Looking at a stock chart, you may be playing connect-the-dots with all the lines crisscrossing the display. But fear not, my fellow traders, those lines are technical indicators – the secret sauce to analysing price movements of securities.
What is an indicator in the stock market?
Indicators are a trading wizard’s toolkit built on preset logic to boost your technical study and make buying, selling, confirming trends, and predicting them easier. There are two types of indicators: leading and lagging.
Leading indicators like to play it fast and loose, signalling a reversal or new trend in advance. However, they can be quite the trickster, leading you astray with false signals.
Lagging indicators, on the other hand, are the tortoise to the hare – they take their time and signal after the event has already happened. But don’t underestimate the value of a good lagging indicator like moving averages.
Momentum measures the rate at which prices change and can be crucial in identifying trends and making trading decisions. A high momentum indicates a faster rate of price change, while a low momentum indicates a slower rate of price change.
By understanding momentum, traders can gain insights into the strength and direction of trends. Exploring various types of indicators can help you identify the ones that work best for your individual trading strategies.
Let’s delve into the different types of technical indicators to find the one that works best for you.
Moving Averages
Moving averages are one of the simplest yet most powerful tools in a trader’s arsenal. They help you visualise the average price of a stock over a certain period, smoothing out the noise and revealing the underlying trend. Here’s how they work:
There are two main types of moving averages: Simple Moving average (SMA) and Exponential Moving Average (EMA). Let’s take a closer look at each of them.
Simple Moving Average (SMA)
A Simple Moving Average (SMA) is the simplest and most commonly used moving average. It is calculated by adding the prices of an asset over a specified period and dividing the sum by the number of periods. The formula looks like this:
SMA = Sum of Prices / Number of Periods
Let’s calculate the 10-day SMA of a stock. We add up the stock prices over the past 10 days and divide by 10. Here’s an example:
Day 1: Rs 10
Day 2: Rs 12
Day 3: Rs 14
Day 4: Rs 16
Day 5: Rs 18
Day 6: Rs 20
Day 7: Rs 22
Day 8: Rs 24
Day 9: Rs 26
Day 10: Rs 28
SMA = (10+12+14+16+18+20+22+24+26+28)/10 = Rs 19
So, the 10-day SMA of this stock is Rs 19.
As new prices come in, the oldest price is dropped, and the newest price is added, creating a “moving” average.
The interpretation of SMA is straightforward – it provides a general idea of the stock’s price direction over time. Traders use it to identify potential price reversals or confirm the trend of a stock. For example, if the current price of a stock is trading below its 50-day SMA, it suggests a bearish trend, while a price above its 200-day SMA suggests a bullish trend.
However, SMA has its limitations. It can be influenced by outlier events or market noise, which can skew the results. This is where the smoothed moving average comes in.
Exponential Moving Average (EMA)
A smoothed moving average, or EMA, is another type of moving average that is commonly used in technical analysis. It gives more weight to recent prices compared to older prices, making it more responsive to current price movements. The formula for calculating EMA is a bit more complex than SMA, but here it is:
Exponential Moving Average (EMA)
EMA = (Current Price * (2 / (Number of Periods + 1))) + (Previous EMA * (1 – (2 / (Number of Periods + 1))))
Let’s calculate the 10-day EMA of a stock. We start by calculating the SMA for the first 10 days. Then, we use the formula above to calculate the EMA for Day 11 and beyond. Here’s an example:
Day 1-10: SMA = Rs 19
Day 11: Price = Rs 30, EMA = (30 * (2 / (10 + 1))) + (19 * (1 – (2 / (10 + 1)))) = Rs 23.09
Day 12: Price = Rs 32, EMA = (32 * (2 / (10 + 1))) + (23.09 * (1 – (2 / (10 + 1)))) = Rs 25.26
Day 13: Price = Rs 28, EMA = (28 * (2 / (10 + 1))) + (25.26 * (1 – (2 / (10 + 1)))) = Rs 25.03
So, the 10-day EMA of this stock on Day 13 is Rs 25.03.
If the stock price is above both the SMA and EMA, it’s a bullish signal – meaning that the stock will likely continue its upward trend.
If the stock price is below both the SMA and EMA, it’s a bearish signal – meaning that the stock is likely to continue its downward trend.
If the stock price is between the SMA and EMA, it’s a neutral signal – meaning that the stock is not showing a clear trend.
This makes it a more reliable tool for traders, particularly those who trade on shorter timeframes.
Relative Strength Index (RSI)
The RSI, aka Relative Strength Index, is an indicator created by J.Welles Wilder that helps traders predict a trend reversal. It’s like a crystal ball for the market, but instead of showing the future, it oscillates between 0 and 100 and gives you an idea of what to expect based on the latest reading.
Now, don’t let the name fool you. It’s not comparing the strength of two securities. Instead, it’s like an internal strength meter for a particular security. RSI is the go-to leading indicator for sideways and non-trending markets, and it’s the bee’s knees of all the indicators.
