Signal lines are used in technical indicators, especially oscillators, to generate buy and sell signals or suggest a change in a trend. Often times, signal lines are moving averages of a technical indicator, such as the moving average convergence-divergence (MACD) and stochastics oscillator.
A signal line is also commonly known as a "trigger line."
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 three- to nine-period moving average of the indicator values. These moving averages may be either simple moving averages (SMAs) or exponential moving averages (EMAs).
Signal lines may also be used to indicate a change in the momentum of a trend, or overbought or oversold conditions. For example, a price that's far higher than the signal line could suggest overbought conditions and vice versa for oversold conditions. It's also important to note that a signal line crossover may not indicate a definitive change in trend, but rather, just a change in the trend's momentum.
While signal lines can be used to generate a buy or sell signal, they're often used in conjunction with other forms of technical analysis, such as technical indicators, chart patterns, or candlestick patterns that provide confirmation. For example, traders may use pivot points to identify potential turning points and then look to MACD signal line movements as a confirmation of a reversal.
The stochastic oscillator is a great example of a signal line being used in a technical indicator. The indicator consists of a 14-period %K calculation and a 3-day simple moving average of the %K, known as the %D, which serves as the signal line.
Trade signals are generated using the following rules:
Let's take a look at an example of the stochastic oscillator with buy and sell signals plotted.
Traders may also look for confirmations in addition to the buy and sell signals generated by the stochastic oscillator. For example, they may look at candlestick patterns for confirmation that a downturn is imminent given the crossover of the signal line. Traders may also use these other forms of technical analysis to place stop-loss and take-profit orders since signal lines don't provide specific guidance in those areas.