Types Of Indicators And How To Use Them
A stock indicator is a formula that takes certain market data and transforms that data into a line or histogram to provide a graphical view of what is happening with price to determine what may happen in the near future. Indicators are near term analysis tools and can't predict long term events. Technical Analysis which includes the study of price patterns and stock indicators, can sometimes anticipate a major intermediate term event but not a precise date.
Although there are hundreds of stock indicators, there are only 3 primary pieces of data used in any stock indicator and those are Price, Volume aka Quantity, and Time.
All indicators are predicated on these few data streams, but there are fewer constraints than you might think. We are dealing with a string of data that is ever changing and there are innumerable ways to manipulate how a formula interprets that data.
Indicator analysis is linear and considers at least two of the three pieces of data in a calculation. What indicator writers attempt to do is to understand what Price, Volume aka Quantity, and Time have done, the relationship between each, and what that means for near future price action. Stock Indicators can expose a weakness that the candlestick chart pattern doesn't show yet, or help the trader recognize the linear progression of price action. The entire purpose of stock indicators is to define where price has been and where it is going.
Price is an indicator unto itself. Price action, especially as it relates to previous Price action tells you more about what is going on than any other indicator by itself. It is no wonder then that most stock indicators are formulated to interpret Price action.
The following are the basic types of indicators:
Velocity or Momentum Indicators
The following is a description of how each of these types of stock indicators, works for a specific type of Market Condition:
Price Oscillators were designed for markets that are moving sideways rather than trending up or trending down. Stochastic is an oscillator that is very popular and has been around for several decades. It is a Price Oscillator that tracks Overbought/Oversold conditions.
Trend indicators work best in an Up Trending or Down Trending Market. The most common and popular trending indicator is the Moving Average. A Moving Average is a formula that smoothes price action over a specific period of time so that the trader can get a better view of what Price is doing, and in particular the Angle of Ascent™ of Price. Moving Averages lag Price, meaning that a Moving Average will continue to move up even when a stock Price has fallen back. The Moving Average takes time to catch up to the Price action. Therefore, Moving Averages are not good in some types of market conditions. At TechniTrader we use Moving Averages as Sub-indicators most often.
Quality indicators work best in value oriented markets rather than speculative market conditions, but can be useful during all market conditions. One of these indicators should be included in every indicator set-up. Quality indicators reveal whether the Price action is likely to continue, and how long it might continue in the short term. One of the most popular quality indicators is Volume. Volume is the most important indicator next to Price. As an example, fading Volume during a velocity run pattern can warn early that the run is nearing its end.
Velocity or Momentum indicators are also Hybrid indicators. They track more than one piece of data at a time. Velocity indicators are important during Trending markets, but can be useful during most market conditions. Velocity or Momentum refers to the acceleration rate at which Price rises or the Volume behind the Price action, so most Velocity indicators track Price and Volume. Worden's MoneyStream MS indicator for example tracks Volume Velocity and Accumulation/Distribution, so it reveals the money flowing into or out of a stock.
Accumulation/Distribution indicators reveal the accumulation and distribution patterns of large lot investors and traders. The institutions dominate the modern marketplace, so it is important to track their buying and selling patterns. Accumulation/Distribution indicators are important during all market conditions and for all trading styles. Worden's Balance of Power BOP is an Accumulation/Distribution indicator. It shows large lot buying with green bars and large lot selling with red bars.
The Cycle Indicator is a type of oscillating indicator that exposes where the stock is in its cycle pattern, whether that cycle is strong or weak, and the duration or length of time between the peak and trough of that cycle. These indicators should only be used for stocks that have a cyclical pattern that occurs repetitively. One such indicator is the Commodity Channel Index CCI.
A Sub-Indicator is a type that can be applied to a primary indicator to make analyzing easier and faster. A common Sub-Indicator is Rate of Change ROC, which tracks how quickly or slowly the primary indicator is changing. As an example if Rate of Change is applied to Volume bars, it will reveal how quickly Volume is changing. If Volume suddenly changed from low volume to high volume, the Rate of Change indicator would show this in an easier-to-read graphical form than Volume all by itself.
We suggest having a well-rounded group of five indicators to use to analyze stocks. With a balanced group of indicators you will have a better idea of whether Price is going to move, and if the move will follow through. In order to have a well-rounded indicator base to analyze stocks thoroughly, you need to include one of each type of stock indicator:
1. Price Trend
2. Price Momentum
3. Money-flow into or out of the stock
4. Volume and consistency of Volume
Stock Indicators will need to be adjusted from time to time based on market conditions, whether it is a trending market or a sideways market. The market is ever changing and requires adaptability. Indicators are only reliable when used as they were intended.
Don't worry about learning all the indicators out there. There are 250+ stock indicators available and all you need to do is have a small group that covers all the different aspects of data analysis. Learn about the different types of indicators and the market conditions in which they work best, and then choose a well-rounded group to use for confirmation of candlestick patterns and buy signals.
And don't go live with every new fad that comes along. There is always the risk of indicators being overused. Indicators can be overused and exploited, and this can cause the trader using these indicators to have poor results. Overuse by too many traders can create an imbalance of order flow or "Cluster Orders," that trigger the automated execution systems of High Frequency Trading HFT.
Experiment with indicators only in paper trading or on a trading Simulator. Testing of an indicator means that you check several hundred charts over an extended period of time to confirm what you believe the indicator is exposing. Going live in the market before you have tested indicator theory is unwise.
Stock Indicators are trading tools. They were designed to aid the investor or trader in determining an indication of market or Price direction, momentum, and potential strength of such action. They are not hard and fast rules. An indicator should not be used as a buy or entry signal. Price is the most important aspect of chart analysis. Therefore Price patterns should be used for entries, with the correct indicators confirming that the stock Price has the energy to sustain and continue moving.
Some stock indicators take time to learn, others are easy to interpret. It is well worth taking some time to learn about the different indicators and what market conditions they work best in. This will increase your success rate for investing or trading in stocks.
I invite you to visit my website at www.technitrader.com
Martha Stokes CMT
Chartered Market Technician
Instructor and Developer of TechniTrader Stock & Option Courses
Copyright ©2015 Decisions Unlimited, Inc. dba TechniTrader. All Rights Reserved.
TechniTrader is also a registered trademark of Decisions Unlimited, Inc.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.