Common Technical Analysis Indicators

Instructor: Brendan Verma

Brendan was a Financial Advisor for 10 years and has completed all 3 levels of the CFA Program.

Technical analysis indicators help in studying the price charts of all types of financial instruments. In this lesson we will look at some of the more common indicators, their characteristics and uses.

What are technical analysis indicators?

Have you ever looked at a stock's price chart and asked, 'How do I make sense of this endless up and down in price? Is this the start of a big trend? Should I be buying or selling now?' If you have, you aren't alone. Every investor runs through these questions at one point or another. That's why technical indicators exist!

Indicators offer clues to key price levels, expected future direction of price, the strength in the current direction of price, the range of expected prices, and the market sentiment. They are calculated using price and/or volume data. Most often, a combination of indicators is used when reading a chart, and the strength of a decision to buy or sell is based on how well each indicator corroborates what the other is ''indicating.''

Example of stock price chart

Price reflects all the reasons buyers and sellers want to buy or sell a stock, currency, or commodity. Volume is the amount of the asset that is bought or sold at any given price. Price and volume are the principal inputs in creating indicators. There is an extremely wide array of indicators a technical analyst can choose from, but the most commonly used are given below.

Moving averages

Simple Moving Average

Moving averages are calculated from price and are usually arithmetic, exponential, or weighted. Of these, the simple moving average is the most widely used. It is the average of either the opening, closing, high, low or average price for any time frame. On a daily price chart, one could take the daily closing price for each of the past 50 days, divide by 50 and thus have calculated the 50 day simple moving average. When seen on a chart, the moving average line would appear much smoother than the underlying price line, as it removes some of the fluctuations due to averaging. This gives an investor a better view of the underlying price trend, by eliminating a lot of the ''noise'' prevalent in price movements.

In addition to showing the underlying trend, moving averages also act as key support and resistance levels. The crossing of moving averages is also taken as a significant indicator of future price direction. For example, the 50 day moving average crossing above the 200 day moving average is taken as a strong signal for an upward trend. Price crossing above or below a moving average is also considered a significant indication of change in price trend.

Pivot points

Pivot Points

A trusted old tool for technical analysts, the pivot points indicator is calculated using the previous period's high, low and close prices. As such, its benefit is that it uses relatively fresher values than moving averages in its calculation. While the calculation of pivot points can be complicated (there are also three different types of pivot points), the important thing to remember about it is that it provides price points that serve as strong support or resistance in the current period.

An application of pivot points would be when the price breaks pivot point prices. This would indicate opportunities to enter the market with the expectation for price to continue in that direction. When prices are bouncing around within a range, pivot point prices also serve as good entry and exit points.

Relative Strength Index (RSI)

Relative Strength Index

Relative Strength Index (RSI) is a momentum indicator and helps in understanding the strength in price movement. Its value ranges from 0 to 100. An RSI reading of over 70 indicates the asset could be overbought, while a reading under 30 indicates the asset could be oversold.

The calculation of RSI gives us a good understanding of the information conveyed by it:

RSI = 100 - (100/(1+RS))

RS is defined as the average gain on the days price is up, divided by the average loss on the days price is down. Thus, RS acts as a gauge of the strength in the overall price movement. An RS value of 1 indicates that the gains and losses are equal and the price has no specific directional momentum.

One must exercise caution in using RSI to buy or sell based on oversold or overbought signals in strongly trending markets, as it often happens that RSI stays above 70 or below 30 for extended periods. This makes the RSI indicator more useful when prices are range-bound, i.e., moving within a price range.

RSI can also be used as an indication of divergence between price and momentum. If price makes a new high but RSI does not, the signal is considered bearish and vice versa. This is similar to a driving a car uphill and taking your foot of the accelerator. For a while the car will continue to move forward, but soon enough it will roll back down.

Moving Average Convergence Divergence (MACD)

Moving Average Convergence Divergence (MACD)

Another very popular momentum indicator is the Moving Average Convergence Divergence (MACD), which is a trend-following momentum indicator. Let's look at how it is constructed.

There are three basic parts of the MACD:

- The MACD line: the difference between a 12- and 26-period exponential moving average

- The signal line: a 9-day exponential moving average of the above difference

- The histogram: a visual representation of the difference between the above two lines

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