What are trading indicators? Part 1May 31, 2021 2021-05-31 10:07
What are trading indicators? Part 1
When it comes to technical analysis, trading indicators are an important area to consider. They’re used in conjunction with the actual price action and function as mathematical calculations broadly based on three inputs — price, volume and time.
They’re visual representations that you can use to help when deciding the future direction of price. Importantly, trading indicators can be used alongside other technical analysis factors such as trendlines and breakouts, patterns and candlesticks. By now, you’ll be familiar with these from our previous lessons.
In this lesson we’ll explain how trading indicators work, how you can use them and why they’re so significant. We’ll also highlight the different groupings of indicators and outline what you need to know in order to use them in your strategies.
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Trading indicators explained
Technical trading indicators are typically displayed below the price chart, but can also be placed on the same chart as the price.
An example of an indicator that’s displayed on the chart with the price is a moving average, as shown below. The Relative Strength Index, or RSI — as it’s better known — is an example of an indicator that’s displayed below the chart. You can see this below the price chart and with a different Y axis.
As highlighted above, technical trading indicators are a graphical representation of a mathematical formula. They’re applied to the price data over time or a combination of price, volume and time data.
Forex trading indicators
When it comes to forex markets, you’d use the same trading indicators as used in most other asset classes. However, the main two differences with forex indicators are:
- Forex markets run 24 hours
- Forex market volume data is not centralised
Consider this scenario — foreign exchange markets open in Asia at the start of the global week on a Monday morning (which is Sunday night European time). These markets don’t close until Friday afternoon, New York time (Friday evening European time).
Given that the price data between these times is uninterrupted and continuous, it means that forex trading indicators are often ‘smoother’. This is evident when they’re compared to other financial markets that have a defined close (such as individual stocks). Markets that have a specific open and close during the week can see jumps in their price data and, therefore, jumps in their trading indicators.
Volume indicators, in particular, tend to be less useful when you apply them to the global forex markets. This is because of the non-centralised nature of these markets. Foreign Exchange transactions aren’t conducted via a central exchange but are made across various trading platforms. This means that accurate volume data isn’t readily available, meaning that volume trading indicators are less reliable when applied to the currency markets.
How do trading indicators work?
Trading indicators work by helping you to make trading decisions, particularly with regard to your strategy and trading tactics.
We’d stress here that technical trading indicators are secondary in nature when it comes to making trading judgments. Primary indicators come directly from the price, which would mean, for example, looking at chart patterns, candlestick patterns, trendlines and breakouts.
Really, you should use technical indicators as secondary indicators — an extra piece of evidence that you can add to your trading decisions and strategies. Essentially to supplement the views that you’ve formed from using the primary indicators.
How to use trading indicators
There are a number of ways in which trading indicators can be used. These include:
- A measure of overbought and oversold market conditions
- As a confirmation of underlying price action
- Divergence — when a technical indicator and the price action are sending differing signals
- To direct trading signals, around which you can build a strategy
Trading indicators are also used in the following circumstances:
Overbought and oversold: Some technical trading indicators are constructed when a market has moved too far in one direction, either in an uptrend or in a downtrend. These would include trend and momentum trading indicators, plus to a lesser extent, moving averages.
Trading Indicator confirmation: Confirmation happens when a market is moving in one direction and the chosen indicator is also moving in the same direction. This confirms the primary price action.
Trading Indicator divergence: Divergence is when a trading indicator is giving a different directional signal to the price. You can then see this as a warning that price may be about to change direction.
Trading signals: You could build a whole trading system and strategy entirely around technical indicators. This would involve either using single or possibly various indicators together, combined with chart patterns or trendlines. This would be a way of defining a trading strategy based on trading indicators.
Why are trading indicators important?
Trading indicators are important because they give another input to your trading strategy — one that can help to either reinforce your view or to counter a trading idea that you may have.
For example, you may have a bullish trading view on a market, but you’re not fully confident in taking this trade. However, should a trading indicator reinforce this view, it could give you an extra valuable piece of information to tip you towards taking the trade.
Conversely, you may, as another example, have a bearish idea for a trade and are quite confident with this view. But, if the technical indicator doesn’t confirm this view, it may cause you to be more cautious when entering this trade. You’d wait for a more significant confirmation signal from the price action.
What should you know before using trading indicators?
