By Cory Janssen, Chad Langager and Casey Murphy
Indicators are calculations based on the price and the volume of a security that measure such things as money flow, trends, volatility and momentum. Indicators are used as a secondary measure to the actual price movements and add additional information to the analysis of securities. Indicators are used in two main ways: to confirm price movement and the quality of chart patterns, and to form buy and sell signals.
There are two main types of indicators: leading and lagging. A leading indicator precedes price movements, giving them a predictive quality, while a lagging indicator is a confirmation tool because it follows price movement. A leading indicator is thought to be the strongest during periods of sideways or non-trending trading ranges, while the lagging indicators are still useful during trending periods.
There are also two types of indicator constructions: those that fall in a bounded range and those that do not. The ones that are bound within a range are called oscillators - these are the most common type of indicators. Oscillator indicators have a range, for example between zero and 100, and signal periods where the security is overbought (near 100) or oversold (near zero). Non-bounded indicators still form buy and sell signals along with displaying strength or weakness, but they vary in the way they do this.
The two main ways that indicators are used to form buy and sell signals in technical analysis is through crossovers and divergence. Crossovers are the most popular and are reflected when either the price moves through the moving average, or when two different moving averages cross over each other.The second way indicators are used is through divergence, which happens when the direction of the price trend and the direction of the indicator trend are moving in the opposite direction. This signals to indicator users that the direction of the price trend is weakening.
Indicators that are used in technical analysis provide an extremely useful source of additional information. These indicators help identify momentum, trends, volatility and various other aspects in a security to aid in the technical analysis of trends. It is important to note that while some traders use a single indicator solely for buy and sell signals, they are best used in conjunction with price movement, chart patterns and other indicators.
The accumulation/distribution line is one of the more popular volume indicators that measures money flows in a security. This indicator attempts to measure the ratio of buying to selling by comparing the price movement of a period to the volume of that period.
Acc/Dist = ((Close - Low) - (High - Close)) / (High - Low) * Period\'s Volume
This is a non-bounded indicator that simply keeps a running sum over the period of the security. Traders look for trends in this indicator to gain insight on the amount of purchasing compared to selling of a security. If a security has an accumulation/distribution line that is trending upward, it is a sign that there is more buying than selling.
Average Directional Index
The average directional index (ADX) is a trend indicator that is used to measure the strength of a current trend. The indicator is seldom used to identify the direction of the current trend, but can identify the momentum behind trends.
The ADX is a combination of two price movement measures: the positive directional indicator (+DI) and the negative directional indicator (-DI). The ADX measures the strength of a trend but not the direction. The +DI measures the strength of the upward trend while the -DI measures the strength of the downward trend. These two measures are also plotted along with the ADX line. Measured on a scale between zero and 100, readings below 20 signal a weak trend while readings above 40 signal a strong trend.
The Aroon indicator is a relatively new technical indicator that was created in 1995. The Aroon is a trending indicator used to measure whether a security is in an uptrend or downtrend and the magnitude of that trend. The indicator is also used to predict when a new trend is beginning.
The indicator is comprised of two lines, an "Aroon up" line (blue line) and an "Aroon down" line (red dotted line). The Aroon up line measures the amount of time it has been since the highest price during the time period. The Aroon down line, on the other hand, measures the amount of time since the lowest price during the time period. The number of periods that are used in the calculation is dependent on the time frame that the user wants to analyze.
An expansion of the Aroon is the Aroon oscillator, which simply plots the difference between the Aroon up and down lines by subtracting the two lines. This line is then plotted between a range of -100 and 100. The centerline at zero in the oscillator is considered to be a major signal line determining the trend. The higher the value of the oscillator from the centerline point, the more upward strength there is in the security; the lower the oscillator's value is from the centerline, the more downward pressure. A trend reversal is signaled when the oscillator crosses through the centerline. For example, when the oscillator goes from positive to negative, a downward trend is confirmed. Divergence is also used in the oscillator to predict trend reversals. A reversal warning is formed when the oscillator and the price trend are moving in an opposite direction.
