What are technical indicators, and how can you use them in your trading strategy?

Written by: Aubrey Hayward | Expert Financial Writer

Technical indicators analyse current and past market data to help predict future pricing trends. They are mathematical calculations based on multiple factors such as historical price data and trading volumes, with the outcome then plotted across a chart. They can form an important part of a trader’s technical strategy, enabling price predictions to be refined and improved through deeper understanding of a market’s behaviour.

In this article, we will delve deeper into the key categories of trading indicators, such as momentum and trend indicators, and look at some specific examples.

How leading and lagging technical indicators differ

Leading and lagging indicators are essential tools in technical analysis to assess market trends. Leading indicators signal potential future market movements, while lagging indicators confirm trends based on historical data. Traders rely on both to better understand market behaviour and improve decision-making.

Leading technical indicators

Leading indicators, also known as momentum indicators, use past price data to forecast potential market movements, ‘leading’ the price. These tools help traders anticipate price changes, enabling them to act early by entering or exiting positions before a trend takes off.

• Common uses: Identifying overbought or oversold conditions to pinpoint entry and exit points.
• Risks: While they offer predictive power, leading indicators often produce false signals. This is why traders often pair them with lagging indicators for validation.

The leading indicator line displays the market's rise and fall before the actual price change, as seen in the image below. Because of this, leading indicators usually determine if the market is overbought or oversold, which aids traders in deciding when to enter or exit the market.

Examples:

• Stochastic oscillator
• Fibonacci retracements
• Relative strength index (RSI)

Lagging technical indicators

Lagging indicators, also known as trend indicators, analyse historical price data to confirm existing trends and their strength. They are slower to react, as they ‘lag’ behind price action, but they can provide traders with greater confidence by reducing the risk of acting on false signals.

• Advantages: Useful for trending or volatile markets, offering reliability in confirming trends.
• Drawbacks: Because they react after price changes, traders may miss the early part of a move, potentially sacrificing profits.

The image below shows that the lagging indicator appears after the price changes. This implies that anyone watching the market will see the price movement before the indicator validates it.

Examples:

• Moving averages
• Bollinger bands
• Moving average convergence divergence (MACD)

Use both for a balanced strategy

A well-rounded trading approach combines both leading and lagging indicators. Leading indicators predict market moves, while lagging indicators confirm trends, creating a comprehensive system for identifying opportunities and managing risks.

The most common leading technical indicators in trading

Relative strength index (RSI)

The relative strength index (RSI) is a popular technical analysis indicator that acts as an oscillator, measuring current price strength relative to historical prices. As a momentum indicator, the RSI measures the amplitude of recent price moves, providing information about market trends and future price reversals. It serves several uses, including:

• Generating buy and sell signals
• Tracking price direction
• Identifying overbought and oversold conditions
• Alerting traders to potential trend reversals

Key RSI levels and signals

• Overbought zone (>70): RSI values above 70 may suggest an asset is overbought and about to reverse or pull back.
• Oversold zone (<30): RSI levels below 30 indicate undervaluation and likely upward reversal.
• Buy signal: This occurs when the RSI crosses above the 30 line.
• Sell signal: Occurs when the RSI falls below 70.

Customising the RSI period

The default RSI setting is based on a 14-day timeframe; however, traders can change it to fit their strategies:

• Shorter durations (eg 7 days): Increase the RSI's sensitivity, resulting in more frequent buy and sell signals.
• Extended periods: Smooth out fluctuations to reduce the quantity of signals.

RSI behaviour in market trends

• Uptrending markets (bullish): RSI typically fluctuates between 40 and 90, with the 40-50 zone as a support level. During a strong rally, an asset may remain overbought for extended periods.
• Downtrending markets (bearish): The RSI runs from 10 to 60, with the 50-60 zone as a resistance indicator. During long-term downtrends, assets may remain oversold.

By analysing these RSI patterns and levels, traders can make more educated judgements on market entry and exit points, tailoring the indicator's parameters to their trading style and market conditions.

Moving average convergence divergence (MACD)

The moving average convergence/divergence (MACD) indicator is a momentum-based tool used in trend trading. While it is classified as an oscillator, it is not commonly used to determine overbought or oversold conditions. On a chart, it appears as two lines that vary without any limitations. The crossing of these two lines produces trading indications comparable to a dual moving average method.

