Since we have learned the basics of technical analysis from our previous units, we are now going to learn an essential component of technical analysis in this unit: Indicators.
Indicators are tools to aid decision making in the market. There are various types of indicators that measure or indicate the trend, the momentum, the volatility, and various other aspects in the market. There are thousands of indicators that are derived out of the price and volume data over time. Here we introduce you with four very useful indicators.
Simple Moving Average
Simple Moving Average or SMA is a moving average which is calculated by adding the closing price of security prices for the last n-periods and dividing it by the total number of time periods.
For example, suppose we want to calculate the 9 periods SMA of a security price.
First, we will add the last 9 Days Closing Price of the security, and then it will be divided by the 9 periods.
The calculation for 9 periods SMA:
P9= Closing Price 9 days ago
SMA is a Technical indicator that is represented by a line and it is directly plotted on the security price. As per the choice of the trader, the periods can be changed in the SMA indicator.
For shorter-term SMA, we can use 5,8,13, etc. For Medium term 20, 34, 50, and for longer-term 100,200 can be used.
If a medium-term moving average is having a positive slope, the trend is considered to be positive in the medium-term and vice versa.
Price breaching a particular moving average from down to up is considered a bullish sign. Similarly, price breaching a particular moving average from upside and closing below is considered bearish.
If we find a shorter term moving average crossing a medium-term moving average from below, often this is called bullish crossover. On the other hand, if a shorter-term moving average crosses a medium-term moving average from upside to below that is called a bearish crossover and often considered a signal of bearishness.
Relative Strength Index (RSI) is a momentum oscillator, developed by J. Welles Wilder, which measures the speed and velocity of the price movement of trading instruments (stocks, commodity futures, bonds, forex, etc.) over a specified period of time.
The objective of the RSI indicator is to measure the change in price momentum. It is a leading indicator and is widely used by Technical Analysts over the globe. RSI can be used to spot a general trend. It is considered overbought when it goes above 70 and oversold when it goes below 30. The 30-70 region of RSI is considered to be a normal zone.
The formula for calculating the Relative Strength Index is as follows
RSI = 100 – 100 / (1 + RS)
RS = Average Gain over a specified period/ Average loss over the same period
The default setting for the Relative Strength Index is 14, but you may change this value to decrease or increase sensitivity based on your requirement.
There are many uses of RSI. However, the most popular ones are, if we find that RSI breaching the 70 levels and at the same time we spot a bearish reversal pattern, then there is an opportunity to take short trade with stop loss. Similarly, if RSI breaches 30 from below to above and we observe a bullish reversal pattern, there is an opportunity to take long trade with stop loss.
In 1987 J. Welles Wilder developed the Average Directional Index (ADX) as an indicator of trend strength.
ADX quantifies the velocity of the price regardless of its north/south/eastward movement.
Hence, two other lines i.e. Positive Directional Indicator (+DI) and Negative Directional Indicator (-DI) are used on the charting system which acts as complements to ADX.
When ADX is above 20 or 25, generally Market is considered to be in a trending phase. The trend can be up or down. On the other hand, +DI crosses the -Di line from below, the market generally moves up and when the -DI line crosses the + DI line from below, the market generally moves in the downward direction.
As we have come to the end of this module. Let's sum up the topics we have covered. We have covered the basics of technical analysis and focused on the different types of charts, chart patterns and most popular candlestick charts. But learning does not end here; there are a lot more things to learn in technical analysis. We have prepared many such modules on different topics of technical analysis and more on topics related to financial markets. Be sure to check them out on ELM School.