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Technical Indicators
Stock market traders who use technical analysis base most of their decisions on the information they derive from a stock's price chart. But analysts will also employ one or more technical indicators that can help define a stock's position or confirm a potential movement that may occur. Technical indicators are used for confirmation that a stock seems to be going in the direction anticipated or as a warning that it may be poised to move the other way.
There are hundreds of indicators available for use in the market today, a number that has been inflated over the last decade because of computers and the popularity of online trading. A hundred years ago such formulas and algorithms were unthinkable because of the difficulty in being able to quickly crunch the numbers. Such high level of math isn't a problem today, especially with the power that comes in every computer case.
There are four primary indicators used by traders as they conduct their technical analysis: moving averages, Bollinger Bands, MACD and stochastics. Each indicator has a specific task and fits with a specific type of strategy when it comes to buying and selling stocks and options.
- Moving averages: A simple moving averages shows the average value of a stock over a period of time, such as 200 days. An exponential moving average is weighted and puts more emphasis on the more recent activity. Moving averages can often be used to signal entries and exits into trades.
- Bollinger Band: Bands are plotted two standard deviations away from a simple moving average and are used to measure volatility. The bands widen during periods of greater volatility and tighten when things aren't as volatile. The closer the price is to the upper band, the more overbought the market, and the closer the price is to the bottom band, the more oversold the market.
- MACD: The MACD (moving average convergence divergence) shows the relationship between two moving averages of prices. There are three common methods used to interpret MACD, when the lines cross, when the price diverges from the price chart, and when it rises dramatically to indicate an overbought or oversold position.
- Stochastics: This indicator compares a stock's closing price relative to its range over a given period of time. It works best for stocks that are channeling sideways. The chart has two dotted lines at 20 percent and 80 percent, with anything above 80 considered overbought and anything below 20 considered oversold. This could potentially give a trader a signal to buy or sell a position.
The important thing is to find indicators that work with your own style of trading. For example, anyone who buys and sells trending stocks will have little use for Stochastics. Traders should avoid using too many indicators, as such strategy can lead to information overload and a "paralysis by analysis" mentality that clouds, rather than clears, the thinking process.
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