Technical indicators are used within technical analysis to gain insight into the supply and demand of securities. Indicators (such as volume) confirm price movement, and the probability that a price move will continue. The indicators can be used as a basis for trading, as they can form buy-and-sell signals. In this slideshow, we'll take you through seven common technical indicators that can help you round out your trading toolkit.
First up the on-balance volume indicator (OBV) is used to measure the positive and negative flow of volume in a security, relative to its price over time. It is a simple measure that keeps a cumulative total volume by adding or subtracting each period's volume, depending on the price movement. This measure expands on the basic volume measure by combining volume and price movement. The idea behind this indicator is that volume precedes price movement, so if a security is seeing an increasing OBV, it is a signal that volume is increasing on upward price moves. Decreases mean that the security is seeing increasing volume on down days.
One of the most commonly used indicators to determine the money flow of a security is the accumulation/distribution line (A/D line). It is similar to on-balance volume indicator but, instead of only considering the closing price of the security for the period, it also takes into account the trading range for the period. This is thought to give a more accurate picture of money flow than the balance volume. The line trending up is a signal of increasing buying pressure, as the stock is closing above the halfway point of the range. The line trending downward is a signal of increasing selling pressure in the security. (For additional reading, see Trend-Spotting With the Accumulation/Distribution Line.)
Average Directional Index
The average directional index (ADX) is a trend indicator used to measure the strength and momentum of an existing trend. This indicator's main focus is not on the direction of the trend, but on the momentum. When the ADX is above 40, the trend is considered to have a lot of directional strength - either up or down, depending on the current direction of the trend. Extreme readings to the upside are considered to be quite rare compared to low readings. When the ADX indicator is below 20, the trend is considered to be weak or non-trending. (For more, see ADX: The Trend Strength Indicator.)
The Aroon oscillator is a technical indicator used to measure whether a security is in a trend, and the magnitude of that trend. The indicator can also be used to identify when a new trend is set to begin. The indicator is comprised of two lines: an Aroon-up line and an Aroon-down line. A security is considered to be in an uptrend when the Aroon-up line is above 70 and above the Aroon-down line. The security is in a downtrend when the Aroon-down line is above 70 and above the Aroon-up line. (For more on this indicator, see Finding The Trend With Aroon.)
The moving average convergence divergence (MACD) is one of the most well-known and used indicators in technical analysis. It is used to signal both the trend and momentum behind a security. The indicator is comprised of two exponential moving averages (EMA), covering two different time periods, which help to measure momentum in the security. The idea behind this momentum indicator is to measure short-term momentum compared to long-term momentum to help determine the future direction of the asset. The MACD is simply the difference between these two moving averages, which (in practice) are generally a 12-period and 26-period EMA. (For more information, see Exploring Oscillators and Indicators: MACD.)
Relative Strength Index
The relative strength index (RSI) is used to signal overbought and oversold conditions in a security. The indicator is plotted between a range of zero-100, where 100 is the highest overbought condition and zero is the highest oversold condition. The RSI helps to measure the strength of a security's recent up moves, compared to the strength of its recent down moves. This helps to indicate whether a security has seen more buying or selling pressure over the trading period. (For more on this indicator, see Ride the RSI Rollercoaster.)
The stochastic oscillator is another well-known momentum indicator used in technical analysis. In an upward trend, the price should be closing near the highs of the trading range. In a downward trend, the price should be closing near the lows of the trading range. When this occurs, it signals continued momentum and strength in the direction of the prevailing trend. The stochastic oscillator is plotted within a range of zero-100, and signals overbought conditions above 80 and oversold conditions below 20. (For more, see Trading Psychology And Technical Indicators.)
Tools Of The Trade: Conclusion
The goal of every short-term trader is to determine the direction of a given asset's momentum and to attempt to profit from it. There have been hundreds of technical indicators and oscillators developed for this specific purpose, and this slideshow has just revealed the tip of the iceberg. Now that you have been acquainted with a few of the basic indicators used in technical analysis, you can go forward and learn more - you are one step closer to being able to incorporate powerful technical indicators into your own strategies.