To understand technical indicators, one needs to understand the basis of technical analysis. A very logical question about technical analysis is that how can you take a decision based on charts without looking at the business of the company and its prospects?
While the question is valid, the important point is the application of technical analysis and the philosophy of the underlying technicals. Technical analysis is based on the following key assumptions:
Market prices of stocks tend to reflect all that there is to be known about the stock. Hence, understanding price patterns is more important than trying to dig for value because the market is omniscient.
Past patterns in stock prices and volumes tend to repeat over time. That is because the psychology that underlies these patterns is determined by human behavior, which reacts similarly to different market triggers.
Investors are better off trying to understand the price patterns and extrapolate these price patterns into the future. These charts should, therefore, form the basis of your trading strategy.
Are technical charts totally smart; at least they are substantially smart!
What do charts do? Essentially, charts capture the mountains of intelligence on stocks through simple and elegant graphs. These graphs are further sliced to identify critical trends and turnaround signals.
We shall focus on four broad themes because each of these themes has a lot of sub-measures and strategies within them.
1. Leveraging the power of moving averages
You must have heard of statements on media and in technical reports that the index or the stock has breached the 100-DMA or the 200-DMA. What does DMA mean here?
Daily Moving Average (DMA) is one of the basic pillars of technical chart patterns for trading. The moving average is a rolling days’ average where the data points keep skipping and calculating. Popular moving averages are the 50-DMA, 100-DMA, and the 200-DMA. Moving averages are very useful in identifying the support and resistance levels of a stock, which enables you to fine-tune your buy or sell decisions. Averages can be simple (SMA) or exponential (EMA).
The DMA make it easy for a trader to identify trading opportunities within the overall direction of the market. Any technical trader can effectively use moving averages to identify the trend and also the critical levels to buy or sell the stock.
How do you trade when the stock takes support at 200-DMA? How do you design your strategy when the stock breaks above or below the 200-DMA? Each of these is a data point. DMAs are normally plotted along with the actual price line and it is the way these DMA lines intersect above or below the price lines that give you indications.
2. An oscillator called the Relative Strength Index (RSI)
The Relative Strength Index (RSI) is also called an oscillator. An oscillator helps the trader to identify whether the particular stock or contract is overbought or oversold. You must have head analysts saying that a particular stock is overbought at the current price. That means the stock could be ripe for a correction. Similarly, a stock that is oversold could be ripe for a bounce higher. Normally, stocks that are overbought tend to become a classic case for either selling or shorting and stocks that are oversold become candidates for buying.
When it comes to overbought and oversold stocks, the big question is not whether, but when. The timing of your entry and exit is what matters. The RSI answers this question. The RSI, being an oscillator, is plotted on a scale of 0-100. An RSI level of 100 indicates that the stock is extremely overbought, while a level of 0 indicates that the stock is extremely oversold.
Remember, that 100 and 0 are purely theoretical levels because the RSI for most stocks ranges between 30 and 70. Stocks or indices are considered to be oversold around the RSI of 30, while stocks are considered to be overbought around the RSI level of 70.
To get the maximum value for their trades, most traders will initiate buy trades around the RSI of 30 and sell trades around the RSI of 70.
3. Fine-tuning your oscillator indicator with Stochastics
The stochastic line, as it is popularly called, is an extension of the RSI indicator. The only difference here is that the stochastic also looks for a double indicator. Hence, for a trader looking to reduce risk, the stochastic becomes a more reliable indicator.
Stochastics also give indications of when a stock is overbought and when it is oversold. However, as stated earlier, the stochastic is more reliable and affirmative of these zones compared to RSI. The RSI does not look for double-confirmation before identifying overbought and oversold zones, whereas the stochastic actually gets a double-confirmation that the overbought and oversold zones are genuine and not a sucker’s trap.
The stochastic identifies the %K
line and the %D
line and uses crossover to identify oversold levels with greater conviction and precision. Even empirically, stochastic has a greater success rate compared to RSI.
4. MACD - Moving Average Convergence Divergence
MACD is referred to as the king of technical indicators since it encompasses moving averages and oscillators. MACD not only identifies the overbought and oversold zones in the chart but also identifies the right levels of entry and exit. MACD is very flexible and can be used in range-bound markets and also in trending markets.
How do you identify signals using MACD? Recognize the lines in relation to the zero line which identify an upward or downward bias in the stock price. Secondly, you try and identify the cross over or cross under of the red line and the blue line to get the appropriate trading signal.
There are many more complicated theories and approaches to technical charting, including Dow Theory, Gann theory, etc. But moving averages, stochastic, and convergence/divergence form the core of a chartist’s decision-making repertoire.