• A MACD crossing above the zero line is a bullish signal, indicating upward momentum. Conversely, a cross below the zero line is seen as bearish, signalling downward momentum. Additionally, when the MACD turns upward while below the zero line, it suggests a potential bullish trend. On the other hand, when it turns downward while above the zero line, it indicates a possible bearish trend.
• When the MACD line moves from below to above the signal line, it is viewed as a bullish indicator; the strength of the signal increases further below the zero line, where the crossover occurs. Conversely, when the MACD line crosses from above to below the signal line, it is considered bearish, with the signal being stronger the further above the zero line, the crossover occurs.
• In trading ranges, the MACD often produces whipsaw signals, with the fast line repeatedly crossing above and below the signal line. During such periods of uncertainty, traders typically refrain from acting on MACD signals or close existing positions to minimise portfolio volatility.
• The divergence between the MACD and price action becomes more robust when it aligns with and reinforces the MACD crossover signals.

Bollinger bands

Bollinger bands are a widely used technical analysis tool that helps traders evaluate price volatility and identify potential buy or sell signals. The main components are a simple moving average (SMA) and a price volatility measure based on standard deviations (SD).

Components of Bollinger bands

• Simple moving average (SMA): The SMA is calculated by summing up the closing prices over a specific period and dividing by the total number of periods. For instance, a 20-day SMA is determined by adding the closing prices of the past 20 days and dividing the result by 20.
• Standard deviation (SD): The standard deviation measures the degree of price variability around the average, quantifying volatility. It is typically calculated using the same period as the SMA.
• Upper and lower bands: The upper band is created by adding a set number of standard deviations (commonly two) to the SMA, while the lower band is formed by subtracting the same number of standard deviations from the SMA. This results in a channel that adjusts dynamically as volatility increases or decreases.

Unique features

Bollinger bands stand out by integrating a trend measure (via the SMA) and a volatility measure (via standard deviations). This dual approach makes them particularly effective for identifying:

• Periods of high or low volatility: The bands expand during high volatility and contract during low volatility.
• Potential price reversals: Extremes in price movement, where the price approaches or exceeds the bands, can indicate overbought or oversold conditions.

Visual and strategic use

As a visual indicator, Bollinger bands make observing dynamic volatility changes on a price chart easy. Traders often analyse:

• Band width: The distance between the upper and lower bands signals volatility.
• Price position relative to the bands: To assess potential trends or reversals.

Stochastics

The stochastic oscillator is a popular technical analysis tool to gauge market momentum and identify potential buy and sell signals. It compares an asset's current closing price to its price range over a specific time. The underlying principle is that closing prices tend to be near the upper end of the range during bullish trends, while in bearish trends, they are closer to the lower end.

How the stochastic oscillator works

• The stochastic oscillator appears on charts as two lines:
  • The oscillator line: Represents the calculated value of the indicator.
  • The signal line: A moving average of the oscillator line, providing smoother signals.

• These lines oscillate between 0 and 100, with key levels:
  • Above 80: Indicates overbought conditions.
  • Below 20: Indicates oversold conditions.

Key signals

• Buy signal: When the oscillator crosses above the 20 level, it may signal a buying opportunity.
• Sell signal: When the oscillator falls below 80, it may suggest a selling opportunity.

Additional insights

• Divergence analysis: If the oscillator trends upward while the price trends downward (or vice versa), it could signal an impending price reversal.
• Momentum and price relationship:
  • If the stochastic indicates the price is near the top of its range and momentum is slowing, it suggests the trend may weaken and reverse.
  • Conversely, if the price is near the bottom of its range and momentum increases, the trend may strengthen and continue.

Average true range (ATR)

The average true range (ATR) is a technical analysis indicator that measures market volatility by calculating the average of an asset's actual price ranges over a specified period. It accounts for price gaps and fluctuations, making it a reliable tool for understanding market dynamics.

Key features of ATR

Calculation periods:

• The standard ATR calculation uses 14 periods, but traders can adjust the timeframe based on their needs:
  • Shorter periods (2–10): Capture recent volatility.
  • Longer periods (20–50): Measure long-term volatility.

