, you may
want to focus primarily on an oscillator. Long-term investors may choose to focus on
sentiment and flow-of-funds indicators to determine if the market is bullish, bearish,
or neutral and to what degree. Once you’ve defined what you want to do, it’s easier
to determine which indicator may be best. Whether you want to build a system or just
enhance your decision-making process, there’s probably a technical indicator that can help.
The next step is to match the appropriate indicators with your investing goals.