Technical indicators play a crucial role in helping traders and investors predict the direction of security prices. A good understanding and application of technical indicators can enhance trading strategies, providing significant profits.
### The Anatomy of Technical Indicators
Primarily, technical indicators are statistical calculations based on the volume, price, and open interest of security. They can generate accurate and helpful trading signals. Examples of these indicators include moving averages, relative strength index (RSI), stochastic oscillator, and Bollinger Bands, among others.
These indicators are generally categorized into two: trend-following and momentum indicators. Trend-following indicators help traders identify the security’s trend direction and enter a trade at a good price within that trend. On the other hand, momentum indicators reveal the speed or strength of a price movement, thereby helping traders anticipate potential turns in prices.
### The Key to Effective Use of Indicators
The process of obtaining valuable insights from technical indicators requires a careful understanding of how each indicator works. Traders should consider the sensitivity of the indicators, as too sensitive indicators may result in a lot of noise and false signals, while less sensitive ones may respond too slowly, leading to late entrances and exits.
Broadly, traders must also consider the timeframe of their trades. Short term traders may find it beneficial to rely on technical indicators that give quick signals, while long-term traders might prefer technical indicators that feature slower signals but more stability.
### Analyzing and Interpreting Indicators
Understanding technical indicators requires more than mere application. Depth in interpretation is key to unlocking the power of these indicators. For instance, the Moving Average (MA) often helps determine whether an upward or downward trend is about to happen. When the price crosses above its moving average, a bullish (uptrend) is usually on the horizon, and vice versa.
In addition, the Relative Strength Index (RSI) helps to determine whether a security is overbought or oversold. Generally, an RSI above 70 implies that a security may be getting overvalued and is set for a price correction—thus a ‘sell’ signal, while an RSI below 30 implies that the security is oversold and is due for a ‘buy’ signal.
When it comes to the Bollinger Bands, they help identify the volatility of the security. The bands expand during heightened volatility and contract during decreased volatility. Movement of prices towards the upper band signals a buying opportunity, while movement towards the lower band signals selling points.