Top-7 technical indicators every trader should know

Unlike fundamental analysis, which studies the company through analysis of various data points like sales, profits, financial statements, etc, technical analysis is the method of forecasting the future movement of the price through an examination of historical data of price and volume.

The application of technical analysis does not result in absolute price predictions, but it can help investors and traders to anticipate what is likely to happen to prices over time. It involves an analysis of market actions that have various data points like historical price data, volumes and other derivative data like open interest, etc.

Technical analysis provides the tools to help navigate the gap between intrinsic value and market price across all asset classes through a systematic and disciplined approach to the market behaviour and the law of supply and demand.

Let us examine a few technical analysis tools and indicators that can help investors and traders to navigate the price action successfully and with efficiency.

Moving Averages (Simple and Exponential)

This is the most basic and rudimentary tool used to identify the trend in the markets. A rising moving average would mean a rising trend; a falling Moving Average would mean a falling trend.

Moving average is a trend identifying indicator as it follows the trend. Moving averages are calculated by smoothing of the price data point. Usually, a 50-Day Moving Average is used to identify a short-term trend, whereas a 200-Day Moving Average is identifying a long-term trend.

Simple moving average and exponential moving average are the two most popular type of moving averages. The only difference between the two is that a simple MA would give equal weight to all days, whereas an exponential MA would give more weight to more recent data points.

It is important to note that a moving average goes into the foundation of making may other momentum indicators and oscillators.

MACD (Moving Average Convergence Divergence)

Moving Average Convergence Divergence, more popularly known as MACD, is a momentum oscillator developed by Gerald Appel. By far, it remains the most simple and effective momentum indicators available.

MACD is a lagging momentum indicator and is made using two exponential moving averages. The main MACD line is a difference between 12-day exponential MA and 26-day exponential MA. Then, there is a signal line which is a 9-day exponential moving average of the MACD line.

Calculation:
MACD line = (12-Day EMA minus 26-Day EMA)
Signal line = (9-Day EMA of MACD Line)
MACD histogram = (MACD Line minus Signal Line)

Signal line crossovers is the most basic interpretation of MACD indicators. A bullish crossover occurs when the MACD turns up and crosses above the signal line. A bearish crossover occurs when the MACD crosses below the signal line.

MACD is an unbounded indicator and therefore it is not particularly useful in identifying overbought and oversold areas. It being a lagging indicator, it follows the price.

Relative Strength Index (RSI)

RSI, developed by J. Welles Wilder in 1978, a momentum indicator which measures the speed and change of price movements of a stock against its own self over a period of 14-day. A 14-day period is the most used period and stays a default setting for the indicator.

Unlike MACD, RSI is a leading indicator. This means that when RSI is subjected to normal pattern analysis, it shows the development of patterns much ahead of the actual price. Being a leading indicator, it is a price that follows the moment of this momentum indicator.

RSI, which is by far one of the most popular momentum indicators, is a bound indicator and moves between 0 and 100. Values above 70 are considered overbought and below
30 is considered oversold.

Interpretation of RSI can be done by looking for divergences and failure swings. It also used to identify a general trend.

RSI is considered overbought above 70 and oversold below 30. Divergences signal important reversal points because the directional momentum fails to confirm with the price. A bullish divergence occurs when the security makes a lower low and RSI form a higher low. Opposite to this, a bearish divergence occurs when the price marks a higher high and RSI does not confirm with this.

Bollinger Bands

Created by John Bollinger, Bollinger bands are “overlay” indicators, plotted on the price scale. Based on the standard deviation, they change ie increase and decrease as the volatility increases or decreases. They are volatility bands, placed above and below a moving average; default being a 20-period simple moving average. The default parameters of construction of a Bollinger band is two bands each of 2 standard deviations, placed above a 20-period simple moving average. They can be used to determine if prices are relatively high or low.

According to its creator, the bands should contain 88-89% of price action, which makes a move outside the band a significant event.

The primary use of this tool is to identify M-Bottoms, W-Tops, and any onset of new breakout depending upon the price closing above or below the band. However, it is crucially important to note that the Bollinger bands are not supposed to be used in isolation as a standalone tool. It should be used along with basic trend analysis and other technical tools should be used for confirmation.

Relative Strength

Relative Strength is different from the Relative Strength Index. Relative Strength, which is also known as price relative, compares the performance of one security to another through a ratio chart. For example, using Relative Strength, we can compare the performance of a stock, say, for example, TCS against Nifty50.
It is calculated by dividing the security by the comparison security.

In the given example, if TCS is divided by Nifty 50, it will show the Relative Strength of TCS against Nifty 50. If the Relative Strength line is rising, then TCS is performing better than Nifty 50. Inversely, if the Relative Strength Line is falling, TCS is underperforming the Nifty 50.

On Balance Volume – OBV

On Balance Volume-OBV is also called the “grand-daddy” of all volume indicators. It measures buying and selling pressure as a cumulative indicator. It will add volume on up days and would subtract it on the down days. Developed by Joe Granville and introduced in 1963, it is often used as a leading indicator because volume precedes the
price action.

The interpretation of OBV can be done by identifying divergences. Bullish and Bearish Divergences can be used to identify a potential trend reversal. If the price is rising and the OBV is not, then it’s a bearish divergence and vice versa. This tool is also used as a trend confirmation tool.

For example, if the price is rising and OBV is rising, then it is a confirmation on the volume front. If the price is yet to break out while the OBV has already made a new high, we can fairly anticipate a breakout of the price in the same direction.

Aroon Oscillator
Aroon Oscillator is nothing but a difference between Arron Up and Aroon down. It is calculated as under:
Aroon-Up = 100 x (25 – Days Since 25-day High)/25
Aroon-Down = 100 x (25 – Days Since 25-day Low)/25
Aroon Oscillator = Aroon-Up – Aroon-Down

The primary use of this oscillator is to identify a beginning or an end of a major trend. When it comes to interpretation, a reading above zero means that Aroon-Up is greater than Aroon Down and this implies that the prices are making new highs more than new lows.

The interpretation of this indicator is pretty straightforward as the difference between Aroon-Up and Aroon-Down will be either positive or negative. A positive or negative threshold can be used to define the strength of the trend. For example, a surge above +50 would reflect a strong upside move, while a plunge below -50 would indicate a
strong downside move.

(The writer is CMT, MSTA, Consulting Technical Analyst and founder of Gemstone Equity Research & Advisory Services)