If you're just about to give the stock market a try as an investment or earning option, you are probably coming across the phrase technical indicators in most of your research efforts. Alternatively, if you're already trading, you probably are using at least one if not more technical indicators to predict stock prices.
Technical indicators are to traders what makeup is to models and shovels are to gardeners. They are essential tools of the trade. Technical indicators assist traders in predicting stock prices. Correct predictions can in turn translate to profits. There are various types of indicators that can be segregated in varying manners but today we are going to look at indicators through the lens of leading indicators, which attempt to predict prices and lagging indicators which look at historical prices.
Leading indicators - in the words of traders - lead the trend. They are like the proverbial crystal ball - telling the trader what is about to happen.
Conversely, traders utilise lagging indicators to confirm that a price change is indeed a trend or a pattern.
Lagging indicators can be categorized into
Relative Strength Indicators
Similarly leading indicators can be categorized into
Mean Reversion Indicators... and
There are also volume indicators, which can fall into either category depending on where their use is employed. They basically look at aaaallll the trading happening on the market and will give the trader a clear answer as to whether he is dealing with a bull market or a bear market. In layman's terms that means that volume indicators tell the trader whether people are buying aggressively thereby driving prices up or selling aggressively, thereby driving prices down. Experts recommend using volume histograms to examine current levels of interest as well as using them to evaluate averages over a period of say 30 days or 50 days to compare current levels of interest to levels of interest over the rest of the 30-day or 50-day period.
Let's take the other 4 one by one, starting with…
….the two lagging indicators named a few minutes ago.
Momentum Indicators give traders an idea of the speed of or the length of intervals between price changes. Quicker price changes obviously mean higher volatility. Momentum indicators will for example prompt traders as soon as a histogram arrives at the peak price and then starts descending. Similarly they will prompt traders when a histogram reaches a trench and then starts ascending. Momentum indicators not only take the interval between price changes into consideration but also the degree to which the stock price had changed. As a result the trader can make an informed guess about the interval and degree of the next price change. He or she can plan his trade accordingly and attempt to make a profit by buying at at stock price level that comes just before the trend reverses to ascend and selling at a stock price level that comes just before the trend reverses to start descending - simply put he can plan to buy at the lowest price and sell at the highest price.
Relative Strength Indicators or RSI tell traders whether a given stock or security is overbought or oversold. Simple demand-supply-economics-related logic will tell you that anything overbought will see a consequent inflation in price whereas anything oversold will see a corresponding decrease in place. Rationalisation of demand is bound to occur and price correction is sure to occur along with it.
Now that we have dealt with lagging indicators let us also wrap our heads around the two leading indicators discussed earlier.
… Starting with
...Mean reversion indicators, which are basically Bollinger Bands which measure how far a stock price travels from its average during a set period. This allows the trader to better set buy and sell prices as well as stop loss orders. Once a trader has a idea that say XYZ stock price will not increase beyond than Rs 3 over a two week period and will not decrease more than Rs 2 during the same period he is able to set prices and stop losses accordingly.
Last but most certainly not the least in any way we have trend indicators which are actually the most popular. If you have conducted any research at all you would have heard of moving averages and exponential moving averages which give traders an idea of where a price trend is by displaying an average of all prices during a given period. Simple moving averages, also referred to as moving averages usually look at shorter term averages while exponential moving averages look at medium to long term average prices.
While all of these indicators are stellar tools to help you make more informed trading decisions they do not negate the need for experience, practice and risk management. No matter how "sure" something seems, based on the information given by your technical indicators, it is always possible for the market to move differently. Make sure you have a diversified portfolio and that you have distributed your capital such that you are not taking more risk than you can manage. What works for the rest of the world need not necessarily work for you. Also, set up stop losses no matter of how sure you are. Always stay cautious.