Introduction on how to be a good traders----Part 3

Here comes the part 3 on Technical Indicators

Indicators are calculations based on the price and the volume of a security that measure

such things as money flow, trends, volatility and momentum. Indicators are used as a

secondary measure to the actual price movements and add additional information to the

analysis of securities. Indicators are used in two main ways: to confirm price movement

and the quality of chart patterns, and to form buy and sell signals.

There are two main types of indicators: leading and lagging. A leading indicator precedes

price movements, giving them a predictive quality, while a lagging indicator is a

confirmation tool because it follows price movement. A leading indicator is thought to be

the strongest during periods of sideways or non-trending trading ranges, while the

lagging indicators are still useful during trending periods.

There are also two types of indicator constructions: those that fall in a bounded range and

those that do not. The ones that are bound within a range are called oscillators - these are

the most common type of indicators. Oscillator indicators have a range, for example

between zero and 100, and signal periods where the security is overbought (near 100) or

oversold (near zero). Non-bounded indicators still form buy and sell signals along with

displaying strength or weakness, but they vary in the way they do this.

The two main ways that indicators are used to form buy and sell signals in technical

analysis is through crossovers and divergence. Crossovers are the most popular and are

reflected when either the price moves through the moving average, or when two different

moving averages cross over each other. The second way indicators are used is through

divergence, which happens when the direction of the price trend and the direction of the

indicator trend are moving in the opposite direction. This signals to indicator users that

the direction of the price trend is weakening.

Indicators that are used in technical analysis provide an extremely useful source of

additional information. These indicators help identify momentum, trends, volatility and

various other aspects in a security to aid in the technical analysis of trends. It is important

to note that while some traders use a single indicator solely for buy and sell signals, they

are best used in conjunction with price movement, chart patterns and other indicators.

MACD: The moving average convergence divergence (MACD) is one of the most well

known and used indicators in technical analysis. This indicator is comprised of two

exponential moving averages, which help to measure momentum in the security. The

MACD is simply the difference between these two moving averages plotted against a

centerline. The centerline is the point at which the two moving averages are equal. Along

with the MACD and the centerline, an exponential moving average of the MACD itself is

plotted on the chart. The idea behind this momentum indicator is to measure short-term

momentum compared to longer term momentum to help signal the current direction of

momentum.

MACD= shorter term moving average - longer

term moving average

When the MACD is positive, it signals that the shorter term moving average is above the

longer term moving average and suggests upward momentum. The opposite holds true

when the MACD is negative - this signals that the shorter term is below the longer and

suggest downward momentum. When the MACD line crosses over the centerline, it

signals a crossing in the moving averages. The most common moving average values

used in the calculation are the 26-day and 12-day exponential moving averages. The

signal line is commonly created by using a nine-day exponential moving average of the

MACD values. These values can be adjusted to meet the needs of the technician and the

security. For more volatile securities, shorter term averages are used while less volatile

securities should have longer averages.

Another aspect to the MACD indicator that is often found on charts is the MACD

histogram. The histogram is plotted on the centerline and represented by bars. Each bar is

the difference between the MACD and the signal line or, in most cases, the nine-day

exponential moving average. The higher the bars are in either direction, the more

momentum behind the direction in which the bars point

As you can see in below figure, one of the most common buy signals is generated when

the MACD crosses above the signal line (blue dotted line), while sell signals often occur

when the MACD crosses below the signal.

RSI (Relative Strength Index): It is another one of the most used and well-known

momentum indicators in technical analysis. RSI helps to signal overbought and oversold

conditions in a security. The indicator is plotted in a range between zero and 100. A

reading above 70 is used to suggest that a security is overbought, while a reading below

30 is used to suggest that it is oversold. This indicator helps traders to identify whether a

security’s price has been unreasonably pushed to current levels and whether a reversal

may be on the way 

The standard calculation for RSI uses 14 trading days as the basis, which can be adjusted to meet the needs of the user. If the trading period is adjusted to use fewer days, the RSI will be more volatile and will be used for shorter term trades Stochastic Oscillator The stochastic oscillator is one of the most recognized momentum indicators used in technical analysis. The idea behind this indicator is that in an uptrend, the price should be closing near the highs of the trading range, signaling upward momentum in the security. In downtrends, the price should be closing near the lows of the trading range, signaling downward momentum. The stochastic oscillator is plotted within a range of zero and 100 and signals overbought conditions above 80 and oversold conditions below 20. The stochastic oscillator contains two lines. The first line is the %K, which is essentially the raw measure used to formulate the idea of momentum behind the oscillator. The second line is the %D, which is simply a moving average of the %K. The %D line is considered to be the more important of the two lines as it is seen to produce better signals. The stochastic oscillator generally uses the past 14 trading periods in its calculation but can be adjusted to meet the needs of the use

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