Interpretation:

• Expanding ATR: Indicates increased market volatility, with more extensive price ranges per bar. A price reversal accompanied by a rising ATR signals the movement's strength.
• Contracting ATR: Suggests reduced volatility, often seen during sideways or consolidating markets.

Directional neutrality:

• ATR does not indicate trend direction; it only measures the degree of volatility. An expanding ATR may result from either buying or selling pressure.

High and low ATR values:

• High ATR values: Often occur after sharp price movements (upward or downward) and may not last long.
• Low ATR values: Typically appear during extended periods of minimal price movement or consolidation, signalling reduced market activity. This can indicate the potential for a continuation or reversal.

Practical uses of ATR

Volatility-based stops and entry points:

• ATR is a valuable tool for setting stop-loss levels or determining entry triggers. Unlike fixed dollar or percentage stops, ATR-based stops adapt to market conditions, accounting for volatility changes.
• A common approach is to use a multiple of ATR, such as 1.5 x ATR, to accommodate sharp price movements or breakouts.

Trend confirmation:

• Expanding ATR values during a trend suggests strong momentum while contracting ATR values during consolidation might precede a breakout or reversal.

The most common lagging indicators

Standard deviation indicator (SDI)

How to use SDI in trading

Measuring volatility:

• Standard deviation relates the spread of price movement to its moving average.
• High standard deviation signifies a broader spread between the price and its moving average, reflecting heightened volatility and dispersed price bars.
• Low standard deviation indicates a smaller spread between price and its moving average, reflecting reduced volatility and tightly clustered price bars.

Interpreting price behaviour:

• Price moves with rising standard deviation suggest above-average strength or weakness in the market.
• Calm markets see a standard deviation decline as price activity stabilises.

Market insights through standard deviation

Market tops:

• Increased volatility (short term): Reflects nervousness and indecision among traders.
• Decreased volatility (long term): Indicates a maturing bull market, often signalling stability.

Market bottoms:

• Decreased volatility (long term): Suggests disinterest and boredom, characteristic of market stagnation.
• Increased volatility (short term): Often results from panic selloffs, signalling a potential reversal or capitulation.

Fibonacci retracement

Fibonacci retracement: for identifying support and resistance

The Fibonacci retracement tool is a widely used technical analysis indicator that identifies potential support and resistance levels based on the mathematical relationships within the Fibonacci sequence. These retracement levels provide insights into possible price objectives and turning points in the market.

How Fibonacci retracement works

Drawing the tool:

• A trendline is drawn between two extreme price points, such as a significant high and low.
• The tool plots six horizontal lines at the Fibonacci levels: 0.0%, 23.6%, 38.2%, 50%, 61.8%, and 100%. These levels represent percentages of the retracement between the selected high and low points.

Support and resistance levels.

• Key levels (23.6%, 38.2%, 50%, 61.8%): These levels often act as support or resistance, allowing the price to pause or reverse.
• Prices frequently retrace a portion of the previous trend before resuming in the original direction, often aligning with Fibonacci levels.

How to use Fibonacci retracement in trading

Support and resistance identification:

• Traders use the retracement levels to anticipate areas where price corrections may occur.
• These levels can also serve as entry or exit points depending on market direction.

Trend continuation:

• In an uptrend, prices may return to a Fibonacci level before resuming the upward move.
• In a downtrend, prices may retrace to a Fibonacci level before continuing lower.

Calculating Fibonacci levels

The Fibonacci sequence is a series of numbers where each is the sum of the two preceding ones: 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, and so on.

The retracement levels are derived from the ratios within this sequence:

• 23.6%: Derived from dividing a number by two places forward (eg 21 ÷ 89 ≈ 0.236).
• 38.2%: Derived from dividing a number by three places forward (eg 21 ÷ 55 ≈ 0.382).
• 61.8% (golden ratio): Derived from dividing a number by the next in the sequence (eg 21 ÷ 34 ≈ 0.618).

Average directional index (ADX)

Understanding the average directional index (ADX)

The average directional index (ADX) is a short-term technical indicator that can be applied to any market condition, including bull and bear markets or periods of high and low volatility. It measures the strength of a trend, irrespective of its direction, by averaging the values of directional movement (DM) lines over a specified period. These DM lines are calculated using the current high and low prices.

