Using trading indicators is a fundamental part of any technical trader’s strategy. When paired with effective risk management tools, it can significantly improve your ability to gain more insights into price trends. Let’s explore the top ten best trading indicators.
Table of Contents
What are Trading Indicators?
Trading indicators, also called technical indicators, are mathematical computations represented as lines on a price chart, serving as valuable tools for traders to recognize specific signals and patterns within the stock market. These indicators are simply a collection of tools applied to a trading chart, which is a graphical representation of the price history of an asset or security over a specified time period. Trading indicators simplify market analysis and make it clearer.
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10 Best Trading Indicators
Tools for day traders and technical analysts include charting instruments that generate buy or sell signals and indicate market trends or patterns. In a broader sense, these tools or trading indicators can be categorized into two fundamental types: overlays and oscillators.
- Overlays: Technical indicators that use the same price scale are superimposed on the stock chart, appearing alongside price data. Some examples of these indicators include Fibonacci lines, moving averages, and Bollinger Bands.
- Oscillators: Instead of being placed directly on a price chart, technical indicators that fluctuate between a local maximum and minimum are typically positioned either above or below the price chart. Some examples of such indicators include the RSI, stochastic oscillator, and MACD.
In this blog, our focus will primarily be on these second kind of technical indicators, oscillators. Traders frequently use multiple technical indicators simultaneously when analyzing a security. Given the thousands of available options, traders must select the indicators that suit their preferences.
1. Moving Average (MA)
The moving average (MA), which stands for ‘simple moving average’ or SMA, is an indicator tool used to figure out which direction the price of something is going right now without getting distracted by shorter-term price jumps. The MA indicator combines the prices of stock or a commodity over a set period of time and then divides it by the number of prices or data points. This gives you a line on the trading chart that shows the overall direction of the price.
The moving average is computed by finding the average of a security’s price across a defined timeframe. The prevalent types of moving averages include simple moving averages (SMAs), weighted moving averages, and exponential moving averages (EMAs). We will discuss EMAs further in the next section. Now, let us look into the formula of SMA:
A SMA for n periods is calculated as below:
SMA = (P1 + P2 + … + Pn) / n
Here, Pn is the data point in the nth period.
Look into the example of SMA in the COH chart given below:
Think of a 21-period simple moving average like this: it adds up the closing prices of the last 21 periods (like days or hours) and then divides the total by 21. Because SMA treats all those prices equally, it’s the slowest of the three types of moving averages. But SMA values can be useful. Simple moving averages give us a steady idea of where the trend is going, which is often a safe bet.
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2. Exponential Moving Average (EMA)
The exponential moving average (EMA) is another form of moving average. Unlike the simple moving average (SMA), it pays extra attention to the most recent data points, which helps it be more responsive to new information. When you use EMA along with other tools, it can help traders confirm big market changes and check if they are legit.
An EMA for n periods is calculated as below:
EMA = (C – P) * (2 / (n + 1)) + P
Here, C and P are the current data points and an exponential moving average of the previous period, respectively.
Now, let’s look at the below-given COH chart once more. But this time, we have two lines on the chart: a 21-period exponential moving average and a simple moving average. They may seem alike, but if you look closely, you’ll see that the exponential moving average sticks closer to the price than the simple moving average does. It’s like a closer friend to the price movements.
3. Stochastic Oscillator
A stochastic oscillator, or momentum indicator, aids in predicting whether a stock will rise or fall within a specific timeframe. It assesses a stock’s current price relative to its recent performance. To reduce its sensitivity to market fluctuations, adjustments to the time period or computation of the moving average can be made. This tool generates values ranging from 0 to 100. A very high number implies the stock might be overpriced, while a very low number suggests the stock could be a favorable investment opportunity.
%K = (Close – Lowest Low) / (Highest High – Lowest Low) * 100
%D = 3 – period moving average of %K
Here:
- %K is the fast stochastic line.
- %D is the slow stochastic line.
- Close is the current closing price of the security.
- Lowest low is the lowest low price for the look-back period.
- Highest high is the highest high price for the look-back period.
4. Moving Average Convergence/Divergence (MACD)
The moving average convergence/divergence (MACD) indicator utilizes two types of exponential moving averages, typically using a 26-period EMA and a 12-period EMA as its standard parameters. It calculates the difference between these moving averages, creating an oscillator, and then applies a 9-period moving average to this difference. This moving average, called the signal line, plays an important role as it triggers a buy signal when the MACD crosses above it and a sell (or short) signal when it crosses below. It’s important to highlight that this MACD application can lead to false signals in a sideways market, similar to other moving average indicators we’ve discussed previously.
MACD = 12-Period EMA − 26-Period EMA
In the above Hershey Co. chart, we’ve identified three ways to utilize MACD. Example A in the chart shows MACD divergence from the trigger line, indicating a strong upward trend. It’s important to note that MACD crossing the trigger line is not always a reliable long signal, as demonstrated in Example B in the chart during a consolidation phase. Another valuable feature of the indicator is when MACD goes horizontal at the zero line, signaling a period of consolidation and indicating it’s not an opportune time to trade in any direction.
5. Bollinger Bands
A Bollinger Band is an indicator used to calculate the typical trading range of an asset’s price. The width of the band increases and decreases to reflect recent fluctuations in price volatility. When the bands are close together, indicating a “narrow” configuration, it suggests that the financial instrument is experiencing lower perceived volatility. Wider bands signify higher perceived volatility.
