What Is a Technical INdicator
What Is a Technical Indicator?
formula to the price data of a security. Price data includes any combination of the open, high, low or close over a period of time. Some indicators may use only the closing prices, while others incorporate volume and open interest into their formulas. The price data is entered into the formula and a data point is produced. For example, the average of 3 closing prices is one data point [ (41+43+43) / 3 = 42.33 ].
However, one data point does not offer much information and
does not make for a useful indicator. A series of data points over a period of
time is required to create valid reference points to enable analysis. By
creating a time series of data points, a comparison can be made between present
and past levels. For analysis purposes, technical indicators are usually shown
in a graphical form above or below a security's price chart. Once shown in
graphical form, an indicator can then be compared with the corresponding price
chart of the security. Sometimes indicators are plotted on top of the price
plot for a more direct comparison.
What Does a Technical Indicator Offer?
A technical indicator offers a different perspective from
which to analyze the price action. Some, such as moving averages, are derived
from simple formulas and the mechanics are relatively easy to understand.
Others, such as Stochastics, have complex formulas and require more study to
fully understand and appreciate. Regardless of the complexity of the formula,
technical indicators can provide a unique perspective on the strength and
direction of the underlying price action.
A simple moving average is an indicator that calculates the
average price of a security over a specified number of periods. If a security
is exceptionally volatile, then a moving average will help to smooth the data.
A moving average filters out random noise and offers a smoother perspective of
the price action. Veritas (VRTSE) displays a lot of volatility and an analyst
may have difficulty discerning a trend. By applying a 10-day simple moving
average to the price action, random fluctuations are smoothed to make it easier
to identify a trend.
Why Use Indicators?
Indicators serve three broad functions: to alert, to confirm
and to predict.
An indicator can act as an alert to study price action a
little more closely. If momentum is waning, it may be a signal to watch for a
break of support. Alternatively, if there is a large positive divergence
building, it may serve as an alert to watch for a resistance breakout.
Indicators can be used to confirm other technical analysis
tools. If there is a breakout on the price chart, a corresponding moving
average crossover could serve to confirm the breakout. If a stock breaks
support, a corresponding low in the On-Balance-Volume (OBV) could serve to
confirm the weakness.
According to some investors and traders, indicators can be
used to predict the direction of future prices.
Tips for Using Indicators
Indicators indicate. This may sound straightforward, but
sometimes traders ignore the price action of a security and focus solely on an
indicator. Indicators filter price action with formulas. As such, they are
derivatives and not direct reflections of the price action. This should be
taken into consideration when applying analysis. Any analysis of an indicator
should be taken with the price action in mind. What is the indicator saying
about the price action of a security? Is the price action getting stronger?
Weaker?
Even though it may be obvious when indicators generate buy
and sell signals, the signals should be taken in context with other technical
analysis tools. An indicator may flash a buy signal, but if the chart pattern
shows a descending triangle with a series of declining peaks, it may be a false
signal.
On the Rambus (RMBS) chart, MACD improved from November to
March, forming a positive divergence. All the earmarks of a MACD buying
opportunity were present, but the stock failed to break above the resistance
and exceed its previous reaction high. This non-confirmation from the stock
should have served as a warning sign against a long position. For the record, a
sell signal occurred when the stock broke support from the descending triangle
in March-01.
As always in technical analysis, learning how to read
indicators is more of an art than a science. The same indicator may exhibit
different behavioral patterns when applied to different stocks. Indicators that
work well for IBM might not work the same for Delta Airlines. Through careful
study and analysis, expertise with the various indicators will develop over
time. As this expertise develops, certain nuances, as well as favorite setups,
will become clear.
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