Table of contents
Introduction
Relative Strength Index (RSI)
Moving Average (MA)
Exponential Moving Average (MACD)
Stochastic Relative Strength Index (StochRSI)
Bollinger Bands (BB)
Summarize
Introduction
Traders use technical indicators to gain further insight into an asset’s price action. These indicators make it easier to identify patterns and spot buy and sell signals in the current market environment. There are various types of technical analysis indicators, and they are widely used by day traders, swing traders, and sometimes even by long-term investors. Some professional analysts and advanced traders even create their own indicators. In this article, we will briefly introduce some of the most popular technical analysis indicators that are suitable for use in any trader’s market analysis toolkit.
1. Relative Strength Index (RSI)
The Relative Strength Index (RSI) is a momentum indicator used to indicate whether an asset is overbought or oversold. It does this by measuring the magnitude of recent price changes (the standard setting is the previous 14 periods, such as 14 days, 14 hours, etc.). This data is then displayed as an oscillator whose value can range from 0 to 100.
Since RSI is a momentum oscillator, it shows the rate of price change (momentum). This means that if momentum is increasing at the same time as price is rising, then the uptrend is strong and more and more buyers will start to step in. Conversely, if momentum is decreasing at the same time as price is rising, this could be a sign that sellers may soon take control of the market.
The traditional interpretation of RSI is that when its value exceeds 70, the asset is overbought; when its value is below 30, the asset is oversold. Therefore, extreme values may indicate an upcoming trend reversal or pullback. Even so, it's best not to view these values as a direct buy or sell signal. Like many other technical analysis (TA) methods, RSI can provide false or misleading signals, so it is always necessary to consider other factors before entering a trade.
Want to know more? Please read our article about the Relative Strength Index (RSI).
2. Moving Average (MA)
Moving averages smooth out price movements by filtering out market noise and highlighting the direction of the trend. It is based on past price data and is therefore a lagging indicator.
The two most commonly used moving averages are the simple moving average (SMA or MA) and the exponential moving average (EMA). SMA is drawn by taking price data for a defined period and calculating the average. For example, the 10-day SMA is drawn by calculating the average price of the past 10 days. On the other hand, the way EMA is calculated puts more emphasis on recent price data. This makes it more responsive to recent price action.
As mentioned above, moving averages are lagging indicators, and the longer the time span, the stronger the lag. Therefore, the 200-day SMA responds to price action more slowly than the 50-day SMA.
Traders often use the relationship of price to a specific moving average to gauge current market trends. For example, if the price is above the 200-day SMA for an extended period of time, many traders will consider the asset to be in a bull market.
Traders can also use moving average crossovers as buy or sell signals. For example, if the 100-day SMA crosses below the 200-day SMA, it may be considered a sell signal. But what does this crossover actually mean? It indicates that the average price over the past 100 days is now lower than the average price over the past 200 days. The idea behind selling at this point is that short-term price movements are no longer following the uptrend, so the trend may be reversing.
Want to know more? Please read our article about moving averages.
3. Exponential Moving Average (MACD)
The Exponential Moving Average (MACD) determines an asset's momentum by showing the relationship between two moving averages. It consists of two lines - the MACD line and the signal line. The MACD line is calculated by subtracting the 26-period EMA from the 12-period EMA. The signal line is an exponential average of the 9-period EMA based on the MACD line. Many charting tools also use histograms to show the difference between the MACD line and the signal line.
By observing the difference between MACD and price action, traders can gain insight into the strength of the current trend. For example, if the price is making higher highs and the MACD indicator is making lower highs, the market may soon reverse course. What can MACD tell us in this case? Price is rising while momentum is falling, so the likelihood of a pullback or reversal is higher.
Traders can also use this indicator to observe the crossover between the MACD line and the signal line. For example, if the MACD line crosses the signal line upwards, it can be interpreted as a buy signal. On the contrary, if the MACD line crosses the signal line downward, it can be interpreted as a sell signal.
MACD is often used in conjunction with RSI as both measure momentum but use different factors. The assumption is that a combination of the two might provide a more comprehensive technology outlook for the market.
Want to know more? Please read our article about MACD.
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4. Stochastic Relative Strength Index (StochRSI)
The Stochastic Relative Strength Index (StochRSI) is a momentum oscillator used to indicate whether an asset is overbought or oversold. As the name suggests, it is derived from RSI as it is generated based on RSI values rather than price data. This indicator is created by applying the so-called "Stochastic Oscillator Formula" to ordinary RSI values. Generally speaking, StochRSI has a value between 0 and 1 (or 0 and 100).
Because StochRSI is faster and more sensitive, it can produce many trading signals that are difficult to interpret. It is also generally most useful when near the upper or lower limits of its range.
A StochRSI reading above 0.8 is generally considered overbought, while a reading below 0.2 may be considered oversold. A value of 0 means that the RSI was at its lowest value during the measurement period (the default setting is usually 14 periods). Conversely, a value of 1 means that the RSI was at its highest value during the measurement period.
Similar to how RSI is used, an overbought or oversold StochRSI value does not mean that the price will necessarily reverse. In the case of StochRSI, it simply indicates that the RSI value (the source of the StochRSI value) is close to the extremes of its most recent readings. It is also important to remember that the StochRSI indicator is more sensitive than the RSI indicator, so it tends to produce more false or misleading signals.
Want to know more? Please read our article about Stochastic RSI.
5. Bollinger Bands (BB)
Bollinger Bands (BB) are used to measure market volatility, as well as overbought and oversold conditions for an asset. It consists of three lines, namely SMA (middle track) and upper and lower tracks. Settings may vary, but generally speaking, the upper and lower rails are both two standard deviations from the middle rail. As market volatility increases or decreases, the distance between these tracks will expand or contract.
Generally speaking, the closer the price is to the upper band, the closer the asset on the chart is likely to be to an overbought condition. Conversely, the closer the price is to the lower band, the closer the asset on the chart is likely to be to oversold conditions. Most of the time, the price will stay between the lines, but on rare occasions, the price may go above or below the lines. This event is not a trading signal in itself, but it can serve as an indication of extreme market conditions.
Another important concept of Bollinger Bands is called the "squeeze indicator". This refers to periods of lower volatility when all the trajectories are very close to each other. It could indicate potential future volatility. Conversely, if all trajectories are far apart from each other, periods of declining volatility may occur.
Want to know more? Please read our article about Bollinger Bands.
Summarize
While indicators can display data, it's also important to consider that interpretation of data is highly subjective. So it's always helpful to take a step back and consider whether personal biases are affecting your decisions. What may be an outright buy or sell signal to one trader, may be just market noise to another.
As with most market analysis techniques, these indicators work best when used in conjunction with each other or with other methods such as fundamental analysis (FA).
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