In layman’s terms, technical indicators – also referred to as simply “technicals” – are nothing but short- to medium-term market trends used by stock technical analysts to predict future price movements in various stocks.
Technical indicators serve as an approximate guide for investors to help them identify stocks in which to invest and decide when to invest, as well as when to exit from them. Mathematically or technically speaking, they are graphical representations of the current market activity over a certain period of time in the recent past (say 30 days).
Deriving technical indicators
Technical indicators are derived from technical charts – which are graphical or pictorial representations of the market activity in terms of upward or downward movements in stock prices over a period of time, though some technical chart formations may also take into account trading volumes in the calculations. Mathematically, a technical chart is a plot of a set of price data (on the vertical axis) as a function of time (on the horizontal axis). The price data can include a stock’s opening price, closing price, day’s high or low price, average price, or a combination of these. The plotted data points on the chart can show as individual points or as small bars.
When all the data points on the chart are joined, a wave-like pattern is obtained, as shown in Figure 1. This pattern is then subjected to technical analysis by experts, who apply standard mathematical formulae to these price movements in order to arrive at technical indicators, from which they can predict the future market price of a stock or its market trend (upward/downward movement).
How do technical indicators help the investor/trader?
If you have watched the stock market action on a computer screen, you would have noticed that stock prices keep fluctuating almost every second and it is impossible to make head or tail of the pattern if all the price movements are planted on a chart. So, to smooth out the data, technical analysts plot any one of the high/low/open/close/average prices on the charts. This also helps in understanding the movements of an extremely volatile stock and then predicting its future price movement. The graph shown above is an example of a very volatile stock (YHOO) whose price data have been smoothed by employing the simple Moving Averages (MA) technical indicator. You will notice how the MA indicator has cut through the noise and established a smooth curve on the charts:
Apart from cutting through the noise generated by the price action, technical indicators also help an investor in the following
- They determine support and resistance levels. Even an amateur technical chartist can determine important technical levels, which when breached will take a stock’s price lower (support levels) or higher (resistance levels).
- Some indicators can help determine the future price of a share.
- Technical indicators help in establishing trends (upward or downward), which are critical for both traders and investors.
- Technical indicators always alert a technical analyst of any major price action/volatility is about to occur in a stock’s price. Even you will be able to interpret the alerts once you are through all the articles featured in this topic.
Types of technical indicators
There are many different types of technical indicators used by analysts to obtain their perspective on the potential market strength of a stock and the trend in its price action – leading indicators, lagging indicators, volume indicators, moving-averages indicators, momentum indicators or oscillators, to name a few. These form the subject matter of another chapter, but we would like to make briefly a special mention of oscillators here because recently momentum stocks and momentum trade have caught the fancy of most traders.
Oscillators are technical indicators that measure a stock’s momentum as it oscillates between an overbought and an oversold zone and then give a buy/sell signal. Oscillators work on a simple principle – when the price of a stock begins climbing, its price momentum moves fast, when the price drops, its momentum becomes slow, and when the price is flat, the momentum tapers off. An analysis of the momentum oscillators can indicate buy/sell signals. Oscillators may give a signal after the trend has begun, they can even point towards a trend that is about to happen, or they can signal that something untoward is happening within a trend.
A few words of caution
The best technical indicators are those that have in the past been tried, tested and proven successful. Nowadays, every other technical analyst develops a new technical indicator or oscillator regularly – our advice to you is to follow the tried and tested indicators.
Do not attempt to master all technical indicators and oscillators. Just pick up knowledge in about three of them. However, you can read through all the technical indicators and work with the ones you feel most comfortable about. Basically, you must master the technical indicators that reconcile with your investment style – short-term, long-term, momentum player, day trader, bull, bear, etc.
Also, do not analyse stock’s price by applying just one indicator – use about 2 or 3 complementary indicators, as using just one indicator may give you a false signal. Using 2–3 indicators can confirm the signals given by one indicator, but if you get a different signal from another complementary indicator then you must not rush into the trade.
With time you will develop the art of judging profitable trades using technical indicators. Do not expect to morph into an expert on day one and carry out trades based on a knee-jerk assessment. First put your new found knowledge to test and begin trading only if you’re proven correct most of the time.