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A technical indicator is a series of data points that are obtained by applying a formula to the price data of the underlying security. Price data includes open, high, low, close, or a combination of such data over a period of time. The most commonly used price data is the closing price, but some indicators also make use of open interest and trading volume as well.
Technical analysts use indicators in tandem with share prices and volumes to confirm trends and possible reversal points in stocks.
Technical indicators are usually shown in a graphical format plotted below or on top of the price chart.
A technical indicator provides a different angle/perspective on a security to determine its price action as well as help analyze its strength and momentum.
Indicators are used to perform three broad functions i.e. to alert, to confirm, and to predict price trends in stocks.
There are two main categories of indicators:
Leading indicators are those created to precede the price movement of a security and have predictive qualities. They are best used during periods of sideways consolidation in price i.e. non-trending sideways movement. This is because leading indicators tend to generate frequent buy/sell signals, which make it best suited for choppy markets compared to trending markets. Traders need to make sure the indicator is heading in the same direction as the underlying trend in the security.
Traders use leading stock indicators to predict future price moves. Ideally, leading stock indicators signal you to enter a trade before a new trend develops or an existing trend reverses so that you can ride the momentum for maximum profit. But the issue with leading indicators is that they may generate many whipsaws or false signals.
Most of the leading indicators are oscillators. This means that these indicators are plotted within a bounded range. As the value of the oscillator reaches the extreme upper value, the security is considered to be overbought. Similarly, it is considered oversold when it reaches the lower end of the band.
Lagging indicators follow a stock's price and provide confirmatory signals. For example, a lagging indicator can confirm that a stock has developed an uptrend and is likely to continue to surge.Lagging indicators are not suitable to predict future rallies or pullbacks. They can confirm what trends have developed up until the current point but are not able to predict the next price movement.
Lagging indicators are more useful during trending periods. This is because lagging indicators tend to focus more on the trend and produce fewer buy-and-sell signals, which is the best strategy in such markets.
There are two main ways to interpret the buy/sell signals that are generated using indicators.
Crossover: Crossover occurs when the indicator moves through an important level or the centerline. It signals that the trend is reversing and this trend reversal will lead to an expected movement in the price of the security.
For example, if the RSI crosses above the 30-level, it signals that the security is moving away from an oversold level and a short-term bounce in its price can be expected.
Divergence: Divergence occurs when the price and the direction of the indicator are trending in opposite ways.
Divergence is of two types – positive and negative.
A positive divergence occurs when the price of the security is trending downwards, i.e. making new lows, while the indicator is trending higher. This is a bullish signal which indicates that the underlying momentum is starting to reverse and a reversal in the price of the security may soon be witnessed.
A bearish divergence occurs when the price of the security is trading higher, i.e. making new highs while the indicator is trending lower. This is a bearish signal that indicates a weakening in the underlying momentum of the stock.
Indicators provide analysts with useful, additional information and help them make better informed decisions. However, taking your trading decisions solely based on a single indicator could be misleading. Hence, indicators are best used in conjunction with price charts.