Technical analysis is a financial analysis technique usually used by traders to examine and analyse the statistical trends of trading activity.
These trends include factors such as price movement and volume. They are used to better predict upcoming trends.
Unlike fundamental analysis – which places the emphasis on the evaluation of business aspects – technical analysis looks into technical indicators to predict the future price movements for the securities or/and the market as a whole.
The idea is to find the linkage between the change in demand and supply of a stock with changes to price, volume and volatility.
Paired together with fundamental analysis, it can help investors make better investment decisions.
There are different types of technical indicators, including leading indicators and lagging indicators.
A leading indicator is a forecast signal that predicts the future price movements while a lagging indicator looks at past trends and indicates momentum.
So, here are five technical analysis indicators that all investors should be aware of if they intend to use this strategy.
1. Moving Average Convergence Divergence (MACD)
The Moving Average Convergence Divergence (MACD) is one of the most common technical indicators that traders look at to signal the momentum of a stock.
To understand MACD, you must first know about Exponential Moving Average (EMA).
EMA is a type of moving average that places a greater weight and significance on recent price changes.
Unlike a simple moving average (SMA) which simply takes the average of the closing prices over the period observed, an EMA calculation adds emphasis on the recent closing prices.
MACD is calculated by subtracting the 26-day EMA from 12-day EMA. The result of the calculation is an MACD line.
A 9-day EMA of the MACD will be called the “signal line”, which is then plotted together with the MACD line.
When the MACD crosses above its signal line, it can seen as a trigger for a “buy” signal while a “sell” signal emerges when the MACD crosses below the signal line.
Aside from that, the speed of crossovers is also taken as a signal of an overbought or oversold market.
Source: IG, ProsperUs
2. Relative Strength Index (RSI)
The Relative Strength Index (RSI) is a momentum indicator used in technical analysis to measure if recent price changes have led to overbought or oversold conditions.
The RSI provides traders and investors with signals about bullish and bearish price momentum and is usually plotted beneath the graph of the stock prices.
The RSI oscillates between 0 and 100. Typically, traders will see a stock as overbought when the RSI is above 70 and is considered oversold when it is below 30.
In an uptrend (or bull market), the RSI tends to remain between the 40-90 range with 40-50 acting as support.
Meanwhile, in a downtrend (or bear market), the RSI usually stays between the 10-60 range with the 50-60 zone acting as resistance.
Source: Fidelity, ProsperUs
3. On-Balance Volume (OBV)
On-balance volume (OBV) is a momentum indicator that measures the positive and negative volume flow.
The theory behind OBV comes from the distinction between the so-called “smart money” or institutional investors, and the less sophisticated investors (or retail investors).
OBV measures the buying and selling pressure as a cumulative indicator, adding volume on up days and subtracting it on down days.
A rising OBV reflects positive volume pressure that can lead to higher prices while a falling OBV reflects negative volume pressure that can lead to downward price movements.
When OBV is rising while prices are either flat or moving down, expect to see prices move higher going forward.
Meanwhile, if OBV is falling, while prices are either flat or moving up, expect prices to move lower.
Traders and investors alike need to focus on the characteristic of the OBV line instead of the absolute value of OBV.
There are three common strategies in using OBV: 1). OBV confirmation of a price trend 2). OBV Divergence and 3). OBV Breakout.
OBV Confirmation of a price trend
Source: Trading-in-Depth, ProsperUs
OBV Divergence signals a change in price movement going forward
Source: Trading-in-Depth, ProsperUs
OBV Breakout
Source: Trading-in-Depth, ProsperUs
4. Stochastic Oscillator
A stochastic oscillator is a popular technical indicator used to generate overbought and oversold signals.
The stochastic oscillator is range-bound at between 0 and 100. Typically, readings over 80 are considered to signal overbought while readings under 20 are considered oversold.
However, traders and investors need to look at changes in the stochastic oscillator for signals on future trend shifts.
Source: Investopedia, ProsperUs
5. Bollinger Bands
Bollinger Bands are trading tools that are used by traders and investors to time their entry and exit in a market.
There are various ways to use the Bollinger Bands but the most common one is using them for overbought and oversold trade signals.
When the share price breaks below the lower band of the Bollinger Bands, prices have fallen too much and could be poised for a recovery or rebound.
Similarly, if a share price has broken above the upper band, the market might have reached an overbought situation and would, therefore, be due for a pullback.
Traders and investors can also create multiple bands for greater insights.
Another popular strategy is to use a squeeze strategy where prices that have been moving aggressively start to move sideways in a tight consolidation.
Multiple bands can also be created to help highlight the strength of price movement.
Source: Bollinger Bands, ProsperUs
The bottom line for investors
There are various technical indicators that traders and investors can utilise in order to better time their entry and exit from the stock market.
These are some of the more popular ones among traders in the market today.
However, while these technical indicators provide indicators for market movement and volatility, they are not 100% accurate all of the time.
It helps to predict the price pattern based on current market movement, volatility and interest but some of these signals are only seen when the price movement is already underway.
Having said that, technical indicators are important tools that can help investors and traders to gauge the market sentiment and price movement going forward.
When used together with fundamental analysis, it can help investors and traders to make better investment decisions.