The Aroon lines and Aroon oscillators are fairly simple concepts to understand but yield powerful information about trends. This is another great indicator to add to any technical trader's arsenal.
Moving Average Convergence
The moving average convergence divergence (MACD) is one of the most well known and used indicators in technical analysis. This indicator is comprised of two exponential moving averages, which help to measure momentum in the security. The MACD is simply the difference between these two moving averages plotted against a centerline. The centerline is the point at which the two moving averages are equal. Along with the MACD and the centerline, an exponential moving average of the MACD itself is plotted on the chart. The idea behind this momentum indicator is to measure short-term momentum compared to longer term momentum to help signal the current direction of momentum.
MACD= shorter term moving average - longer term moving average
When the MACD is positive, it signals that the shorter term moving average is above the longer term moving average and suggests upward momentum. The opposite holds true when the MACD is negative - this signals that the shorter term is below the longer and suggest downward momentum. When the MACD line crosses over the centerline, it signals a crossing in the moving averages. The most common moving average values used in the calculation are the 26-day and 12-day exponential moving averages. The signal line is commonly created by using a nine-day exponential moving average of the MACD values. These values can be adjusted to meet the needs of the technician and the security. For more volatile securities, shorter term averages are used while less volatile securities should have longer averages.
Another aspect to the MACD indicator that is often found on charts is the MACD histogram. The histogram is plotted on the centerline and represented by bars. Each bar is the difference between the MACD and the signal line or, in most cases, the nine-day exponential moving average. The higher the bars are in either direction, the more momentum behind the direction in which the bars point. (For more on this, see Moving Average Convergence Divergence - Part 1 and Part 2, and Trading The MACD Divergence.)
As you can see in Figure 2, one of the most common buy signals is generated when the MACD crosses above the signal line (blue dotted line), while sell signals often occur when the MACD crosses below the signal.
Relative Strength Index
The relative strength index (RSI) is another one of the most used and well-known momentum indicators in technical analysis. RSI helps to signal overbought and oversold conditions in a security. The indicator is plotted in a range between zero and 100. A reading above 70 is used to suggest that a security is overbought, while a reading below 30 is used to suggest that it is oversold. This indicator helps traders to identify whether a security's price has been unreasonably pushed to current levels and whether a reversal may be on the way.
The standard calculation for RSI uses 14 trading days as the basis, which can be adjusted to meet the needs of the user. If the trading period is adjusted to use fewer days, the RSI will be more volatile and will be used for shorter term trades. (To read more, see Momentum And The Relative Strength Index, Relative Strength Index And Its Failure-Swing Points and Getting To Know Oscillators - Part 1 and Part 2.)
The on-balance volume (OBV) indicator is a well-known technical indicator that reflect movements in volume. It is also one of the simplest volume indicators to compute and understand.
The OBV is calculated by taking the total volume for the trading period and assigning it a positive or negative value depending on whether the price is up or down during the trading period. When price is up during the trading period, the volume is assigned a positive value, while a negative value is assigned when the price is down for the period. The positive or negative volume total for the period is then added to a total that is accumulated from the start of the measure.
It is important to focus on the trend in the OBV - this is more important than the actual value of the OBV measure. This measure expands on the basic volume measure by combining volume and price movement. (For more insight, see Introduction To On-Balance Volume.)
The stochastic oscillator is one of the most recognized momentum indicators used in technical analysis. The idea behind this indicator is that in an uptrend, the price should be closing near the highs of the trading range, signaling upward momentum in the security. In downtrends, the price should be closing near the lows of the trading range, signaling downward momentum.
The stochastic oscillator is plotted within a range of zero and 100 and signals overbought conditions above 80 and oversold conditions below 20. The stochastic oscillator contains two lines. The first line is the %K, which is essentially the raw measure used to formulate the idea of momentum behind the oscillator. The second line is the %D, which is simply a moving average of the %K. The %D line is considered to be the more important of the two lines as it is seen to produce better signals. The stochastic oscillator generally uses the past 14 trading periods in its calculation but can be adjusted to meet the needs of the user. (To read more, check out Getting To Know Oscillators - Part 3.)
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