In-depth Analysis

5 technical indicators every trader should know about

To make your trading decisions, you can either rely on technical analysis, fundamental analysis, sentiment analysis or a combination of these types of market analysis.

If you want to rely on technical analysis, you will certainly use drawing tools, chart patterns, and technical indicators.

Based on mathematical formulas, technical indicators often use the price or trading volume of an asset over a period of time to highlight the trend, momentum, extreme price situations, potential trend reversal zones, and divergences among other market situations.

Let’s discover 5 of the most popular technical indicators in this article.

1. Moving Average (MA)

What is it?

Through their formula, moving averages smooth the prices of an asset to provide an average price. Because they ignore the “market noise” that often influences an asset over the short-term, moving averages allow its users to quickly visualize the main trend of an asset.

When prices are above the moving average, then the overall trend is bullish. On the other hand, when prices are below the moving average, the primary trend is bearish. Sometimes, traders open trading positions when prices cross up (buy) or down (sell) its moving average.

Moving averages are also used to provide support and resistance zones, as they represent an average price to which an asset tends to regress towards.

They can also be used in a trading system to provide trading signals. Usually, such a trading system includes a short and a long moving average. When an asset’s short-term moving average drops below its longer-term one, then it’s a sell signal – this figure is called a death cross. Conversely, when an asset’s short-term moving average breaks above its longer-term one, then it signals a potential upcoming bullish market – this figure is called a golden cross.

While the simple moving average (SMA) represents the average price over a period of time, the weighted moving average (WMA) and the exponential moving average (EMA) give more weight to the most recent prices.

Therefore, the WMA and the EMA are much more sensitive and responsive moving averages than the SMA, which means that they follow prices more closely and potentially give more trading signals.

What does it look like?

Daily EUR/GBP chart and the 3 types of Moving Averages – ActivTrader Platform

Daily EUR/USD chart with a 50-period SMA – ActivTrader Platform

Pros

  • One of the most popular trend-following technical indicators that can also provide support and resistance zones, as well as trading signals.
  • Very easy to use and integrate into any trading strategy.
  • Very flexible indicator, as there are 3 types of moving averages you can configure however you want.
  • You can use them on all markets and with all types of trading styles (scalping, day trading, swing trading, etc).

Cons

  • Lagging indicator.
  • Indicator that can provide false trading signals, depending on the parameters used.
  • Better used in combination with chart patterns.

2. Relative Strength Index (RSI)

What is it?

The Relative Strength Index, or RSI in short, is used to visualize overbought and oversold situations allowing traders to better identify moments of momentum and trend changes.

When an asset’s price enters extremely bullish (RSI>70) or bearish (RSI<30) price situations, traders can look for other signals to confirm that prices are expected to move back toward a mean value after a trend reversal. Usually, investors wait for prices to exit extreme zones to open a position.

The neutral level of 50 is also often used to determine the overall trend. When the RSI is above the 50-level, prices are considered bullish. On the other hand, when the RSI is below the 50-level, prices are considered rather bearish. Some traders wait for the RSI to cross above or below the 50-level to enter the market.

What does it look like?

Daily NZD/USD chart with a 14-period RSI – Bullish and Bearish Reversals & Bullish Divergence – ActivTrader Platform

Pros

  • One of the most popular ways to spot overbought and oversold prices that might reverse.
  • Moments when prices exit extreme zones can provide strong trading signals.
  • Technical indicator very easy to use in every market and with any type of trading strategy.
  • Divergences can provide signals of an upcoming reversal. They occur when prices and the mathematical indicator are moving in opposite directions.

Cons

  • Can provide false trading signals.
  • Being in extreme overbought or oversold situations doesn’t mean that prices will automatically reverse, as they can sometimes stay there for a while if the trend is strong.

3. Bollinger Bands (BB)

What is it?

Bollinger Bands are a dynamic volatility indicator that allows traders to identify situations where an asset might be too expensive/cheap and about the reverse towards a more average price.

Bollinger Bands are price envelopes formed by adding and subtracting two standard deviations from a simple moving average, forming an upper band and a lower band. While the area formed by the two bands is considered a “normal” movement, when prices approach and cross the upper/lower bands, then it means that they might be overbought/oversold and that they might reverse towards the moving average.

The moving average can act as a key level for some traders that will open long/short positions when prices cross up/down the middle band.

As a volatility indicator, the Bollinger Bands can be used to visualize the strength of an asset’s price volatility by looking at the distance between the upper and the lower band. If the Bollinger Bands are wide, then it means that the volatility is important. On the other hand, when the bands are narrow, then it means there is low volatility.