Key features of ADX

Range of values:

• ADX fluctuates between 0 and 100, similar to indicators like RSI and stochastics.
• Readings above 25 generally indicate a strong trend.
• Readings below 20 suggest the absence of a trend.
• Readings between 20 and 25 are often considered neutral and lack a clear interpretation.

Strength vs direction:

• The ADX line measures the trend's strength.
• The two accompanying lines, DMI+ (DI+) and DMI- (DI-) determine the trend's direction:
  • If DMI+ is above DMI-, the trend is positive (uptrend).
  • If DMI- is above DMI+, the trend is negative (downtrend).

Interpreting ADX signals

Rising ADX line:

• Indicates a strengthening trend, regardless of its direction.
• Trend-following strategies, such as moving averages or channel breakouts, will likely perform better when ADX rises.

Falling ADX line:

• Suggests the existing trend is weakening or the market is becoming range-bound.
• Trend-following systems may yield less reliable signals in these conditions.

Uncommon readings:

• ADX readings above 60 are rare but indicate powerful trends.

Example (above) and insights

• In the provided example:
  • The ADX line is at 27, suggesting a current strong trend.
  • However, the ADX has recently trended lower, signalling potential short-term weakness in the uptrend despite stocks hitting all-time highs.
  • If the ADX falls below 25, it might confirm further trend weakening.

How to use ADX effectively

Supplementing fundamentals:

• ADX should be used alongside a broader investing framework grounded in fundamentals, such as the global economy and business cycles.

Monitoring for conflict:

• While the ADX is painting a bullish picture, conflicting signals—such as a falling ADX in a rising market—should be carefully analysed for signs of underlying weakness.

Bullish and bearish trends:

• Combine the ADX line's strength readings with DMI+ and DMI- to confirm trend direction:
  • A strong uptrend is indicated when ADX rises and DMI+ > DMI-.
  • A strong downtrend is indicated when ADX rises and DMI- > DMI+.

Ichimoku cloud

Understanding the ichimoku cloud indicator

The ichimoku cloud, also known as ichimoku kinko hyo, is a comprehensive technical analysis tool combining support, resistance, momentum, and trend information into a single chart view. It uses five distinct plots an a ‘cloud’ (the area between Senkou A and Senkou B) to provide insights into market trends and potential trading signals.

Key components and calculations

TenkanSen (conversion line):

• Calculation: (High+low)/2 over a default period of 9.
• Role: A short-term indicator similar to a moving average.

KijunSen (base line):

• Calculation: (High+Low)/2 over a default period of 26.
• Role: A medium-term indicator used alongside TenkanSen.

Chiku Span (lagging span):

• Calculation: The closing price shifted back 26 bars.
• Role: A lagging indicator showing historical price trends.

Senkou A (leading span A):

• Calculation: (TenkanSen+KijunSen)/2, shifted forward 26 bars.
• Role: Forms the upper boundary of the cloud during an uptrend.

Senkou B (leading span B):

• Calculation: (High+Low)/2 using a period of 52, shifted forward 26 bars.
• Role: Forms the lower boundary of the cloud during an uptrend.

Using the ichimoku cloud for trend analysis

Relationship between TenkanSen and KijunSen:

• When TenkanSen rises above KijunSen, it signals a positive trend.
• When TenkanSen falls below KijunSen, it signals a negative trend.

TenkanSen and KijunSen relative to the cloud:

• If both are above the cloud, the trend is positive.
• If both are below the cloud, the trend is negative.

Price position relative to the cloud:

• Prices above the cloud indicate an uptrend.
• Prices below the cloud indicate a downtrend.

Senkou A and Senkou B:

• When Senkou A is above Senkou B, the uptrend is strengthening.
• When Senkou A is below Senkou B, the downtrend is strengthening.

Trading signals with the ichimoku cloud

Reinforced buy signal:

• This occurs when TenkanSen crosses above KijunSen, and all three—TenkanSen, KijunSen, and price—are above the cloud.

Reinforced sell signal:

• This occurs when TenkanSen crosses below KijunSen, and all three—TenkanSen, KijunSen, and price—are below the cloud.

Summary of the five plots in the ichimoku cloud

Simple moving averages (SMA) and exponential moving averages (EMA)

Understanding simple moving averages (SMA)

Simple moving averages (SMA) are fundamental tools in technical analysis used to analyse trends, smooth price data, and generate trading signals. The SMA is calculated as the average price of an asset over a specified period, with the value updated for each new bar on the chart. It is called ‘moving’ because it continuously adjusts as new data points are added.

