Understanding and using technical indicators is an important aspect to excel for trading in the stock market, particularly for a day trader and a short term trader. Most of the short term traders and especially day traders rely on the technical indicators for different signals of buys and sells. In this article, we will explain what are the technical indicators and how to use them in analyzing and finding signals in stock markets.
And also we will understand the difference between the leading and lagging indicators. How these two indicators are different from each other and how can one best use these indicators in different scenarios.
What are Technical Indicators?
The series of points that are arrived at after applying certain formulas on the price of the underlying security is called technical indicators. For example, if we are interested in the simple moving average indicator with a time period of 5 days, then we just take the closing price of the stock over the last 5 days and find the average of the price to arrive at the simple moving average point of that particular stock.
Usually, the price data include open, close, high and low price details. Few indicators only use the Closing price of the stock and few indicators also use the volume of the stock.
To arrive at the buy or sell signal, we cannot do that with just one indicator. We need two or three indicators clubbed together to identify the proper signals. For example, the simple moving average over a period of 5 days in the above gives just average price but nothing about a proper movement of the price of the stock nor it gives any buy or sell signals. We in fact need more than one signal combined to get proper signals. You can actually calculate the simple moving average over a period of time and plat a line graph to see what is the direction in which the price of the stock is moving. here we combined the simple moving average with the time period to get a directional movement of the stock.
Once a technical indicator is shown in graphical form, then the indicator along with the price of the stock will help in understanding the movement of the stock price.
Technical indicators provide us with a lot of information which just the price of the stock unable to provide. It makes us understand more depth about the movement of the price of the stock. Indicators are ranging from very simple such as Simple moving averages to complex ones such as Williams %r. The different indicator provides different information and by combining multiple indicators an investor can get a lot of information about the movement of the stock price. To say, technical indicators provide a unique perspective about the stock price which we will not get with just observing the stock price.
A technical indicator such as a Simple moving average helps us in understanding the smoothened movement of the price of the stock in times of high volatility and when the stock price is moving zigzag. It removes the noise out of the price movement and gives us a simple smoothened curve to understand the price movement of the stock.
Technical Indicators are also used in Algorithmic Trading and you can check all codes regarding Algorithmic trading in algorithmic section.
Why to use Technical Indicators
Technical indicators serve the purpose to study the price action more closely with more information presented. There can be a breakout from the support levels or a reversal from the resistance, these can be identified from the technical indicators and help to identify the proper signals for trading.
Combining multiple indicators we can confirm the movement and breakouts. For example, if there is a breakout from the support level, then the simple moving average crossover will help us in conforming to the trade direction.
Indicators will help us to study the historic price patterns and also predict future price movements based on the price patters in the past.
When dealing with the signal it is important to differentiate between the trend confirming signals and false signals. There may be may technical signals and these signals should be avoided. The chart patters have to be carefully observed to conclude the signal if is a proper signal or a false signal. The experience will help us in identifying those signals.
What are Leading Indicators
Leading indicators as the name suggest leads the price of the instrument. The indicator takes into account the price of the instrument over the past few days and calculates the indicator value based on the formula of different indicators. For example, a Stochastic oscillator with a 20day period will taking into account the closing price of the instrument for the last 20 days and calculates the indicator value right now. All price before that is not considered in the price calculation.
The most famous leading indicators are Momentum oscillators. Some of the more popular leading indicators include Commodity Channel Index (CCI), Momentum, Relative Strength Index (RSI), Stochastic Oscillator and Williams %R.
What are Lagging Indicators
Lagging indicators are also may be called price following indicators as these following the price as they happen and also referred to as Trend following indicators. Trend following indicators will work best when the market has a strong trend.
When there is a sideways market lagging indicators give complete or most of the false signals and is not suitable to use. Only in strong trending markets, the lagging indicators will give the proper singles to buy ad sell.
Some popular trend-following indicators include moving averages (exponential, simple, weighted, variable) and MACD.