Introduction to Indicators in Stock Market Technical Analysis
Trends occur in different time frames, but indicators are a handy method of sorting them out. Charting of the prices of commodities began in Japan in the 1600s. Towards the end of the 19th century, people began to chart the prices of shares on Wall Street. The 20th century saw the continual development of charting in many forms, as investors and traders sought to analyze and take advantage of the shifting balance of supply and demand on stock and futures markets.
After World War II, analysts began to develop mathematical methods of analyzing prices. At first this was very limited because calculations had to be made by hand or with a slide ruler. The advent of calculators helped but it was still difficult to calculate indicators for any number of markets or shares and it was only practical to employ fairly simple indicators. Once personal computers became readily and cheaply available in the 1980s, it became feasible to calculate even quire complex indicators and to process very large amounts of information.
By the early 1990s it was within the reach of almost any investors to quickly see a range of mathematical studies for every market and every stock almost as soon as new data was available. By the end of the decade, charting facilities were available on the internet that increasingly allowed indicators to be plotted on the charts.
Why Use Indicators
We will explain the most popular indicators in use today and show some of the ways they can be used by traders and investors. Indicators are widely used by short-term traders, mainly because in short time periods there is little other hard information to help them. Short-term traders operate in markets that are largely driven by emotional responses to the pressures that markets place traders under.
However, in the longer term, prices are more rational and are loosely tied to company earnings expectations. Indicators are also useful in this setting because they assist in taking some of the noise out of the price action and show more clearly the underlying shifts in supply and demand. Indicators can therefore also be useful to investors who will be looking to see the longer trends in better perspective.
Indeed, this is one of the attractions of indicators. Trends unfold in many time frames simultaneously. By choosing appropriate time periods over which indicators are calculated, we can use them to help sort out trends in different time frames.
Trend Following Indicators and Momentum Oscillators
There are two major groups of indicators. The first group is generally referred to as trend-following indicators, They can take several different forms, but they are classified by their use, which is to track trends. As we proceed through this charting guide, you will meet moving averages, the parabolic time/ price system, the directional movement system, the moving average convergence divergence indicator (MACD) and Bollinger bands.
The second group of indicators is generally referred to as momentum oscillators. Their primary use is to trade sideways or ranging markets, but they are also useful in getting on board established trends.
They can also give warning signals that there is potential for a trend to change. As we proceed through this charting guide, you will meet the relative strength index (RSI), the stochastic oscillator and the MACD histogram, which is a derivative of the MACD trend-following indicator.
Four Types of Signals
There are four types of signals driven by indicators, which are interpreted in various ways. When indicators behave in certain ways, they are said to give signals, These are sometimes loosely spoken of as buy or sell signals, but they are really more subtle than that. The signals really tell us that the balance of supply and demand is changing. That will have implications for traders and investors, who may react in ways that are more sophisticated than simply buying and selling. They may move their stop-losses, hedge their positions, take some profits or increase their position. Only some of the time will they simply sell what they hold or buy a full position. The four types of signal are:
- The direction of the indicator. With the exception of the directional movement system, when an indicator is rising, the trend is up and demand exceeds supply. When the indicator turns down, the trend is down and supply exceeds demand.
- The indicator crosses another line. This line may be the price, another indicator line, a trend line or an arbitrary level (see “Overbought and Oversold”).
- The indicator unfolds in the form of some kind of pattern, which, when completed, constitutes a signal.
- The peak or troughs formed by the indicator are opposite to the peaks or troughs formed by the price. This is called divergence.
There are two concepts arising out of this which require explanation before we begin to discuss the specific indicators. The first is the concept of overbought and oversold. The second is the concept of divergence.
Overbought and Oversold
These are jargon terms that are in common use in analysis of indicators. The idea behind ‘overbought’ is based on the way prices seem to surge upward for a while. When all the keen buyers have purchased, the price tends to stop rising and the market is said to be overbought. Think of the market being overbought as a condition where all of the buying has been done.
‘Oversold’ is just the opposite. It is based on the way prices sag downward when the market is negative about a stock. When all the apprehensive sellers have sold, the price tends to stabilize and the market is said to be oversold. Think of the market being oversold as a condition where all the selling has been done.
Chart 1-1 shows the Relative Strength Index (RSI) for Telstra. RSI fluctuates between zero and 100. Below 30 is oversold and above 70 is overbought.
Where these concepts are useful is that overbought markets tend to be ripe for a fall and oversold markets tend to be set up for a rise. This is based on the idea that markets tend to endlessly fluctuate above and below a value line of some kind, depending on the emotional state of buyers and sellers.
Overbought and oversold refer to momentum oscillators. In some momentum oscillators, the indicator is calculated so it fluctuates between set values like zero and 100. In this case, analysts often use a specific value above which the indicator is said to be overbought and another specific value below which it is said to be oversold. (see chart 1-1)
However, other oscillators have no finite boundaries. The overbought and oversold levels are determined by observation and judgment. Chart 1-2 shows the moving average oscillator. The moving average oscillator has no fixed boundaries. Overbought and oversold are determined by observation and judgment.
Chart 1-2 shows the moving average oscillator for Telstra. The moving average oscillator has no fixed boundaries. Overbought and oversold are determined by observation and judgement.
As a price chart unfolds, the price tends to move up and down, either generally sideways or in a rising or falling trend. Likewise, momentum oscillators also swing up and down. In an uptrend, successive peaks on the price chart will tend to be higher than the peak before them. However, this does not always happen on the momentum oscillator. When the price makes a higher peak than previously, but the oscillator makes a lower peak, there is said to be divergence between the price and the oscillator. This signals a higher likelihood that the uptrend may end than when both the price and the oscillator make higher peaks together. Similarly in a downtrend, the price will tend to unfold in a series of troughs, with each one lower than the one before it.
When the oscillator makes a trough that is higher than its previous trough, there is said to be a divergence. This signals a higher likelihood that the downtrend may end than when the price and the oscillator make lower peaks at the same time.
Divergences take a little time for most people to get their minds around. They key rule is that we compare peaks in an uptrend and we compare troughs in a downtrend. If it helps to remember, think uptrend and peaks- the capitals making the word UP. A downtrend is the opposite. Chart 1-3 of Commonwealth Bank shows examples of divergences. The sloping lines mark the peaks and troughs that we are comparing.
The Need for Confirmation
One of the most common traps beginner fall into is that they discover indicators and they no longer need to worry about the price. This is a mistake. The more you work with indicators, the more you will come to realize two thins.
One is that indicators are not perfect tools. The other is that no matter what the indicator is telling you, you need to watch for confirmation on the price chart that the supply and demand balance has indeed changed. Sometimes conditions can change so quickly that indicators cannot pick it up. Indicators can also be early with their signals, as well as late at other times.