In order to become a successful investor, you need to be able to develop two distinct sets of skills: fundamental and technical analysis. They are very different yet equally important to learn if you truly want to understand what is going on with your stocks. The best investors in the history of stock investment have relied on technical indicators to gain some insight into the demand and supply of securities and related market psychology. Indicators in the stock market, like certain metrics to gauge trades are essential before you get into specific trades. Things like trading volume, for instance, can give you some fruitful knowledge leading to successful trading.
Fundamental analysis is essentially digging into a company's financials. Fundamental analysts study everything that could potentially affect a company's value. This can include both macro and micro economic factors as well as the company's strategic planning, supply chain and even employee relations.
Technical indicators, collectively called "technicals", are distinguished by the fact that they do not analyse any part of the fundamental business, like earnings, revenue and profit margins. The most effective uses of technicals for a long-term investor are to help identify good entry and exit points for the stock by analysing the long-term trend.
What is a 'Technical Indicator' and the Technical Analysis of Stocks?
In technical analysis of stocks, a technical indicator is a mathematical calculation based on historic price, volume, or (in the case of futures contracts) open interest information that aims to forecast financial market direction. Technical indicators are a fundamental part of technical analysis and are typically plotted as a chart pattern to try to predict the market trend. Indicators generally overlay on price chart data to indicate where the price is going, or whether the price is in an "overbought" condition or an "oversold" condition.
Traders who use technical analysis in their regular trading routines, are chartists who use a broad variety of indicators, oscillators and patterns to generate signals. Many technical indicators have been developed and new variants continue to be developed by traders with the aim of getting better results. New technical indicators are often back tested on historic price and volume data to see how effective they would have been to predict future events. Technical indicators look to predict the future price levels, or simply the general price direction of a security, by looking at past patterns. There are also momentum indicators that technical analysis tools employ, and most technical analysis is done with many tools used together rather than a single indicator. Of course, you may not need all of them, but you can choose the indicator that best suits your trading strategy, say the best indicator for intraday trading.
There are dozens of indicators that can be displayed on the charts, but here is an outline of the most important technical indicators to know.
The Accumulation/ Distribution Line
What the accumulation/distribution line (A/D line) seeks to determine if money is flowing into or out of a security. When the A/D line is sloping upward, it can be assumed that new money is coming into the security. The opposite is true when the slope is headed lower. In most cases this indicator runs pretty close to the movement of the stock, but it does tend to move slightly sooner than the underlying security and can be used to tell if a near-term rally or sell-off is expected.
MACD - Moving Average Convergence/Divergence
Several indicators in the stock market exist, and the Moving-Average Convergence/Divergence line or MACD is probably the most widely used technical indicator. Along with trends, it also signals the momentum of a stock. The MACD line compares the short-term and long-term momentum of a stock in order to estimate its future direction. Simply put, it compares two moving averages that can be set for any time period as desired. Typically the 12-day and 26-day moving average of the stock are used.
When the short-term line crosses the long-term line, it is a signal of future stock market trading activity. When the short-term line is running under the long-term line, and then crosses above it, the stock will typically trade higher. Likewise, we can predict a selloff when the short-term line crosses under the long-term line.
Head and Shoulders Pattern
The head and shoulders is a chart pattern that appears when a stock rises to a peak to form the first “shoulder” and then falls. Then it rises above the previous peak to form the “head” and then falls below the first shoulder before rising again to the level of the first shoulder and falling, hence creating the second shoulder.
Technical analysts believe that a head and shoulders pattern is a solid indicator of changing trends. If one of your holdings is developing such a pattern, it could suggest that future selling could be coming.
In the technical analysis of stocks, the head and shoulders pattern gets formed when any stock’s price goes up to a peak and subsequently falls back to the base point of the previous move. Then, you will find that the stock price rises over the former peak and forms a “nose”. Declines to the original price will happen next, and then the stock price will increase to the level of the first peak. You tend to see this pattern when a bullish to bearish trend reversal is going to happen.
Gaps
Gaps occur when a stock opens much higher or lower than the previous day’s closing price. This difference could be the impact of some news that was released before the market opened. This could result in a sizable move during after hours trading, and the stock picks up at this point when the normal trading day gets under way. Gaps are important because they create new support or resistance lines for the security. Traders set up sell orders using these support and resistance points as their stop loss or limit.
You should note that common gaps are not placed in the patterns of prices. All they do is represent a place where the price of a stock has gapped. There is such a phenomenon as continuation gaps (runaway gaps) and these can occur in the midst of a price pattern. They signal a rush of sellers or buyers who share a universal belief about the future direction of an underlying stock. In the simplest terms, gaps refer to a price range during which no shares have changed hands.
Double Tops or Bottoms
This chart pattern also forecasts changing trends. Spotting this chart pattern is a fairly simple process. In terms of a double top, a stock on two occasions tests a specific price level, and in both cases the stock hits resistance. On the other side, a double bottom occurs when a stock falls to a certain price level and finds support on both occasions. A double top indicates future selling, while a double bottom indicates that the stock is getting ready to trade higher.
Are Indicators in the Stock Market Useful?
The question that any traders often ask themselves is whether technical indicators and fundamental analysis are reliable in the market. Technical analysis is done on the basis of the reading of market sentiments, using patterns on graphs, as well as certain signals of trading. A range of empirical research has supported the effectiveness of technical analysis, but many investors still rely on their “gut”. The accuracy of technical indicators remains undecided to this day, but it can help you get started. Using it along with fundamental research is the key to sound investment decisions.
Find Your Indicator
Active traders in the market use technical indicators most extensively, as they are designed primarily for analysing short-term price movements. To a long-term investor, most technical indicators are of little value (but some may be) as they do nothing to shed light on the underlying business. Depending on your trading strategy and the kinds of trades you wish to perform, you can find indicators that help you more than others. For instance, the best indicator for option trading may be an indicator which has no use in a short-term strategy, but one like the Relative Strength Index or Bollinger Bands.
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