Key Features of SMAs

Trend identification:

• Uptrend: The SMA is moving upward.
• Downtrend: The SMA is moving downward.
• Common timeframes:
  • 200-bar SMA: A proxy for the long-term trend.
  • 50-bar SMA: Indicates the intermediate trend.
  • Shorter SMAs (eg 20-bar): Reveal short-term trends.

Smoothing data:

• SMAs smooth price movements and indicators by averaging data points.
• Longer-period SMAs provide smoother lines but introduce more lag.
• Shorter-period SMAs react more quickly to price changes but may need to be smoother.

Price crossing SMA:

• A typical trading signal occurs when the price crosses the SMA:
  • Price above SMA: This may indicate a buying opportunity or a signal to cover short positions.
  • Price below SMA: This may suggest a selling opportunity or an exit from long positions.

SMA crossover strategy:

• Signals are generated when SMAs of different periods cross:
  • Short-term SMA crosses above long-term SMA: Go long (bullish signal).
  • Short-term SMA crosses below long-term SMA: Go short (bearish signal).

How SMAs work

The SMA is calculated as the mean (average) of prices over a specified period. For instance, a 50-bar SMA averages the closing prices of the last 50 bars, updating with each new bar to create a continuously moving line.

Practical applications of SMA

Identifying trend strength:

• The slope and direction of the SMA line help determine the prevailing trend's strength and duration.

Filtering noise:

• By smoothing out minor price fluctuations, SMAs help traders focus on the overall market direction rather than reacting to every price movement.

Triggering signals:

• Price-SMA interaction: A crossover between the price and the SMA often signals potential trend reversals.
• SMA-SMA interaction: A crossover strategy, such as the ‘golden cross’ (short SMA crossing above long SMA) or ‘death cross’ (short SMA crossing below long SMA), indicates possible entry or exit points.

Understanding exponential moving average (EMA)

The exponential moving average (EMA) is a type of moving average that, like the simple moving average (SMA), measures trend direction over a specified period. However, unlike the SMA, the EMA gives greater weight to more recent price data, allowing it to respond more quickly to price changes.

Key features of EMA

Faster responsiveness:

• Due to its weighted calculation, the EMA reacts more quickly to price movements than the SMA, helping to identify trends earlier.
• This increased sensitivity can be both an advantage and a drawback:
  • Advantage: Faster trend identification.
  • Drawback: Greater susceptibility to short-term price fluctuations and potential false signals.

Rules for interpretation:

• The same principles used to interpret SMAs apply to EMAs, focusing on their greater responsiveness to price changes.

How to use EMA in trading

Determining trend direction:

• Rising EMA: Indicates an upward trend; consider buying during dips near or below the EMA.
• Falling EMA: Signals a downward trend; consider selling during rallies near or above the EMA.

Support and resistance:

• A rising EMA often acts as a support level for price action.
• A falling EMA tends to act as a resistance level.
• This reinforces the strategy of buying near a rising EMA and selling near a falling EMA.

Timing and delays:

• Like all moving averages, the EMA does not identify price movements' exact tops or bottoms.
• It helps align trades with the overall trend but introduces some signal delay.
• Compared to the SMA with the same period, the EMA offers a shorter delay, making it more responsive.

Practical considerations

• Trade with the trend: use the EMA to confirm the prevailing trend and align trades in its direction.
• Balance sensitivity and stability: while the EMA provides earlier signals than the SMA, it may generate more noise in volatile markets. Combining it with other indicators can improve reliability.
• Dynamic support and resistance: incorporate the EMA's ability to act as a support or resistance level into your strategy to fine-tune entry and exit points.

Using technical indicators to trade strategically

Technical indicators are essential for traders, offering insights into market trends, momentum, and volatility. By combining leading and lagging indicators, such as RSI, MACD, Bollinger bands, and Fibonacci retracements, traders can develop a balanced strategy to identify potential opportunities and manage risks effectively. While these tools enhance decision-making, they should be used alongside a thorough understanding of market fundamentals and an awareness of the risks in trading. Tailoring these indicators to individual trading styles and objectives can lead to more informed and strategic trading decisions.