What You Should Know About Technical Indicators

Publish date: Sun, 15 May 2016, 09:49 PM 

1. What You Use Technical Indicators For

So far, I have written about MACD and RSI. They are called technical indicators. But what do you use technical indicators for ?

Indicators serve three broad functions :-
(a) Alert - an indicator can act as an alert to study price action a little more closely. For example : If momentum is waning, it may be a signal to watch for a break of support at the price chart.
(b) Confirm - indicators can be used to confirm other technical analysis tools. For example : if there is a breakout on the price chart, a corresponding moving average crossover could serve to confirm the breakout.
(c) Predict - some investors and traders use indicators to predict the direction of future prices.  



2. Tips For Using Indicators

(a) Whenever Possible, Indicators Should Be Used In Conjunction With Price Charts - Sometimes traders ignore the price action of a security and focus solely on an indicator. Indicators filter price action with formulas. As such, they are derivatives and not direct reflections of the price action.
Any analysis of an indicator should be taken with the price action in mind. What is the indicator saying about the price action of a security ? Is the price action getting stronger ? Weaker ?

(b) Indicators' Behaviour Varies From One Stock To Another -  As always in technical analysis, learning how to read indicators is more of an art than a science. The same indicator may exhibit different behavioral patterns when applied to different stocks. Indicators that work well for Tenaga might not work the same for Datasonic (due to, amongst others, different volatility of the stock).
Through careful study and analysis, expertise with the various indicators will develop over time. As this expertise develops, certain nuances as well as favorite setups will become clear.

(c) Focus On Two To Three Indicators - There are hundreds of indicators in use today. Given the amount of hype that is associated with indicators, choosing an indicator to follow can be a daunting task. 
Attempts to cover more than five indicators are usually futile. It is best to focus on two or three indicators and learn their intricacies inside and out.
Try to choose indicators that complement each other, instead of those that move in unison and generate the same signals. For example, it would be redundant to use two indicators that are good for showing overbought and oversold levels, such as Stochastics and RSI.



3. Leading Vs. Lagging Indicators

There are two types of Technical Indicators - leading and lagging.

Leading Indicators
As their name implies, leading indicators are designed to lead price movements. Most represent a form of price momentum over a fixed look-back period. Some of the more popular leading indicators include Momentum, Relative Strength Index (RSI) and Stochastic Oscillator.

Because they generate more signals, leading indicators are best used in trading markets (neither bull nor bear). In a strong trend, leading indicators might generate many signals that are not valid. 

Lagging Indicators

As their name implies, lagging indicators (MACD, moving averages, etc) follow the price action and are commonly referred to as trend-following indicators. Lagging indicators tend to generate signals too late. They work best when the stocks develop strong trends. They are designed to get traders in and keep them in as long as the trend is intact.
These indicators are not effective in trading or sideways markets. If used in trading markets, trend-following indicators will likely lead to many false signals and whipsaws. 



4. The Trend Is Your Friend, It Is Dangerous To Fight It

When the trend is strong, banded oscillators (for example : RSI) can remain near overbought or oversold levels for extended periods. An overbought condition does not indicate that it is time to sell, nor does an oversold condition indicate that it is time to buy. In a strong uptrend, an oscillator can reach an overbought condition and remain so as the underlying security continues to advance. 

Similarly, in a strong downtrend, an oscillator can reach an oversold condition and remain so as the underlying security continues to decline.

EG Industries is one good example. During the period from November 2015 until early January 2016, the stock was in a bullish trend. During that period, its RSI indicator flashed Overbought 5 times, yet the price did not come down until the fifth signal.

As a general principle, try to AVOID trading an oscillator signal AGAINST the market trend. 

For example : During bull market, you should try to use RSI to detect Oversold so that you can buy. Avoid using RSI to detect Overbought to sell during that time.

By the same token, during bear market, RSI should be used to detect Overbought so that you can sell. Avoid using RSI to detect Oversold to buy during that time.