What are trading Indicators? Part 2
May 31, 2021 2021-05-31 10:10What are trading Indicators? Part 2
Trading indicators are mathematical calculations (or algorithms) usually based on three inputs — price, volume and time — which you can use to help determine the direction of price.
We introduced this type of technical analysis in more depth in our previous lesson on trading indicators.
Now, we’re going to build on what we’ve already learned, so feel free to have a recap before we move ahead.
How many types of trading indicators are there?
There’s a countless number of trading indicators, and individual traders and analysts add to the tally on a daily basis.
There are however particular types of technical indicators, used globally by many traders, that have proven useful over the years. We’re going to focus on these ones in particular, to help you with your trading.
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What category do these trading indicators fall into?
As we highlighted in our previous lesson on trading indicators, they fall into many categories. These are:
- Trend indicators
- Momentum indicators
- Volatility indicators
- Volume indicators
- Moving averages
- Channel indicators
Let’s move on to categorise many of the more important trading indicators.
Indicator Categories | |||||
Trend | Momentum | Volatility | Volume | Moving Average | Channel |
Aroon Oscillator | Ichimoku Cloud Bounce | Standard Deviation | Volume ROC | BB MACD | Linear Regression Forecast |
Automatic Trend Line | Relative Strength Index (RSI) | Adaptive Price Zone | Positive Volume Index | Simple/ Arithmetic Moving Average | Bollinger Bandwith |
Average Directional Index (ADX) | Darvas Box | Traders Dynamic Index | Volume Weighted Moving Average | Cycle Period | Linear Regression Squared |
Balance of Power | CMO | Chaikin Volatility | On Balance Volume | High Low Bands | Standard Deviation |
Demark Trend Line | Money Flow Index | Bollinger Bandwith | Trade Volume Index | Kaufman Adaptive Moving Average | Bollinger Percent |
Detrended Price Oscillator | Awesome | Average Range | Volume Oscillator | Detrended Price Oscillator | Stoller Average Range Channel Bands (STARC Bands) |
Directional Movement Index (DMI) | Awesome Oscillators | Average True Range (ATR) | Accumulation Distribution Line | Exponential Moving Average | Equidistant Channel |
Elliot Wave Oscillator | Price ROC | Average True Range with Percent (ATRV) | Negative Volume Index | Keltner Bands | Fibonacci Retracement |
Ergodic Oscillator | Price Oscillator | Bollinger Percent | Traders Dynamic Index | Moving Average Envelope | Linear Regression Intercept |
Falling Three Methods | Commodity Channel Index (CCI) | Stoller Average Range Channel Bands (STARC Bands) | Weighted Moving Average | Bollinger Bands | |
Fibonacci Retracement | Momentum Oscillator | OsMA | Donchian Channel | ||
Fisher Transform | Stochastic Momentum Index | Stochastic Double Smoothed | Keltner Channel | ||
Hilo Activator | TRIX | Tillman T3 | Linear Regression Sloped | ||
Ichimoku Cloud Bounce | True Strength Index | Centre of Gravity | |||
Kaufman Efficiency Ratio | Stochastics | Time Series Moving Average | |||
KDJ | Stochastic Oscillator | Smoothed Moving Average | |||
MACD | MACD | MACD | |||
Mass Index | Williams %R | Traders Dynamic Index | |||
Parabolic SAR | Disparity Index | Donchian Channel | |||
Pivot Points | Aroon Oscillator | ||||
Range Expansion Index | Triangular Moving Average | ||||
Rising Three Methods | Variable Moving Average | ||||
Schaff Trend Cycle | Alligator | ||||
Sine Wave | Hull Moving Average | ||||
Spearman Correlation Coefficient | VIDYA Moving Average | ||||
Super Trend | Volume Weighted Moving Average | ||||
Trend Adjusted Oscillator | Stoller Average Range Channel Bands (STARC Bands) | ||||
Trend Strength Index | |||||
Zigzag |
What are the most commonly used trading indicators?
The most commonly used trading indicators are Moving Average Convergence Divergence (MACD), Relative Strength Index (RSI) and Stochastics.
You’ll find other widely-used indicators include:
- Bollinger Bands
- Directional Movement Index (DMI)
- Parabolic SAR (SAR)
- Pivot Points
- Average True Range (ATR)
- Commodity Channel Index (CCI)
Let’s look at each of these in turn.
Moving average convergence divergence (MACD)
Moving Average Convergence Divergence (which is usually shortened to MACD, pronounced ‘Mac-Dee’) is a trend indicator you can categorise as either a momentum or moving average indicator.
MACD is essentially based on two moving averages and can indicate a new trend — either bullish or bearish. As the market saying goes, ‘the trend is your friend’.
When calculating the MACD, you need to consider three inputs:
- The first two are for two moving averages of the price
- The third is a moving average of the difference between the first two moving averages
These inputs are plotted below the chart as two lines. One line is the difference between the two moving averages and the second line is the moving average of this first line. Sometimes, a histogram or bar chart is also plotted, which shows you the difference between the two lines.
You can see this in the image here.
At first, it might sound complicated, but these are the main takeaways for your trading with MACD:
- Buy/sell signal – As the two lines converge and then crossover, the histogram goes to zero. You can consider this a sign of one trend ending and another trend starting in the opposite direction
- Momentum – If the two lines diverge, then the histogram grows larger, you’ll recognise this as a sign of the current trend starting to be stretched. Either overbought for a bull trend or oversold for a bear trend
- Divergence – If the market is trending up, creating higher highs and higher lows but you see the MACD create a lower high, this indicates that momentum is slowing. This can be a signal to exit your long trade, or enter a short trade
Relative strength index (RSI)
You’ll have seen the Relative Strength Index referred to by its acronym, RSI. It’s a very popular and widely used momentum indicator developed by the famous technical analyst, Welles Wilder.
