About Technical Indicators and How Technical Indicators are used
Introduction of technical indicators
A technical indicator is a series of data points that are derived by applying a formula to the price and/or volume data of a security. Price data can be any combination of the open, high, low or closing price over a period of time.
Some indicators may use only the closing prices, while others incorporate volume and open interest in their formulae. The price data is entered into the formula and a data point is produced.
Explanation of technical indicators
Technical indicators measure money flow, trends, volatility and momentum etc. They are used for two main purposes: to confirm price movement and the quality of chart patterns, and to form buy and sell signals.
A technical indicator offers a different perspective from which to analyze the price action. Some, such as moving averages, are derived from simple formulae and are relatively easy to understand.
Others, like stochastics, have complex formulae and require more effort to fully understand and appreciate. Technical indicators can provide a unique perspective on the strength and direction of the underlying price action.
If a technical indicator is constructed using the average of the closing prices, then the average of the 3 closing prices is one data point ((41+43+43)/3=42.33). However, one data point does not offer much information.
A series of data points over a period of time is required to enable analysis. Thus we can have a 3-period moving average as a technical indicator, where we drop the earliest closing price and use the next closing price for calculations.
Uses of technical indicators
- Moving average: The moving average is a lagging indicator that is easy to construct and is one of the most widely used. A moving average, as the name suggests, represents an average of a certain series of data that moves through time.
- Moving Average Convergence Divergence (MACD): MACD is a momentum indicator and it is made up of two exponential moving averages. The MACD plots the difference between a 26-day exponential moving average and a 12-day exponential moving average.
- Relative Strength Index: The relative strength index (RSI) is another of the well-known momentum indicators. Momentum measures the rate of change of prices by continually taking price differences for a fixed time interval. RSI helps to signal overbought and oversold conditions in security.
- Stochastic Oscillator: The stochastic oscillator is one of the most recognized momentum indicators. This indicator provides information about the location of a current closing price in relation to the periods high and low prices.