What are Technical Indicators?
Technical indicators analyze short-term price movements of a currency or any other instruments. The technical Indicators are derived from applying a formula to the price data of any currency pair and from that predict future price levels or simply the general direction of a currency.
Used correctly technical indicators can help to spot unique trading opportunities, help you make more informed trading decisions, and enhance your trading experience.
Types of Technical Indicators
First, we must learn about the three different types of indicators:
- Lagging indicators (Example: Moving Averages).
- Leading indicators (Example: Stochastic and MACD).
- Confirming indicators (Example: On Balance Volume).
Technical indicators can also be classified based by what information we can extract from them. There are four main categories: trend, momentum, oscillators, and volatility.
The lagging indicators are called lagging because they often use a longer period for the calculation. The lagging indicators are used as filters, like the Moving Average for trend determination. The whole idea about using lagging indicators as filters is that they remove the short term noise because it’s a longer period indicator. When we remove the noise it helps to identify the trend.
All indicators are lagging but the Leading indicators are so named because they try to “predict” price by using a shorter period in the calculation. Leading indicators are created to precede price movements. The reason why every indicator is lagging is because they are not price action itself.
Leading indicators can be a useful tool to be used for trade entries. The leading indicators perform best during periods of consolidations or ranges and underperform during strong trading periods. The most popular leading indicators are the Relative Strength Index (RSI) and the Stochastics. They are both oscillator indicators.
The three most popular ways that the leading indicators are used to signal potential buy and sell signals are (1) through spotting bullish/bearish divergences (2) overbought and oversold conditions or (3) crossovers.
A bearish divergence occurs when the price makes a new higher high, but the oscillator indicator fails to do so and makes a lower high and vice versa for a bullish divergence.
Confirming indicators can help us validate our analysis and our trades. Just like the name says they only confirm a move by looking at volume or other confirming indicators. They reassure us that what we’re doing is more than likely correct. In this regard, they can be a very powerful tool in our trading arsenal.
One example of confirming indicator is On Balance Volume. In technical analysis, an increase in volume confirms the prevailing trend. If the market moves in a downtrend or uptrend and the volume increases, it means the odds that we have a real trend are higher.
Proper Use of Indicators
Use indicators with care. Using more than one of the same types of indicators can do more harm than good. For example, if you’re using the Stochastic Oscillator and RSI at the same time, you’re using two leading indicators that explain the same thing. They will end up confusing you. It’s important to know what each indicator can tell you before combining them on a chart.