Technical indicators are some of the most important quantitative tools used by active traders.
Unlike chart patterns, trend lines and other subjectives tools, technical indicators provide numeric data that can be used to make trade decisions. Some traders even use these indicators to create fully automated trading systems!
In this article, we will look at different types of technical indicators and how you can build them into trading strategies.
Four Types of Technical Indicators
There are thousands of different technical indicators developed over the years. While they’re all computed using a security’s price and volume, they can be combined in many different ways to draw many different conclusions about future price movements.
It helps to break down technical indicators into various categories in order to better understand how to use them.
The four major types of indicators include:
- Trend Indicators – Trend indicators are designed to show the trend or direction of the security. For example, is a stock trending higher, lower or sideways? Examples of trend indicators include moving averages, moving average convergence-divergence (MACD) and average directional index (ADI).
- Momentum Indicators – Momentum indicators measure the speed at which a security’s price is moving in a given direction. For example, is a stock’s uptrend strong or weak? Examples of momentum indicators include the relative strength index (RSI), stochastics, and the commodity channel index (CCI).
- Volatility Indicators – Volatility indicators show how volatile a security is at a given point in time. For example, how much might a stock drop over the next week or two? Examples of volatility indicators include Bollinger Bands, envelopes, and average true range (ATR).
- Volume Indicators – Volume indicators show the volume behind a security’s price movement and serve as a confirmation. For example, is the volume following a breakout strong enough for it to hold key support levels? Examples of volume indicators include on balance volume (OBV), Chaikin Money Flow and the Force Index.
To learn more about technical indicators, check out our Trading Indicators section that dives deeper into specific technical indicators and how to use them.
How to Use Charting Techniques of Technical Indicators
There may be thousands of different technical indicators, but adding a lot of indicators to a chart can quickly lead to chaos – especially if you don’t understand them. It’s better to focus on just a handful of useful indicators that you take the time to clearly understand. One such messy chart setup is shown below.
The most common approach is to select one or two types of technical indicator and use them to create a well-rounded trading strategy. For example, you may look for MACD convergences or divergences (trend) for trade entries, look at on-balance volume for confirmation (volume) and then set stop-loss or take-profit points based on Bollinger Band levels (volatility).
There are a few key points to remember when combining technical indicators:
- Trend indicators are most useful for determining the direction of a trade (e.g. a long or short trade).
- Momentum indicators are helpful for determining if a trend is likely to continue or if a reversal is coming soon.
- Volatility indicators are great for setting stop-loss and take-profit points, as well as avoiding getting stopped out.
- Volume indicators are best used as confirmation for other technical indicators.
If you’re trading currencies or futures contracts, you may also want to consider following economic indicators. These are quantitative indicators, but they’re based on economic readings (e.g. GDP or inflation) rather than the price of a security.
Effective Use of Using Technical Indicators
Let’s take a look at a few examples of technical indicator combinations and how they can be used in practice.
1. RSI, MACD & Moving Averages
Many traders use moving averages and the MACD to identify trend reversals, along with the RSI to show when a trend is losing steam. In the example below, buy signals are generated when the price is nearing a key moving average and the MACD is crossing over. Meanwhile sell signals are generated when the RSI approaches overbought levels, suggesting the trend is likely to end.
2. Envelopes & Stochastics with Trendlines
Moving average envelopes are a great way to show support and resistance levels. They also work great with stochastics to generate buy and sell signals. In the example below, buy signals are generated when stochastics reach oversold levels and the price hits the bottom of the envelope and sell signals are generated when the price hits the top of the envelope and stochastics reach overbought levels.
The Bottom Line
Technical indicators are arguably the most important tools for active traders since they provide a quantitative measure of trend direction, momentum, volatility or volume. By understanding how they work and combining them, you can create powerful trading systems that can help increase risk-adjusted returns over time.