Just like meters and indicator lights on your car’s dashboard, indicators signal conditions you should be aware of to make decisions. Instead of concerns of when the gas tank is empty, often your first concerns as an investor is when to buy and sell? At what price? Technical indicators, often used with stock charts and technical analysis, help answer these questions by organizing stock price or other data in meaningful ways. How do indicators do this? The simplest of technical indicators takes confusing stock prices and calculates averages. So, you can see where the stock is right now compared to it’s average (how the stock usually performs). Knowing how the stock is doing, you can improve your buying and selling decisions where the odds are in your favor. Many people think the stock market is 50/50 gambling. But with proven strategies and indicators that help identify good and bad odds, your conscious decision to only buy and sell when the odds are better than 50/50 makes it a business which you can earn money over time.
In the past, before computers and the Internet, successful traders must be skilled at “read the tape”. That is, understanding the stock’s situation, the market situation, and the odds he is facing in an investment decision with nothing more than intuition and experience. Just watching the price. Nowadays, we have the luxury of using indicators that help interpret market opportunities. However, understanding your decision criteria is a big deal when trying to decide which indicators are right for you. Different indicators calculate different things, showing you different odds. Often different indicators will give conflicting signals, one showing good odds for one part of your decision and another showing bad odds. Just like looking at your car’s dashboard, you must look at everything the indicators are telling you and make a decision. There’s no single indicator that tells you everything about when to buy or sell. The following is a quick guide of factors that go into choosing technical indicators:
- Experience: The most important thing with any technical indicator is experience with the indicator. Understanding what it is designed to tell you and how it reacts in a certain situation is the key. When you’re putting your hard earned money on the line (when investing), you must know the indicators you’re using inside and out. When does it work the best (giving you high odds)? When does it have a history of being unreliable? What other indicators are better in such situations to compliment the one you’re using? Answers to these questions come with understanding and practice using your indicators. We recommend you test the accuracy and reliability of technical indicators by paper-trading (trading simulators) before you start using it for real.
- Trading Style: Whether you’re an investor or trader, when faced with the decision of when and where to buy or sell, you see the market can only do one of two things. Stay in a range by going up and down, or continue going in one direction (up or down). Oscillating indicators are great for stocks and markets stuck in a range. Meanwhile, directional and momentum indicators are best when stocks are moving in one direction (up or down) and continues in that direction with momentum. Your plan should also include an exit: where to get out if you have a profit or a loss. Leading indicators and predictive indicators are good tools to help estimate high probability prices where the stock is likely to go. For example, Fibonacci extensions calculate Fibonacci math sequences of high probability areas where a stock will go based on where the stock has been.
- Risk Appetite: How much risk do you want to undertake in your investments? Some indicators are extremely risky due to their statistical setup and trigger points. However, most indicators are customizable to adjust the settings to something you’re comfortable with. For example, Simple Moving Averages (SMA) can be customized to taking the past 8, 20, 50, or 200 period average of the stock price. The shorter the period, such as using only 8 or 20 periods, the faster the SMA indicator will change and the faster you’ll have to react. Thus, shorter periods are usually suited for active traders and investors only concerned with the short time period.
- Asset Class: The different asset classes to which most indicators would pertain are stocks, fixed income (interest rates, etc), futures, forex, and options. Certain indicators are more useful for specific asset classes than others depending upon what types of relationships exist. Some indicators, like RSI, Bollinger Bands, and SMA are momentum oscillators that are useful for trending general stocks, futures and forex because they take advantage of statistical traits innate to the historical movement of the observation. Others are more specific to a particular asset class. Volatility indicators are an example that would pertain more towards options (and derivatives) trading than to any other asset class (although it can help you trade the other asset classes too). The reason for this is that options are derived from the underlying and thus their changes in price and payoff are based off of implied volatility, along with other factors like price, decay time and interest rate. Knowing the major factors that affect the asset class that you’re trading along with the strategies that you hope to employ can help to determine the best indicators for you.
- Types: Fibonacci Sequence, Pivot Points, Support & Resistance
- Pros: Based on historical and behavioral investing psyche to be able to predict supports and resistance -- extremely useful in finding potential entry/exit levels for all styles of investing, and identifying potential profit/loss margins
- Cons: Not easy to prove “why” they predict, except by using investor psychology; Not useful for volatility or predicting directions of trends
- Summary: Great for identifying where to potentially watch for entering/exiting/limiting a trade; useful for intermediate / advanced traders
- Types: Stochastic Indicators, Momentum Indicators, Oscillating Indicators, etc
- Pros: Extremely useful for confirming a trade, predicting direction of trade, and predicting potential reversal points
- Cons: Does not predict ranges well; does not actually “predict” direction because usually based off historical stochastics or psychology, just gives a “probable” direction
- Summary: Great for trending, potential reversals (and swings), and useful for intermediate / advanced traders
- Types: Bollinger Bands, Standard Deviation, Implied Volatility, etc
- Pros: Useful for predicting average range (variation) of movement based upon historical data; Useful for predicting unpredictability & risky nature of particular asset; useful for spread techniques
- Cons: Bad for direction trades & trending; bad for entry/exit points
- Summary: Most useful for spreads and options techniques or predicting potentially risky trades (and thus potential high reward) if used in conjunction with aforementioned indicators.