If the price consistently moves to the upper bounds of the band, it may indicate an overbought condition, whereas if it consistently falls below the lower band, it could suggest an oversold condition.
BOLU = MA(TP,n) + m∗σ[TP,n]
BOLD = MA(TP,n) − m∗σ[TP,n]
Here,
- BOLU = Upper Bollinger Band
- BOLD = Lower Bollinger Band
- MA = Moving average
- TP (typical price) = (High + Low + Close) ÷ 3
- n = Number of days in smoothing period
- M = Number of standard deviations
- σ[TP,n] = Standard deviation over last n periods of TP
6. Relative Strength Index (RSI)
The relative strength index stands as a most-used momentum indicator, created through the comparison of upward and downward price movements within a specified time frame. This indicator is well-suited for assessing overbought and oversold conditions, with 70 indicating overbought status and 30 signifying oversold conditions.
RSI = Umean / Dmean
After that, RSI is calculated using the following formula:
RSI = 100 – (100/[1 + {14-Day Average Gain/14-Day Average Loss}])
In this example, when we see a clear break at these levels (70 and 30), it’s a good sign that a market reversal might happen. Another method to interpret the RSI indicator involves observing values surpassing or falling below 50. If the RSI is above 50, it typically means the market is going up, while below 50 indicates a downward trend, as shown in the example above.
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7. Fibonacci Retracement
Fibonacci retracement is an indicator tool to determine the extent of a market’s deviation from its current trend. This deviation, commonly called a retracement or pullback, is a temporary decline in market prices.
People who trade in the stock market use Fibonacci retracement to figure out if the market is about to go up or down. This tool assists in identifying specific levels where the market could pause or alter its direction. Knowing these levels helps traders decide when to protect their investments and when to buy or sell stocks.
8. Ichimoku Cloud
The Ichimoku Cloud is primarily used to identify trends, potential trend reversals, and support/resistance levels. Traders often look for various combinations and positions of these components to make trading decisions. When the components align in a certain way, it can be seen as a signal to buy, sell, or stay out of the market. It’s a complex tool, but it can be very informative for experienced traders.
9. Parabolic SAR
The Parabolic SAR, created by J. Welles Wilder, serves as a technical tool designed to ascertain the asset’s trajectory. This indicator, commonly known as the SAR (stop and reverse) system, is employed to pinpoint potential shifts in the price movement of traded assets and to establish entry and exit points.
The parabolic SAR primarily operates within trending markets. Wilder’s recommendation is for traders to initially discern the trend’s direction through the parabolic SAR and subsequently employ other indicators to gauge the trend’s strength.
When visualized on a chart, the parabolic SAR indicator manifests as a sequence of dots. If these dots materialize beneath the present price, they are construed as a bullish signal. Conversely, when they materialize above the current price, they are interpreted as a bearish signal. These signals are utilized to determine stop-loss and profit-taking levels.
Uptrend: PSAR = Previous PSAR + AF (EP – Previous PSAR)
Downtrend: PSAR = Previous PSAR – AF (Previous PSAR – EP)
Here:
- EP is extreme price. In an uptrend, EP is the highest high. In a downtrend, EP is the lowest low.
- AF is an acceleration factor. The default AF is usually 0.02, with most platforms allowing an AF value of up to 0.20.
10. Average Directional Index (ADX)
The average directional index (ADX) is utilized for quantifying the strength of a trend. Its calculations are based on a moving average of the expansion in price range over a specified period, typically set at 14 bars by default. However, other timeframes can also be applied. ADX is a versatile tool applicable to various trading assets, including stocks, exchange-traded funds, mutual funds, and futures.
ADX is visually represented as a single line, displaying values that span from zero to 100. It’s worth noting that ADX lacks a directional bias; it gauges the strength of a trend, whether prices are moving upward or downward. Usually, this indicator appears on the chart alongside the two directional movement indicator (DMI) lines, from which ADX is calculated.
What You Need to Know Before Using Trading Indicators
Trading indicators are tools that can help you make better trading decisions, but they are not perfect.
Here are some things to keep in mind when using trading indicators:
- Don’t rely on indicators alone. Use them in conjunction with other forms of analysis, such as fundamental analysis.
- Not all indicators are created equal. Choose indicators that are appropriate for your trading style and goals.
- Don’t use too many indicators. Focus on a few well-chosen indicators.
- Confirm signals with other methods. Don’t trade solely on the signals generated by indicators.
- Backtest indicators before using them in live trading.
Benefits of Using Trading Indicators
Trading indicators are mathematical calculations that help traders analyze and interpret price charts. They can be used to identify trends, measure momentum, and spot potential reversals. While no indicator is perfect, they can be valuable tools for traders who use them correctly.
Here are some of the benefits of using trading indicators:
- Identify Trends: Indicators can help traders identify the direction of a trend, which can be helpful for making decisions about buying or selling. For example, a moving average crossover can signal a trend change.
- Measure Momentum: Indicators measure a trend’s momentum, aiding traders in assessing its strength and potential continuation. For instance, the relative strength index (RSI) helps recognize overbought and oversold situations.
- Spot Potential Reversals: Indicators can also help traders spot potential reversals in a trend. For example, a divergence between price and an indicator can be a sign that a trend is losing momentum and may reverse.
Final Word
Trading indicators are tools for understanding the stock market. They show us things like which way prices are going, how fast they’re moving, and how many people are buying and selling stocks. Big banks, investment firms, experts in trading, and even regular folks who invest for the long term use these tools to help them make smart decisions. But just like any tool, you have to use them the right way and know what they’re telling you to get the most out of them.
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