There are four kinds of technical indicators that we will discuss; price-based indicators, momentum oscillators, sentiment indicators and flow-of-funds indicators.
They incorporate the information contained in the current and past market prices. The common types are:
It is the average of the closing prices over a specified number of periods. They are used to smooth out short-term price fluctuations and help identify the trend. When a short-term moving average crosses from underneath a longer-term average, this movement is considered bullish and is known as a golden cross. When a short-term moving average crosses from above a longer-term average, this movement is considered bearish and is known as a dead cross.
Bollinger bands consist of a moving average plus a higher line representing a set number of standard deviations and a lower line representing a set number of standard deviations. The figure below shows a Bollinger band and a moving average.
The more volatile the security becomes, the wider the range becomes between the two outer lines or bands. A common use of a Bollinger band is to create trading strategies such as a contrarian strategy. In this strategy, an investor sells when a security’s price reaches the upper band and buys when it reaches the lower band. The contrarian strategy assumes that the security’s price will stay within the bands.
They help to identify changes in the market sentiment. The common types are:
Rate of change (ROC) oscillator:
It oscillates around 0 (or around 100 if an alternative formula is used for calculation). When the ROC oscillator crosses zero into the positive territory, it is considered bullish. When the ROC oscillator crosses zero into the negative territory, it is considered bearish.
Relative strength index (RSI):
RSI graphically compares a security’s gains with its losses over a given period. The popular time period is 14 days. The value of the RSI is always between 0 and 100. A value above 70 represents an overbought situation while a value below 30 suggests that an asset is oversold.
It is based on the observation that in uptrends, prices tend to close at or near the high end of their recent range. Similarly, in downtrends, they tend to close near the low end. It is composed of two lines, called %K and %D that are calculated as follows:
C = latest closing price
L14 = lowest price in past 14 days
H14 = highest price in past 14 days
%D = average of the last three %K values calculated daily
%D is the average of three %K values. It is slower moving and is also called the signal line.
When the %K moves from below the %D line to above it, this move is considered a bullish signal. On the other hand, when %K moves from above the %D line to below it, this pattern is considered bearish.
The stochastic oscillator has a default setting of 14-days.
Moving-average convergence/divergence oscillator:
It is the difference between a short-term and a long-term moving average of the security’s price. It is composed of two lines – MACD line and signal line.
The indicator oscillates around 0 and has no upper or lower limit.
MACD is used in technical analysis in three ways.
The most known use of momentum oscillators is to indicate the overbought or oversold position of a security. Thus, they help in providing signal for buying or selling security but do not help to set the target price.
They gauge investor activity for signs of bullishness or bearishness. The common types are:
Regular polls are conducted of investors and investment professionals to gauge the overall market sentiment.
Calculated statistical indices:
They indicate the change in potential demand and supply. The common types are:
The Arms index: (also known as TRIN)
It is calculated as:
When this index is near 1, the market is in balance. A value above 1 means that there is more volume in declining stocks and that the market is in a selling mood. A value below 1 means that there is more volume in increasing stocks and that the market is in a buying mood.
Margin loans may increase the purchases of stocks and declining margin balances may force the selling of stocks.
Mutual funds cash position:
Mutual funds must hold some of their assets in liquid assets (i.e. cash and cash equivalents) to pay for miscellaneous expenses and to fund redemptions. During a bullish market, the cash positions tend to be low. During a bearish market, the cash positions tend to be high.
New equity issuance:
IPOs are often timed with bullish markets to get the best valuations. A large number of IPOs may indicate that a market is near its peak.
Like IPOs, technicians also monitor secondary offerings to gauge potential changes in the supply of equities.