If you understand how technical indicators work, it will make your charts analysis a more enjoyable, and more of a research and discovery process instead of a mechanical one.
Now, there are indicators that can inform you of the trend in advance, and these are referred to as LEADING INDICATORS
Then there are indicators that analyze the past prices, and then give a signal. These signals are slightly late and such indicators are referred to as LAGGING INDICATORS.
However, many chartists prefer to slot technical indicators into the following categories:
TYPES OF TECHNICAL INDICATORS
- TREND INDICATORS
- MOMENTUM INDICATORS
- VOLUME INDICATORS
Some chartists worship any one type of indicator while others work with a combination of 2-3.
There is one more indicator type – VOLATILITY INDICATORS. However, some of the indicators in the three categories above help you see through volatility too and therefore I am not covering volatility indicators here.
This may put off intermediate analysts but this is a basic article intended for beginners.
Therefore, if you want to become a proficient chart reader, you should learn all types, and play around with combos until you discover that magic mix that works for you. Remember that we are now slotting indicators based on the 4 categories above, not as lagging or leading.
Before getting into different types of indicators, check this image out:
What do you conclude?
That 5 Minute, 15 Minute and 30 Minute Charts are bearish. The 1D chart may test a near term support. The 1 Week Chart is in an uptrend but is encountering stiff resistance at 10900 levels.
The lesson is that you must always check all chart periods regularly to figure out the larger and the smaller pictures before applying any indicator.
In the case above you know that the short term (1-2 days) indications are bearish and that the bearishness may continue if the Nifty breaks key support levels that you see in the 1 Day and 1 Week charts.
With that out of the way, let’s move to the different types of indicators:
A. TREND INDICATORS
Trend indicators help traders by showing the trend of the stock or the commodity.
Each indicator has its own peculiarities and you must understand all the key indicators mentioned below, at the very least.
WHEN THE MARKET IS IN A NARROW RANGE THERE ARE 50% CHANCES THESE INDICATORS CAN SIGNAL FALSE POSITIVES.
Some key indicators that will help you spot trends are:
Exponential Moving Averages (Crossovers)
B. MOMENTUM INDICATORS
These indicators measure the strength of the price movement. These indicators are also referred to as Oscillators.
Momentum Indicators can help you spot:
- Overbought and Oversold levels
- Shift in trend
- Bull Zone or Bear Zone
- Divergences (for example when price is rising but Momentum Indicator starts falling)
Some of the key Momentum Indicators are
C. VOLUME INDICATORS
Volume is an important component of trade and volume based indicators use price and volume to indicate to traders when heavy quantities are being lifted or sold.
Some of the key Momentum Indicators are:
Money Flow Index
Elder’s Force Index
Chaikin Money Flow
The Issue With Indicators
Traders want the right signals and they want these on time.
Therein lies the problem.
The issue is that indicators have a default period – for example, RSI is set at 14, CCI at 20, etc.
The 14 and 20 numbers imply that the indicator line is drawn based on the calculation of the prior 14 or 20 candles.
However, there is no fixed rule that either 14 or 20, or whatever, represent the Holy Grail.
Intra day traders who trade on 3 and 5 minute candles set their indicators to very low periods. For example they may set RSI to 7, CCI to 10, etc.
Herein lies the problem.
When the default period is lowered the numbers of signals increase, but the accuracy goes down.
When the default period is increased the the accuracy goes up, but indicator slows down and the signal is late (after the price action has happened) .
So there is a trade-off between sensitivity to price and accuracy of signal.
To overcome this issue, you have no option but to try different periods and practice. You also must flip through different time periods on a chart to understand the intra-day, short and medium term trends. Regular practice will help you get a deep understanding of how indicators work and within a month of regular practice, you will be able to determine periods that provide reasonably accurate signals.