If you’re clever, insightful, and lucky enough, along with taking potentially high amounts of risk, it’s possible to make staggering fortunes in a short amount of time by watching how stocks move. But if you make a mistake somewhere along the way, you can lose just as much money in just as short a time.
It’s no wonder, then, that analyzing the market has attracted some of Earth’s brightest minds. Sure, some may do it for the money, but others do it for the thrill, for the sense of finding those vanishingly thin threads of signal in the howling torrents of noise.
But how is this feat achieved? One set of tools is known as technical indicators, and it’s the subject of our focus today. We’ll first situate technical indicators in the broader field of technical analysis, then turn to discuss the specifics of different indicators.
What Is Technical Analysis?
Technical analysis addresses itself to finding statistical patterns in the price movements of financial markets. The idea is if you can look at a chart and confidently determine the price of ACME stock will go down tomorrow, you can make money shorting it and vice versa.
While technical analysis is generally used for trading strategies that operate over a short period of time (such as in day trading), it can also be used to inform trading systems that are more oriented toward the long term.
Technical analysis was first introduced in the latter part of the 19th century by Charles Dow, and its modern form has changed little in the intervening 150 years.
The ideas of technical analysis can be difficult for beginners, but it ultimately rests on three fundamental assumptions about the market:
- Markets aggregate information: In finance, there is a concept known as the “efficient market hypothesis (EMH),” which states that the factors affecting a given stock price are already baked into it. Because investors are strongly incentivized to correctly understand the current price of the stock, they will have already looked at the company’s earnings statement from the last quarter as well as the CEO’s most recent Twitter controversy.
- There are consistent patterns in price action: Technical analysis proceeds on the assumption that there are price trends that can provide useful trading signals. Whether they’re looking at a five-minute or five-hour price chart, technical analysts claim they know how to look at chart patterns and trend lines and interpret them as buy or sell signals.
- History usually repeats: A related point is that past information about a stock’s properties — its 200-day simple moving average (SMA), say, or its volatility over the previous two years — tells you a lot about what it will do in the future. This is believed to stem in part from what is called “market psychology,” i.e., the fear and exuberance that investors experience. These are powerful engines affecting future prices. If everyone is seeing bullish indicators, they’ll likely all pile in, driving the stock’s price higher; bearish signals, conversely, could cause mass sell-offs, cratering the price.
Technical Analysis vs. Fundamental Analysis
Technical analysis is one of the two big ways of trying to make sense of market movements. The other is fundamental analysis.
Whereas technical analysis rests its conclusions purely on a stock’s price, fundamental analysis focuses on trying to derive the intrinsic price of a stock from an examination of the company’s fundamentals.
This means you might conduct a deep dive into the experience of the board of directors, the potential of its underlying technology, or how robust its supply lines are. This information can be leveraged to try and predict the price range or future average price levels of the company’s stock.
Obviously, this is really difficult to do, as there are so many things that redound to the ultimate success or failure of a stock. Still, if you get it right, you could end up purchasing Facebook or Coca-Cola stock early enough to make a killing.
What Is a Technical Indicator?
A technical indicator is essentially any number that informs your technical analysis. These can range from fairly trivial to extraordinarily complex, but they tend to fall into a few broad categories (the number of categories depends on the source you consult, we’ve used several below).
Let’s walk through the major types of technical indicators and when you’d use them.
Whether candlestick charts even count as a technical indicator is open to debate, but they show up so often in conversations around technical analysis that it’s worth explaining them briefly.
The image at the top of this section is a candlestick chart, so-called because it resembles a candlestick.
A candlestick chart is made up of three parts: a top wick, a bottom wick, and a bigger rectangle between the two. The top wick is the highest price the stock achieved over the relevant time frame, the lower wick is the lowest price the stock was at over that time frame, the top of the rectangle is the higher of the opening price or the closing price, and the bottom is the lower of the opening price or the closing price.
If the stock finished up, that means the closing price is higher than the opening price and the candlestick is green; otherwise, it’s red.
In one image, you can see how high and low the price went (the wicks), how it started and ended (the top and bottom of the rectangle), and whether it’s up or down (the color).
One of the most basic kinds of technical indicators is the moving average. It’s calculated by taking the mean of a stock’s price over a particular time frame, then recalculated for each successive interval — i.e., if you calculate a 30-day moving average on Monday, you’ll have to calculate it again on Tuesday because the 30-day window has moved forward by one day.
There are a few ways of calculating moving averages. The simple moving average (SMA) is calculated by adding up all the data points and dividing by how many there are, while the exponential moving average (EMA) weights recent days more heavily on the premise that they’ll be more informative.
Bollinger bands are a common technical analysis tool that makes use of moving averages. They display the moving average, plus some number (usually one or two) standard deviations above and below the moving average.
When the price approaches the upper band, analysts will tend to interpret that as the market being in an overbought condition, and when it approaches the lower band, they’ll interpret that as the market being in an oversold condition.