The RSI is calculated using the following formula:
RSI = 100 – [100 / (1 + (Average Gain / Average Loss))]
To simplify this formula, we can break it down into its basic components. The RSI compares a security’s average gains and losses over a specified period, typically 14 days. The formula calculates the average gain and average loss separately and then plugs them into the larger equation to arrive at the final RSI value.
The RSI formula can make your head spin, but the objective is simple: identifying oversold and overbought price areas. When a stock is overbought, the positive momentum is high and could be corrected soon. When it’s oversold, the negative momentum is high, and a possible reversal is on the horizon.
The RSI ranges from 0 to 100 and measures the strength of a stock’s price action over a certain period. Here’s how it works:
If the RSI is above 70, the stock is considered overbought, meaning it may be due for a price correction or reversal.
If the RSI is below 30, the stock is considered oversold, meaning it may be undervalued and due for a price bounce.
If the RSI is between 30 and 70, the stock is considered neutral, meaning it’s not showing a clear overbought or oversold signal.
You can also interpret RSI in many other ways besides the classic interpretation. For instance, if the RSI stays in the overbought region for an extended period, look for buying opportunities instead of shorting.
If the RSI stays in the oversold region for a long time, look for selling opportunities rather than buying. If the RSI breaks out of the oversold zone after being there for an extended time, it may indicate a good opportunity to go long.
Conversely, if the RSI breaks out of the overbought zone after being there for an extended time, it may indicate a good opportunity to go short.
To gain an advantage as a trader, you must analyse and adopt strategies that work best for you. Keep in mind that using a shorter lookback period to calculate the RSI will increase the volatility of the indicator.
Moving Average Convergence and Divergence (MACD)
In the late 70s, Gerald Appel created the Moving Average Convergence and Divergence (MACD) indicator. Despite being created in the disco days, the MACD still reigns supreme as one of the most reliable indicators for momentum traders.
Its name is pretty self-explanatory, as it measures the convergence and divergence of two moving averages. When the moving averages get closer to each other, it’s called convergence, and when they move away, it’s divergence.
It consists of two lines, the MACD line and the signal line, as well as a histogram that measures the distance between the two lines.
Here’s the formula for the MACD indicator:
MACD Line = 12-period Exponential Moving Average (EMA) – 26-period EMA
Signal Line = 9-period EMA of the MACD Line
Histogram = MACD Line – Signal Line
We subtract the 26 EMA from the 12-day EMA to estimate the Convergence and Divergence (CD) value, which we plot on a simple line graph called the MACD line.
The signal line generates trading signals when it crosses above or below the MACD line.
When the histogram is positive, it indicates that the MACD line is above the signal line, which is bullish. When the histogram is negative, it indicates that the MACD line is below the signal line, which is a bearish signal.
A positive MACD value indicates upward momentum, while a negative MACD value indicates downward momentum.
The magnitude of the MACD value is also important, as it tells you how strong the trend is. For instance, a MACD of -90 indicates a stronger downward trend than a MACD of -30. However, the magnitude can also be influenced by the price of the stock – higher-priced stocks tend to have higher magnitudes.
It’s worth noting that the MACD indicator works best when there’s a strong trend and isn’t particularly helpful when the market is moving sideways. And don’t forget that the MACD’s parameters aren’t set in stone – you can change the time frames of the two EMAs to suit your preferences.
Bollinger Bands
Bollinger Bands is used to measure a security’s volatility. It consists of three lines: a simple moving average (SMA) in the middle, and an upper and lower band.
The upper band is created by adding a multiple of the standard deviation (SD) of price movement to the SMA, while the lower band is created by subtracting the same multiple of SD from the SMA.
Here’s the formula to calculate the Bollinger Bands:
- Middle Band (MB): 20-day Simple Moving Average (SMA)
- Upper Band (UB): MB + (2 x 20-day SD of price)
- Lower Band (LB): MB – (2 x 20-day SD of price)
Now, don’t be intimidated by the term “standard deviation.” It’s a fancy way of saying how much a stock’s price varies from its average. The higher the standard deviation, the more volatile the stock. See, not so scary after all!
The Bollinger Bands indicator uses the SD to determine the width of the bands.
So, if the middle line (20-day SMA) is at 7800 and the standard deviation is 75, we can calculate the upper and lower bands. The upper band would be 7950 (7800 + (752)), while the lower band would be 7650 (7800 – (752)).
Now that we have our bands, what do they mean? When the current market price is near the upper band, the stock is considered expensive compared to the average. This is a signal to sell, with a target price of 7800.
On the other hand, when the price is near the lower band, the stock is considered cheap compared to the average. This is a signal to buy, with a target price of 7800.
But wait, there’s more! The upper and lower bands also act as triggers for initiating a trade. When the price touches the upper band, it’s time to short the stock and expect it to revert to its average price. When the price touches the lower band, it’s time to go long and expect the price to bounce back up to the average.
However, it’s important to note that BB works best in sideways markets and can fail in trending markets. The BB’s upper and lower bands expand when the price drifts in one direction for an extended period, indicating strong momentum. This is called an envelope expansion and can cause BB signals to fail.
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