In this article we will take a look at the primary type of indicators technical analysis relies on to try to determine the trend of the market and the strength and viability of that trend. These technical indicators can be broken up into two broad categories:
- Trend following
- Oscillator or momentum indicators.
Trend following indicators are used to identify the direction of the market. Oscillator or momentum indicators are mainly designed to identify the strength of the current trend in the market. The most commonly used trend following indicators include moving averages, MACD, basic trend lines, gaps, and Bollinger bands.
The primary goal in using a moving average is to try to determine the direction of the market's trend. Moving averages provide the trader with objective buy and sell signals. The two key concepts when using moving average analysis are a crossover and support resistance. Crossover is exactly what it sounds like, crossover occurs when two moving averages intersect. We will discuss support and resistance in greater detail in later articles.
Let's take a look at how the moving average is used.
In the graph below the crossover of the 15 day and 50 day moving average signaled the beginning of uptrend. The 50 day moving average tracked the uptrend and the average is used to find support. A trader would look to buy the market when the averages cross over. A trader would also look to the longer term moving average for support within a trend.
An uptrend may be confirmed when a short-term moving average crosses above the long-term and that short-term moving average remains above that long-term. Conversely a downturn may be confirmed when short-term moving average crosses below the long-term and remains below that long-term moving averages.
Another technical indicator that traders use is MACD (Moving Average Convergence / Divergence). MACD is a trend following momentum indicator that plots the relationship between two moving averages of prices. When using MACD you will be looking for the crossover of the two moving averages: the fast and slow exponential moving averages of closing prices. The computer will plot this for you so you don't have to worry about calculating the actual the moving average yourself. A buy signal occurs when the faster line crosses above the slower and both lines are below zero. A sell signal takes place when the faster line crosses below the slower from above the zero line. MACD is basically plotting a moving average of another moving average.
Here is an example of how you would use MACD by looking for a downward crossover or upward crossover of the MACD. In this example the downward cross signaled a turn down in trend. The upward cross signaled the reversal to an uptrend.
Moving averages and the MACD are useful tools for deciding a trading strategy, are very popular in Forex trading and work best when the markets are in strong up or downtrend.
Another popular technical indicator used to try and determine trend is gap analysis. A gap is simply space left on a bar chart were no trading has taken place. There are two main types of gaps that are important for you to look for in a chart pattern. The first is a down gap. The down gap is formed with the highest price of the day is lower than the lowest price of the prior day. Down gap is generally a sign of market weakness .Second is an up gap. An up gap is the opposite of a down gap and is generally a sign of market strength.
Here is an example of a down gap and up gap in the market price direction. The market changed direction in reaction to the price gaps. The first gap is down gap and signaled a change in trend. The second gap was a breakaway gap and confirmed a reversal of downtrend. As a general rule the trader would go with the direction of the gap.
Another technical indicator that you should be aware of that is similar to moving averages and focuses on moving average envelopes is Bollinger bands. Bollinger bands are often looked to for forecasting of reversals in non-trending markets and are also used in ranging market.
Here is an example of Bollinger bands
There are different ways that you can use Bollinger bands, one is to buy the market when the price touches the lower Bollinger band and look to exit your trade and price touches the moving average in the center of the bands. Another way to use Bollinger bands is to buy on the price breaks above the upper Bollinger band or sell when prices fall below the lower Bollinger band.
We have discussed the major indicators used to identify trend analysis lets shift gears and talk about oscillator and momentum indicators.
Oscillator or momentum indicators are mainly designed to identify the strength of the current trend in the market. The most common oscillator and momentum indicators are RSI or relative strength stochastics volume, momentum, and SAR.
RSI or relative strength is a technical indicator used to measure whether the market is overbought or oversold. The RSI can generally be used to complement other technical indicators as a gauge of strength of the underlying price action. Trading signals based on RSI are best when the RSI is at an extreme either above 80 or below 20 on the RSI index.
Here is an example of RSI
In this example of RSI the index is trading near 80. This may be a warning that the uptrend is about to reverse. Trading signals based on RSI are best when the RSI is an extreme either above 80 or below 20. So based on RSI you would be looking to sell this market. When RSI moves above or below 50 it can also be used to confirm trend. Above 50 may confirm uptrend and below 50 a downtrend in prices.
Next let's take a look at stochastics. Stochastic is an oscillator that determines where the most recent closing price is relative to its price range for given time. The idea behind this indicator is that prices tend to close near their past highs in bull markets, and near their lows in bear markets. Signals can be spotted when the stochastic oscillator crosses its moving average. Stochastic indicators are favored for use in range bound market.
Here is an example of what you would be looking for in using the stochastic indicator. It is similar to the RSI indicator. The circled areas would be signals for buy and sell levels.
Keeping in mind that we're looking at these indicators to try to determine the strength of a market trend there are two additional indicators that can help you determine the strength or weakness of the market these indicators are volume and momentum.
Volume is simply the number of contracts traded in a given market. The higher the volume during a price trend the more likely the move will be sustained and significant.
Here is an example of how volume was increasing as the market declined. The increase in by them confirmed the downtrend in the market.
Momentum measures the rate of change of a currency pair. You can look at the momentum indicator to see if momentum continues with the market price action. If there is a diversion between market price action and momentum this may be a signal that the trend is weakening or about to reverse.
Take a look at this example where the peak in momentum signaled a peak in the market rally during the 09 10 period. Momentum troughs and peaks can be used to confirm buy and sell signals.
So far we have mainly discussed how to use technical indicators to identify trend and to measure the strength of the trend. Now let's take a look take a look at an indicator that may be used to try to spot reversal of trends.
SAR or stop and reversal is a parabolic indicator that may be used for setting of stops and trying to spot trend reversals. Note in the graph below SAR parabolic places dots on the chart to indicate potential reversals in price movement. A dot above the bar is a sell signal; a dot below the bar is a buy signal.
Here is an example of how SAR track short-term reversals in the recent price daily price will action in the-year-old currency.
Summary
This finishes our discussion on technical indicators and how they may be used by you to spot trends and trading opportunities Traders will use one or more of these technical indicators or combination of these indicators to try to determine a trend and the strength of the trend. Moving averages, MACD, trendline analysis, gaps and Bollinger bands are used to identify trend. RSI, stochastics, volume and momentum are mainly used to look at the strength of the trend. SAR works best for placing stops and trying to spot reversals in established trends.
The first step would be to pull up a line or bar chart and look to draw trendlines and channels. This would be used to identify market direction. The second step, plot a moving average or MACD analysis. This would be used for timing of trade entry and trend recognition. The third step, set up a momentum indicator like RSI or stochastic to look for possible reversal of trend will you or timing of entry or exit of the trade. The fourth step, look at volume indicators to measure the strength or weakness of the trend. A fifth step, look for gaps, as a sign of possible trend change. Step six, set up Bollinger bands looking for support resistance at the high and low the bands. And finally as a seventh step if the trend is well-established, look at SAR to spot possible trend reversal and help with placement of stops. |
