What is a Signal Line
Signal lines are used in technical indicators, especially oscillators, to generate buy and sell signals or suggest a change in a trend. They are called signal lines because when another indicator or line crosses them it is a signal to trade or that something potentially important is happening with the price of an asset. It could be that the price was trending, pulled back, and is now starting to trend or again, or it could signal that a new uptrend or downtrend is starting.
Signal lines are often moving averages of a technical indicator, such as the moving average convergence-divergence (MACD) or stochastic oscillator. The signal line is applied to the indicator to generate more trade signals than would be available without the signal line.
A signal line is also commonly known as a "trigger line."
- A signal line is not a technical indicator in and of itself.
- It is usually a moving average of an indicator that is applied to the indicator so that the signal line and indicator can cross to generate trade signals.
- Signal lines may be used in different ways for different indicators, but typically when the indicator crosses above the signal line it is interpreted as bullish for the price and when the indicator crosses below the signal line it is bearish for price.
The Formula For a Signal Line is
The signal line is not an indicator, therefore, it will be calculated differently for each indicator it is used in. This is because the creator of an indicator will often create a formula for the signal line when making the indicator. The signal line is part of the indicator.
Signals lines are usually simple calculations. For the example, the signal line for the MACD is a nine-period exponential moving average (EMA) of the MACD value.
The signal line for the stochastic oscillator is a three-period simple moving average (SMA) of the stochastic (called %K in this case).
How to Calculate a Signal Line
- Find the formula for the signal line of the indicator you are using. Typically the formula is an EMA or SMA of the indicator.
- Calculate the indicator or add it to a chart in charting software.
- Calculate the EMA or SMA of the indicator. Alternatively, apply the applicable moving average to the indicator on the chart to create the signal line.
What Does a Signal Line Tell You?
Signal lines can be applied to many different technical indicators, but the moving average convergence-divergence (MACD) and stochastic oscillators are the two most popular. Most signal lines are created by using a moving average of the indicator values. These moving averages are usually SMAs or EMAs.
Signal lines may also be used to indicate a change in the momentum of a trend. For example, if an indicator crosses above the signal line it indicates the price is starting to move up. If an indicator crosses below the signal line it indicates the price is starting to move down.
These signals are typically used in conjunction with other pieces of information. For example, if the price is visibly in a longer-term uptrend then a trader may consider only taking long trades on bullish crossovers. They may sell when there is a bearish crossover, but they wouldn't enter a short position because that would go against the longer-term uptrend.
Other pieces of information that signal line crossovers are often used in conjunction with include other forms of technical analysis, such as technical indicators, chart patterns, or candlestick patterns that provide confirmation. As another example, traders may use pivot points to identify potential turning points and then look to MACD crossovers for confirmation of a reversal.
The Difference Between a Signal Line and a Moving Average
A moving average can be the average of anything, but in technical analysis most people consider a moving average to be based on price or sometimes volume, such as the 200-day moving average of price. In most cases, a signal line is a moving average but is called a signal line instead of a moving average to help avoid confusion with the price-based moving averages. Signal lines are a moving average of an indicator calculation and are therefore used to generate trade signals for that indicator only.
Limitations of Signal Lines
Signal lines are usually just a moving average of an indicator. In this way, the signal line lags the movements of the indicator. As the indicator reacts to price changes it moves quicker than the signal line and this generates a crossover.
While signal lines can produce good signals at times, which result in large trend changes and price moves, many crossovers will be false signals. A false signal is when the indicator crosses the signal line but the price fails to move in the direction expected. The price may also crisscross the signal line, resulting in multiple signals which lose the trader money if the trade signals are traded.
For these reasons, signal line crossovers are rarely used in isolation. Other forms of technical or fundamental analysis are used to confirm trade signals or rule out taking certain signal line trades.