Trading with indicators

The final part of the technical traders’ toolkit that we’re going to cover in this course is the technical indicator.

What are technical indicators?

Technical indicators are tools you can apply to a market’s chart that use mathematical calculations and formulas to give you extra insight into its price movements. Instead of relying on the patterns formed by an asset’s live price, they offer an additional dimension to assist in making trading decisions.

There are hundreds of technical indicators you can use when trading, and more are created all the time. However, they fall into two main categories: trending markets and non-trending markets.

Lots of traders will use technical indicators to refine their timing. Others will use them to determine the strength of prevailing trends, so they can decide whether the opportunity is worth the risk.

Essentially, most indicators take complex calculations and automate them on your chart. While the formulas themselves may be tricky to understand, the art is learning how to interpret the signals they generate.

Drawbacks of technical indicators

As technical indicators derive their figures from a market’s price, most will be ‘lagging’ or backwards-facing by their nature. By the time you come to apply their results to a live trade, the opportunity may have passed. Like any trading tool, they are not 100% effective and should be used with caution.

Plus, indicators are usually subjective – two traders may well derive completely different conclusions from the same one.

We’re going to take a look at three commonly used indicators in the next lesson, but before we do that let’s take a look at the most popular one of all: moving averages.

Moving averages

Moving averages (MAs) smooth out a market’s price movements over a given period so you can see through the noise and spot general trends. They are created by averaging out a market’s closing prices over a given number of sessions.

You can create a moving average for any timeframe you wish. A 20-day MA, for instance, will show you a market’s average price over the past 20 days. A five-day MA, on the other hand, averages out the last five days of price action.

Types of moving average

There are a few different types of MAs, which calculate averages in different ways. The two most popular, though, are simple moving averages (SMAs) and exponential moving averages (EMAs).

To calculate a market’s SMA, you divide the total of its closing prices over a given number of sessions by the number of sessions. So to calculate Amazon’s five-day SMA, you just take the sum of its closing prices over the last five days and divide the figure by five.

Calculating EMAs is a little bit more complicated, as they give more weight to price action that is closer to today’s date. Which means that EMAs generally react more quickly than other moving averages.

When you use a moving average on a chart, it will automatically recalculate for each new session. So you’ll see a trend line following your market’s price. The more days you include in the average, the further it will appear from the live price.

Trading with MAs

In general, a market may be considered bullish when it is trading above its MA, and bearish if it is below. However, there are a few other common signals that traders might look out for:

1. A buy signal if the moving average is rising and pointing up
2. A buy signal if the market closes above the moving average
3. A sell signal if the MA is falling and pointing down
4. A sell signal if the market closes below its MA

Moving average crossovers

One popular way to MAs is to watch for crossovers. This involves using two MAs at once:

• One is slower, meaning it has a long-term timeframe (say, 50 days or more)
• One is faster, meaning it has a short-term timeframe (15 days or less)

A crossover occurs when the faster MA crosses the long-term one. If it crosses from below to above (crosses up), then it is taken as a sign that the market is entering an uptrend. If it crosses from above to below (down), then a bear run may be on the cards.

The levels at which the lines cross may also become a new support or resistance area.

One drawback to using MAs is that they can be a heavily lagging indicator, as they require lots of past price data to function. Because of this, they may give false signals, when the market move you predicted using the indicator has petered out by the time you come to trade it.

MACD

As well as being used on their own, moving averages form the basis for several other indicators – including moving average convergence divergence, or MACD.

When you select MACD on a chart, it will appear in its own box, usually at the bottom. In the box, you’ll see three components:

• The MACD line, which is calculated by subtracting the market’s 26-period EMA from its 12-period EMA
• The signal line, which is a nine-day EMA of the MACD line
• A histogram, which measures the difference between the MACD line and the signal line

If the market’s 12-period EMA is above its 26-period EMA, then the MACD line will be positive. If its 26-period is above the 12-period EMA, then it will be negative.

Trading with MACD

There are three main signals that traders will watch for when using MACD: crossovers, zero-line crosses and divergences.

However, remember that an issue with MAs is that they can lag behind the market’s live price? Well MACD – which is essentially an average of MAs – can lag even more. So it is particularly important to watch for false signals and pay attention to your risk management when using it.