When it comes to technical trading indicators, you should know that they usually fall into two main categories — leading or lagging.
Leading technical indicators try to predict future price moves. Lagging trading indicators reflect past trading conditions that could be influencing the current price action and therefore future price movements.
Although we’ve defined these two broad categories, it’s useful to recognise the further subcategories, which we’ll look at in the following sections of this lesson.
What are the different types of indicators?
There are a number of differing categories of trading indicators. These include:
- Trend indicators
- Momentum trading indicators
- Volatility indicators
- Volume indicators
- Moving averages
We’ll now look at these different types of trading indicator categories separately.
Whether the market is moving in an uptrend, a downtrend or a sideways, non-trend range environment, trend indicators are, generally speaking, lagging indicators. They reflect the overall direction of a market over a defined timeframe.
The best examples would be the various moving averages, which we’ll explore in more detail below.
Momentum trading indicators are leading indicators and are a measure of the velocity of price changes. You can think of them as the amount of speed, force, pressure or power that the market is expressing in a particular direction, over a specified timeframe.
A good example of a momentum trading indicator would be the Moving Averages Convergence Divergence, better known as the MACD indicator (typically pronounced ‘Mac Dee’).
Volatility is a complex indicator and measures the degree of variation of the price of a financial market. It’s an indicator of the dispersion or distribution of returns of a financial market asset or asset class.
Broadly speaking, the higher the volatility, the riskier the financial asset and the more uncertain the returns. Higher volatility means the price of the market can change significantly over a short period, in either direction.
So, low volatility means for a safer asset where price fluctuations tend to be less aggressive.
An example of a volatility indicator would be the CBOE Volatility Index, better known as the VIX and the Average True Range (or ATR).
Volume is a measure of the number or size of transactions being made at differing prices. With this in mind, volume indicators usually look at the volume in the market over a set period of time. Sometimes, the volume and time data are combined with price data for more complex volume indicators.
The simplest example of a volume indicator would be the volume itself — this is how much a market has traded in a certain time period. A more complicated example would be On-Balance Volume, or OBV, which you’ll see in the chart below.
Moving averages are specific forms of trading indicators, but are deserving of their own category as they’re widely used in technical analysis as indicators.
You’ll recognise three main types of moving averages:
- Simple moving averages
- Weighted moving averages
- Exponential moving averages
Moving averages are used to smooth out how markets are moving and essentially gets rid of any unwanted noise. This makes the underlying trend easier to see. Like all averages, it acts as a median point where price will always revert back to.
Below you can see all three types of moving average in the following chart.
How to use moving averages
You can determine how fast and slow the moving average is by how many periods you choose to set. For example, a 10-day moving average will be closer to the price more regularly than a 200-day moving average. How sensitive you choose is up to you.
The faster the moving average the earlier you will get signals, however the higher the chance of those being false signals. It’s a balance, and it will depend on your style of trading, which you prefer.
Trading with moving averages
There are several ways you can trade with moving averages. Quite often this is dependent on how many moving averages you use.
- One moving average – Here you can determine the trend by the direction the moving average is pointing. Then look to buy or sell whenever the price comes back to meet it. Ideally you would want a confirmation that the moving average will hold and the trend will continue. An example might be a candlestick pattern.
- Two moving averages – Here you would use a fast and a slow moving average. The slow shows the trend direction, while the fast would be used to time the market. A cross over of the two moving averages would offer a signal to buy or sell.
- Three moving averages – Similar to the two moving average strategy, you would have three, all set at different settings; fast, medium, slow. Here you would wait for all three moving averages to be in order of speed and then trade in that direction. If the slow was at the bottom, then the medium and the fastest was above, then you would be looking to buy the market.
Moving averages are plotted on the actual price but analysts have devised ways of interpreting the moving averages as oscillators below the chart. An example would be the MACD, which we’ll cover in more detail in our next lesson, ‘What are trading indicators part 2’.
Trading indicators summary
In this lesson, we’ve looked at what trading indicators are, how they work and how you can use them. We’ve also detailed the different categories, why they’re important and what you should know before using them.
A key takeaway of this lesson is that, while trading indicators are very useful, they should still be considered a secondary indicator. These signals are best used to confirm primary indicators.
All of this should give you the basis to start to use trading indicators within your trading strategies. To help you to decide which to use, we’ll look at the different types in more depth in our next lesson, ‘What are trading indicators part 2’.