Here are your key RSI takeaways:
- It’s plotted below charts on a scale of 0–100
- It’s primarily a measure of how stretched a market is — either oversold or overbought
- Generally speaking, if the RSI falls below the 30 level, it’s considered oversold. This can be used as an opportunity to buy or exit your short position
- Above 70 would signal the market is overbought. This can be used as an opportunity to sell or exit your long position
Some interpretations say that it’s only when the trend’s shifted direction that the RSI enters into, and then comes back, from the overbought and oversold levels. For example, above 70 and then back below 70. Or down below 30 and then back above. Therefore until this happens, the trend should continue
Bollinger bands
Bollinger Bands are a channel indicator. We’ll touch upon them in this part of your lesson, but you’ll learn more about these in our next lesson ‘What are trading channels?’
They’re a set of price channels or envelopes around a simple moving average, plotted two standard deviations above and below the simple moving average.
The main two takeaways for your trading are:
- Bollinger Bands can indicate when a market is stretched in one direction — oversold in a bear trend, overbought in a bull trend.
The Bollinger Band ‘squeeze’ can indicate the potential for an upcoming breakout. Again, you can see more in our next lesson ‘What are trading channels?’
Directional movement index (DMI)
The Directional Movement Index (DMI) was also created by Welles Wilder and is a trend indicator.
The indicator has two lines — the positive directional movement line (+DI) and the negative directional movement line (-DI). You’ll notice how these lines are created when comparing previous highs and lows.
So, for example:
- When +DI is above -DI, this means the market is showing a more positive trend
- When +DI is below the -DI, the market is showing a more negative trend
The wider apart the +DI and -DI, the stronger the trend. But when these two lines crossover, it’s a signal that the trend could be shifting direction, as you’ll see in the image below.
Parabolic SAR (PSAR)
The Parabolic SAR or just SAR (where SAR stands for ‘stop and reverse’) is a trend indicator that’s mainly used to signal when a trend ends. The SAR is shown on charts as a series of dots above or below the current market price.
When the dots are below the current price, for example, this signals an up-trend.
So, of course, when the dots are above the current price, it signals a downtrend.
You’ll find that this tool is best used when a market is trending. It’s also an indicator used to exit trades — when the dots move from one side of the current price to the other. This signals that the trend may be over.
Traders often use this indicator to place their stop loss, moving it with the trend.
Stochastics
The Stochastic is a momentum indicator that you can use to signal the potential end to market direction. Rather than use it in a trending market, you’d find that the Stochastic is best used in a sideways market.
Your Stochastic key takeaways:
- It’s plotted as two lines below the chart on a scale of 0–100
- The Stochastic is a measure of how stretched a market is when it’s in a range environment
- A level above 80 would signal that the market’s overbought. Below 20 would tell you the market’s oversold
- If the two lines cross over above 80, it gives a sell signal, but if they cross over below 20, it indicates a buy signal
Pivot points
Pivot Points are trend indicators generated from calculations based on the high, low and closing prices from the previous trading day. Using these calculations, you can identify support and resistance levels and build your trading strategy around the recognised levels.
A very simple signal to see whether the market is showing bullish or bearish momentum is whether the price opens above or below the pivot point. Above and you would say the market is bullish on the day, below and you’d say the market was bearish.
So, by taking the high, low and close from the previous day, these are the calculations you’d use to establish your pivot points:
Pivot Point (PP) = (High + Low + Close)/ 3
Resistance 1= (PP × 2) − Low
Resistance 2= PP + (High−Low)
Support 1 = (PP × 2) − High
Support 2= PP−(High−Low)
For more on Pivot Points, explore our earlier lesson What is support & resistance in trading?
Our image illustrates Pivot Points in action.
Average true range (ATR)
The Average True Range is a volatility indicator (shortened to ATR) and is another developed by Welles Wilder. It’s usually calculated from the 14-day moving average of the True Range. The True Range is whatever is greatest of the following:
- Current high less the current low
- Current high less the previous close (absolute value)
- Current low less the previous close (absolute value)
Therefore, day 1 the greatest could be ‘a’, while day 2 could be ‘c’. The largest is taken from each day or period and then it’s averaged.
You’ll find that the ATR’s best used to reflect markets that are becoming more volatile. So, a higher or rising ATR would signal a market that’s seeing increased volatility. As a result, this may cause you to adjust your trading strategy.
You’ll also find it useful for swing, position and day traders when setting realistic price targets for trades.
Commodity channel index (CCI)
The Commodity Channel Index (or CCI) is another momentum indicator. It’ll help you identify when a market’s overstretched (overbought or oversold). You can also use the CCI to indicate trend force and direction.
In simple terms, it’s a calculation of how much the current price is deviating from the average price over a time frame (with 20 periods most commonly used).
As the indicator has no upper or lower boundaries, you’ll have to view overstretched conditions in a historical context. So, this means looking back at previous indicator readings to get a feel of when price reversed direction.
It’s important for you to understand that if the CCI moves from zero to above +100 this can be seen as an up-trend. You’d view zero to below -100 as the formation of a downtrend.
Trading indicators summary
We’ve built on the previous lesson on trading indicators by looking at how many types of trading indicators there are and the categories that each fall into.
We’ve also looked at the most commonly used trading indicators and explored each in detail. With this knowledge, you can use these indicators to improve your trading strategies, and most importantly, your trading results.
This should give you the confidence to go ahead and use these indicators to plot the future direction of price. These are normally considered secondary indicators when compared to those that are directly influenced by price. Using these are a good way of confirming your view or entry level. These are all available as MT4 indicators.
In our next lesson, we’ll explore the answer to the question ‘What are trading channels’?
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