When it comes to investing, we use a ton of different metrics to derive a stock’s value.
Digging deep into a firm’s balance sheet and checking sales, debt levels and a variety of other information are used to create statistics like P/E or PEG ratios. We can use this to compare various stocks across the board.
The thing is, none of these metrics work when it comes to trading.
That’s because trading is all about the short-to-medium term. Traders rely on a different set of indicators and metrics to determine whether or not to buy or sell a stock or options contract. And these indicators are very different than what we use for more traditional buy & hold investing.
But how do you know your Bollinger Band from your MACD? How do you choose what indicator is right for your portfolio and needs? Luckily, here at TraderHQ, we’ve done some of the legwork for you. Here’s our quick guide to choosing the right technical indicators.
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A Focus on Signals & Charting
Perhaps the biggest difference and what gets a lot of investors into trouble when they start trading is that we aren’t looking at fundamentals. A firm’s sales, price or other “value” determining metrics are pretty meaningless when it comes to trading. What we are really looking for are signals that will determine a stock’s movement in the short-to-medium term. It doesn’t matter if a stock’s P/E is a screaming bargain if the signals are not there to move it higher. All in all, technical indicators are mathematical calculations that can be applied to a stock’s past performance to help determine its future position
To that end, successful investors-turned-traders need to switch up their thinking and focus on these short-term signals. And they basically come in four flavors: Momentum, Trend, Volatility and Chart Studies. Individual indicators under these categories can either be leading, which predict a future pattern, or lagging, which can be used to conform and ride a trend.
Besides normal trading strategies, it is equally important to keep track of the broader market via different types of economic indicators. Click here to have a broad idea about these indicators.
To start, momentum indicators are used to determine the speed of price movements over time. Like Isaac Newton said, “objects in motion tend to stay in motion.” This is true for stocks. Stocks that are moving higher or lower will generally keep that pattern for some time. Momentum indicators like Stochastic oscillators and the Relative Strength Index (RSI) tend to be leading indicators, in that they predict the pattern of movement.
Trend indicators are designed to measure the direction and strength of a stock’s price. After establishing a baseline, trend indicators such as the 200-day moving average can be used to see if a stock is moving higher or lower. For example, if a stock breaks through its 200-day MA, it can be thought of as a bullish sign for future movement. A stock’s Moving Average Convergence Divergence (MACD) seeks to quantify this movement down to a signal number – above zero and the price trend is likely up. Below zero and the opposite is true. Traders can base their buying/selling decisions on that number.
Volatility is a measurement of the magnitude of price fluctuations over time. Basically, you’re looking at how far a stock will move in either direction. And that’s just what volatility indicators are trying to do. You’re looking to see how much a stock is moving relative to its past performance or broader index. For example, Bollinger Bands measure the highness and lowness of a stock’s volatility to create a range. Breaking through this range tends to indicate a new pattern of highs and lows.
Finally, traders rely on charts to determine indicators for future movements. Charts can be helpful in measuring volume of shares traded or finding patterns in trend lines. The very popular Fibonacci series of charting techniques uses volume patterns within a chart to show break-outs and drop-offs in a stock.
A Combination of Indicators Is Critical
Certainly, there are traders who only specialize in one of these major indicator categories or sub-metrics. However, the best traders often use a few different indicators to place their bets and optimize their performance. The key is making sure you don’t choose redundant indicators.
Given the four basic varieties of technical indicators choosing two signals from the same category will produce similar results. Both stochastics and RSI metrics tend to predict the same thing with slight variation. Running both on a stock may not produce different results and that could lead to confirmation bias and a bad trade. It’s best if traders pick one or two indicators from different categories to provide a correct signal for the trade. Complementing indicators is the best way to help fight redundancy.
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A prime example of this could be combining RSI, Bollinger Bands and MACD for a stock. Here, the relative strength index can be used to gauge a firm’s momentum, up or down. The Bollinger bands look to see the volatility of the stock’s price movements. Has it been more volatile lately and broken through its trading range? Finally, comparing this to its 50- and 200-day moving averages can underscore future price/movement trends. The following chart of beverage firm Coca-Cola (KO) shows the three indicators in action and you can see how KO has trended higher across all three metrics.
The Bottom Line
Unlike investing, trading comes down to indicators. It’s all about whether or not a signal has gone off to support a movement higher or lower. And there are a variety of different signals to choose from. The key is for investors to find complementary metrics to confirm a trade. Picking one from each major category is what separates the just-ok traders from the good ones. Helping fight redundancy in the signals is what makes for profitable trades.