If the price crosses either the upper or lower band, this is known as a breakout, and it’s important.
Mean reversion refers to the belief that volatility and returns will tend to revert back to their long-term mean. In any given hour, there might be wild swings in these values, but if you zoom out a little, they’ll tend to go back to whatever they’ve been doing recently.
Bollinger bands are predicated on mean reversion, and other metrics, like p/e ratios, can be utilized for the same kind of analysis.
Fibonacci numbers are named for a 12th-century mathematician who defined the famous “Fibonacci sequence.” The Fibonacci ratios are 24%, 38%, 62%, and 76%, and they are typically used by technical analysts to identify good places to buy or sell a stock.
The price of ACME stock might soar, then hit a Fibonacci retracement by dropping 24% before resuming its upward climb. The fibonacci technical analyst will be on the lookout for that retracement as a place to enter the market.
Trading Volume Indicators
Trading volume refers to just how much a stock has been bought and sold over a certain period of time, and it’s an important source of technical indicators because it tells you how much interest there is in the stock.
The money flow index (MFI), for example, is an oscillator that incorporates both stock price and trading volume and can be used to find overbought and oversold stocks. It’s similar to the relative strength index (RSI), but since it also includes volume, it is sometimes called the volume-weighted RSI.
The MFI bears a resemblance to another strength indicator, the accumulation/distribution line. The accumulation/distribution also uses volume and price to figure out whether a stock is generally being bought more or sold more. If the price of stock is rising but the accumulation/distribution line is falling, this could indicate that there is an impending correction because demand is not sufficient to sustain the higher price.
In financial markets such as the Foreign Exchange (Forex), volatility refers roughly to uncertainty around future returns. More volatility means we can be less sure about our prognostications, while low volatility means we can be more sure.
Volatility indicators are pretty important. The average true range (ATR) is a popular volatility indicator, and it’s derived by first solving three equations:
- Current day’s high minus current day’s low
- Current day’s high minus previous day’s close
- Previous day’s close minus the current low
This gives you three different “true ranges,” and you next take whichever of these quantities is highest and calculate its exponential weighted average. If the ATR is high, this means a greater variety of true ranges and more volatility, and you must be careful because there’s a lot of turbulence in the market.
In physics, momentum is the mass of an object multiplied by its velocity. A bigger object moving at the same speed as a smaller object will have a bigger momentum.
The same thing applies in finance. If a high-volume stock suddenly begins to plummet, we can be more confident that this downtrend will continue than we could be if the same thing were true of a thinly traded stock.
There are lots of momentum indicators. The moving average convergence divergence (MACD) is a line found by subtracting the 26-period EMA from the 12-period EMA (here, “period” could mean hour, day, week, or any other time period, but it’s customary to use days). It’s considered a bullish signal to have the MACD cross over the signal line, and bearish when it crosses under.
On-balance volume (OBV) is another. It captures the net flow of volume into or out of the trading of a given stock. OBV’s developer, Joseph Granville, likened it to “a spring being wound tightly.” That is, if there’s a ton of new trading volume in a stock without a concomitant increase in its price, we can safely bet there will be a price surge at some point in the near future.
Finally, there’s the commodity channel index (CCI). The CCI is a momentum oscillator that, in essence, quantifies the distance between where the price is now and where it’s been relative to an average historical price. It’s commonly used to find under and oversold levels, and for getting a handle on how strong a new trend is.
Relative strength is a type of momentum indicator that quantifies how well a given stock has done, compared either to some benchmark or the market in general.
The relative strength index is used to assess how rapid and how large recent price movements have been and is often used to find securities that are either overbought or oversold.
Similarly, the average directional index (ADX) also attempts to get at how strong a trend is by looking at both the negative directional indicator and the positive directional indicator. The math is a little involved, but ultimately, what comes out the other side is a number you can use to think about where a stock price is likely to go in the future. By and large, when the ADX is above 25, it’s assumed that a trend is in place and will continue.
A Note About Trend Lines
A trend line, or “signal line,” is used to predict future price action for a stock. Like a candlestick, it’s not actually a technical indicator, but they’re often added as an overlay to charts during technical analysis.
In the abstract, it’s generally seen as important when a stock’s price crosses over a trend line. If the price drops below the 200-day moving average, for example, this can be interpreted as a downtrend; if it climbs above it, this can be interpreted as an uptrend. Such an event is known as a “crossover,” and it’s something technical analysts pay attention to.
Technical Indicators as a Candle in the Dark
The stock market is fascinating. There are so many ways of thinking about, analyzing, and predicting the vicissitudes of price movements that it furnishes an endless supply of intellectual challenges.
But for this same reason, it’s difficult to make sense of it all, and that’s where technical indicators come in. Momentum indicators, volatility indicators, and the other metrics we’ve encountered today are all ways that analysts try to quantify the market and tame its mysteries.
But they’re only as good as the data you give them. It doesn’t matter how fancy your math is, if you feed in bad numbers, you’ll get bad results, and it’s not possible to build a trading strategy around that.
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