Trading with indicators
Indicators are a core part of technical analysis. They’re used to identify trends and to make decisions about when to enter and exit trades. In this lesson, we’re going to take a closer look at why they’re popular, as well as the potential disadvantages of using indicators.
Understanding technical indicators
Indicators are mathematical calculations based on various forms of data – such as price or volume – that help traders identify signals and trends within a market’s price. They can give an understanding of the supply and demand of an asset at any given moment.
The calculations and formulas of some of the technical indicators may appear to be complex or scientific, but for traders, the only real focus should be on learning how to read the signals they give.
We’re going to take a look at some popular indicators over the next couple of lessons, but broadly speaking there are two main categories for you to be aware of:
- Overlays: these are plotted on top of the price chart. Examples include Bollinger Bands, moving averages and Fibonacci retracements
- Oscillators: these are plotted below a price chart on a separate graph. Examples include the stochastic oscillator, MACD and the relative strength index (RSI)
Each indicator is used differently and will give different signals. That’s why it’s common to use a combination of different indicators to confirm price movements.
Did you know?
There are 65+ technical indicators that you can apply onto City Index charts to help identify trends and trading opportunities.
When markets enjoy a sustained trend moving in one direction with minor corrections, you’d be looking to identify the direction of the trend and assess how long the move will last.
Indicators can help you stay on the right side of the market, as long as there are no major corrections. Examples of trend indicators include moving averages, MACD and the parabolic SAR.
At times when the markets are moving in a range between support and resistance levels, you would be looking to identify these key levels. Commonly used indicators for finding support and resistance levels include the stochastic oscillator and RSI.
Lagging vs leading indicators
Another important distinction to be aware of when choosing an indicator is whether it’s leading or lagging.
A leading indicator predicts future price movements, helping you to forecast what will happen based on previous market movements. Most leading indicators are oscillators; examples include the RSI, stochastic oscillator and on-balance volume. You’ll need to be aware that leading indicators are prone to false signals due to the sheer speed at which they churn out information.
A lagging indicator looks at what has already happened. It provides a signal after the fact, so the price has already moved on or the trend is in progress. You’d use these indicators to confirm a price trend and give you the confidence to trade. Most lagging indicators are overlays, such as moving averages or Bollinger Bands.
Disadvantages of indicators
It is not uncommon for technical indicators to provide a false signal – when the price diverges from what the indicator implies. Never forget that they’re based on past data and cannot provide a 100% accurate signal for what buyers and sellers will do in the future.
This is why no trading strategy should be based purely on the signal of a technical indicator. It is important to use multiple analysis tools and a risk management strategy to support your decisions.
Learn more about risk management in our guide to strategies and risk.
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