When the bands are narrow – which is called a “squeeze”, the likelihood of a significant upcoming price movement is higher. If you want to take advantage of those moments, then you have to look for a market situation where prices move closer to the moving average.

What does it look like?

Weekly EUR/CAD chart – Bullish and Bearish Reversals & Squeeze – ActivTrader Platform

Pros

  • One of the most popular volatility indicators.
  • A rather simple trading tool to use in order to determine entry/exit points when prices touch/exit the bands.
  • Also used to spot overbought and oversold conditions that might lead to a trend reversal.

Cons

  • Lagging indicator because of the moving average use.
  • Other trading and technical tools are often used in combination with Bollinger bands, as trading signals this indicator provides aren’t reliable enough to be used alone.
  • It can provide false trading signals, as prices do not always reverse when touching/exiting the bands.

4. Moving Average Convergence Divergence (MACD)

What is it?

The Moving Average Convergence Divergence, or MACD in short, is a trend and momentum indicator based on the convergence and divergence of the two moving averages to provide indications of a price change direction more quickly than with the classic moving average.

When the MACD line is positive and ascending, the uptrend is usually strong – the steeper the MACD, the stronger the uptrend. On the other hand, when the MACD is negative, then the downtrend is strong – the steeper the slope of the line, the stronger the downtrend.

The indicator is composed of a MACD line (difference between 2 exponential moving averages), a signal line (EMA of the MACD line), and a MACD histogram to visualize more quickly the distance between the two lines of the indicator.

Traders will use the two lines’ crossover as trading signals. When the MACD line crosses the signal line on the upside, it is considered a buy signal. Conversely, when the MACD line crosses down the signal line, then it indicates a bearish movement and is considered a sell signal.

A trading signal can also be used when the MACD line crosses the central or base line of 0. A buying signal will occur when the MACD crosses up the base line, while a selling signal will happen when the line crosses down the 0 line.

To get an idea of the strength of the momentum, you can monitor the distance between the MACD and the signal lines.

The further apart they are, the stronger the momentum is. Conversely, the closer they are, the more it can signal a weakening trend and a potential reversal. You can also use the histogram to spot such situations. If the histogram is getting closer to the base line, then it means that both lines are getting closer and vice-versa.

What does it look like?

Weekly USAIND chart – MACD – ActivTrader Platform

Pros

  • Great momentum and trend indicator.
  • Simple and widely used by all types of traders.
  • Flexible trading tool that can be used with any trading style and financial markets.
  • Divergences can provide reversal trading signals.

Cons

  • Lagging indicator.
  • Can provide false trading signals.
  • Relatively short-term indicator.

5. Average Directional Index (ADX)

What is it?

You’ve probably heard the saying “the trend is your friend’, which means that traders should be trading in the direction of a trend, rather than against it. Being able to take advantage of strong trends also usually reduces global risk, while increasing overall profitability.

The Average Directional Index, or ADX in short, is a technical indicator used by traders to determine the strength of a trend or momentum, regardless of the price direction. A falling ADX doesn’t necessarily imply a trend reversal, it only means that the current trend is weakening.

Usually, an asset is believed to be trending when the ADX is above 25. On the other hand, there is no trend – or a weak one – when the ADX is below 20. The trend is strong, very strong and extremely strong, when the ADX is respectively between 25 and 50, between 50 and 75 and between 75 and 100.

It’s important to highlight that a non-trending asset doesn’t mean that its prices aren’t moving. It could simply mean that there might be a trend inversion or that the direction of the asset isn’t clear enough.

Two accompanying indicators are often used with the ADX line: the negative directional indicator (-DI), or movement (-DM), and the positive directional indicator (+DI), or movement (-DM), which gives information about the direction of the trend.

Prices generally move upward when the +DM is above the -DM, while they’re moving downward when the -DM is above the +DM.

You can use crossovers as trading signals. For instance, if the +DI line is above the -DI, while the ADX is above 20 or 25, then it is a potential buy signal. Conversely, if the +DI line is below the -DI, while the ADX is above 20 or 25, then it is a potential sell signal.

What does it look like?

Daily AUD/USD chart – ADX & DMI – ActivTrader Platform

Pros

  • Easy indicator to understand and use.
  • The ADX is a great indicator to quantify the strength of a trend.
  • The +DM and -DM lines are useful to spot the direction of the trend.
  • It is possible to visualize both bulls’ and bears’ strengths at the same time if the -DI) and the +DI lines are also added to form a trading system.
  • Divergences can provide reversal trading signals.

Cons

  • Can provide false signals, as crossovers can happen frequently and result in confusion.
  • Is more relevant when used in trending markets.

 

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