Summary
- Technical indicators are mathematical patterns found in securities that provide clues to which direction the price may be heading.
- Using a combination of indicators can generate signals for buying or selling a security.
- False signals are when the signal received is the opposite of what happens.
Technical Indicators are mathematical patterns found in securities that provide clues as to what direction their price may be heading next. The results of these calculations are to produce a signal to buy or sell a security. There are many indicators telling similar or different stories and typically you’ll use a combination of indicators instead of one alone. These are not guarantees to higher trading success or an easy wealth-building strategy. Like any new skill, it takes practice, research, and time to be good at it. Use these as part of your investment strategy and not your whole strategy.
Classes of Indicators include overlays, oscillators, cumulative, and indices. Indicators are shown graphically on a line chart accompanying the price chart. Most often you’ll see the price chart displayed using the candlestick format. Overlays are graphs that are plotted directly over the price chart. Oscillators will do exactly that and oscillate between local minimums and maximums, often between 0 – 100. Cumulative indicators provide running totals. An index is a measurement of something. These indicators will always line up with the same time intervals as the price chart.
The different types of indicators are trend following, momentum, volatility, volume, support/resistance indicators. A trend indicator can help determine when a trend may be changing directions. Momentum will measure how fast a stock’s price goes up or down. Volatility identifies high and low fluctuations in the price. Volume indicators measure the numbers of shares or contracts traded over a certain period. Resistance is an uptrend that pauses when it hits a ceiling level and may break through or come back down. Support is the opposite, a downtrend looking to pause when it hits a floor level that may break through or bounce back.
Leading vs. Lagging. Leading indicators are a predictive tool that can help provide insight into future performance, price movements, and market trends before they happen. Lagging indicators provides signals after a price move has already happened, confirming an existing trend rather than predicting one.
False Signals. Indicators are designed to provide a result that tells you what to expect from the price of a security. False signals occur when the indicator says the price is going to do one thing, but the economic reality does another. The idea is that you don’t use a single indicator alone to help you with trade decisions. You use one or more additional indicators to confirm what the other is telling you. On the other hand, you don’t want to use too many resulting in multicollinearity which is when you have at least 2 indicators that provide the same information, so it doesn’t benefit you by using them together. In fact, it could be harmful because you’re now waiting for too many indicators to trigger possibly missing opportunities.
Overall, technical indicators are helpful tools to aid your trading decisions. You can rely solely on them or combine them with other methods. As in all investing, take caution as nothing is ever guaranteed. I recommend practicing using them in different scenarios, with different types of securities, and back test to understand the security’s history and how it reacts under various market conditions. Learn as much as you can and then apply to the real world.
