Guide to Technical Analysis: What are indicators and How to use them

As discussed in the earlier post “Guide To Technical Analysis: What Is Candlestick?“, This article is a continuation of the post.

This guide is aimed towards intermediate and advanced traders where we explain what are indicators and how to use them to get the perfect entry and exits in a trade for maximizing the profit.

Technical indicators are tools that help in understanding Technical Analysis in a better way.

Without the help of Technical indicators, trading would have been quite difficult. These are chart analysis tools that can help traders to understand and act on price movement in a better way. Technical indicators generally complement fundamental analysis. It helps traders acting fastly and more efficiently. There are multiple indicators, one should focus on only one indicator and should confirm the trade with the help of other technical indicators. Lagging indicators give a slow response while leading indicators give a fast response, which makes them prone to give false signals. Leading Indicators are indicators that lead price movement whereas lagging indicators usually follow price movements.

The best way to use technical indicators is to go to TradingView which is one of the web-based charting platforms available on the internet. All you need to do is visit TradingView, type up the asset name in “Ticker” and load up the chart.

Technical Indicators are of two types:-

Leading Indicators

It is used to forecast the future trend of a market which helps traders to predict market movements too early. It can give false signals too, so it is often used with other technical indicators.

Lagging Indicators

It gives delayed signals based on historical trends. It is used by traders to confirm the price trend before taking any position.

Lagging Indicators

Types of lagging indicators:-

Moving Averages
MACD
Bollinger Bands

Moving Averages

With the help of moving averages, one can find pivot points and from there resistance and support can be easily calculated. Long-term investors generally go with 100 or 200 day moving averages while swing and short-term traders generally use 9/13/20/50 day moving averages.

A rising moving average on charts indicates an upward trend of a particular scrip or index while a declining moving average on charts indicates a downward trend.

Fig: Upward trend

Fig: Downward trend

But the question arises when to buy or sell with the help of moving averages?

Whenever a smaller time-frame moving averages crosses above comparatively larger time-frame moving averages on charts, it generally gives a buy signal (coupled with other technical indicators).

Similarly, whenever a smaller time-frame moving averages dip below comparatively larger-time frame moving averages on charts, it generally indicates a sell signal (coupled with other technical indicators).

Moving averages are of two types:-

Simple moving averages
Exponential moving averages

Simple Moving Averages

It is the simplest form of moving average. It can be computed by the arithmetic mean of a given set of values.

→ How to calculate Simple Moving Averages:-

DAY	NIFTY(50) CLOSING PRICE
1	10891
2	11095
3	11101
4	11200
5	11214
6	11270
7	11322
8	11308
9	11300

SMA = Σ NIFTY(50) CLOSING PRICE

1 _____________________

No. of Days

Here SMA will be 11189 in this case.

Exponential Moving Averages

It is a kind of moving average that is more sensitive to price changes. It gives a quicker indication of buy and sells as compared to that of simple moving averages.

→ How to compute Exponential Moving Averages:-

EMA = Closing Price * Multiplier + EMA (previous day)* (1-multiplier)

Multiplier = [2/(number of observations+1)]

Here no. of observations = 2

Multiplier = 0.1

DAY	NIFTY(50) CLOSING PRICE	EMA
1	10891	10891.00
2	11095	10911.40
3	11101	10936.40
4	11200	10962.76
5	11214	10987.88
6	11270	11016.09
7	11322	11046.69
8	11308	11072.82
9	11300	11095.54

Important terms:-

Crossover:- A crossover is generally used by an analyst/trader for forecasting the trends of a particular asset. Crossover signals can be used to buy or sell an asset. It gives us an idea about breakout and breakdown.

Examples:-

Golden Crossover:- It is a candlestick pattern which is bullish in nature in which relatively short-term moving averages cross long-term moving averages.

Let suppose 50 day MA crosses 200 day MA at some point on the candlestick chart, that point will indicate a change in trend (bullish).

Death Crossover:- It is a candlestick pattern which is bearish in nature in which relatively long-term moving averages cross short-term moving averages.

Let suppose 200 day MA crosses 50 day MA at some point on the candlestick chart, that point will be an indication of the change in trend (bearish). Death crossovers are an indication of huge-sell in an asset.

Bollinger Bands

It is a type of technical indicator which was developed by John Bollinger. It is used for generating oversold and overbought signals.

Bollinger Band is composed of three lines:-

Middle Band:- Exponential moving average (EMA)
Upper Band:- Exponential moving average (EMA) + Standard Deviation
Lower Band:- Exponential moving average (EMA) – Standard Deviation

These bands will expand or contract as the price of an asset becomes volatile or becomes range-bound.

If the price of an asset touches the upper band regularly, it is considered to be overbought. Similarly, it is considered to be oversold if an asset touches the lower band regularly.

The market becomes more volatile when the band widens since standard deviation is a measurement of volatility.

Bollinger Band theory says periods of low volatility generally tend to be followed by periods of high volatility and vice-versa.

→ How to calculate Bollinger Bands:-

Upper Band = MA (TP,n) + m*σ [TP,n]

Lower Band = MA (TP,n) – m*σ [TP,n]

Where MA = Moving average

TP = (High+Low+Close)/3

N = no of days (depends on the type of trade either it is for long term or short term)

m = no of standard deviation (generally it is taken 2)

σ= standard deviation over the last n periods.

Important terms:-

The Squeeze:- When bands come close together, it is called the squeeze. It is a period of low volatility and is anticipated as a potential sign of increased volatility.

Moving Average Convergence Divergence (MACD)

Moving Average Convergence Divergence or MACD is an indicator that shows correlation between two moving averages of an asset’s price. It is the difference between 12-day EMA and 26-day EMA. It represents trend-following as well as momentum.

MACD Line:- The points obtained by calculating the difference of 12-day EMA and 26-day EMA when plotted on the base line gives a MACD line.

Signal Line:- It is a 9-day EMA of the MACD Line.

MACD Histogram:- It is drawn by computing the difference between the MACD Line and Signal Line.

MACD Crossover:- Whenever MACD Line and Signal Line intersect each other, it forms a crossover. MACD crossovers can be either bullish or bearish.

Bullish crossovers are formed when a MACD line crosses above the Signal line and similarly bearish crossovers are formed when a Signal line crosses above the MACD Line.

Bullish crossovers indicate signals to buy an asset whereas bearish crossovers indicate signals to sell an asset.

MACD Divergence

What is Divergence?

It is formed when the price of an asset is moving in the opposite direction of a technical indicator. Divergence is an indication that the current trend might change.

Divergence can be either bullish (positive) or bearish (negative). Bullish divergence is formed when the price of an asset is going down while a technical indicator is moving upwards. Bearish divergence is formed when the price of an asset is going up while a technical indicator is moving downwards.

A bullish MACD divergence can be when the MACD forms two rising lows that correspond with two falling lows on the price. It is a bullish signal when the long-term trend is still bullish.

A bearish MACD divergence can be when the MACD forms two falling highs that correspond with two rising highs on the price. It is a bearish signal when the long-term trend is still bearish.

Leading Indicators

Types of Leading Indicators:-

Relative Strength Index (RSI)
On-Balance-Volume (OBV)
Fibonacci Retracement
Pivot Points

Relative Strength Index (RSI)

RSI is a momentum indicator and was developed in 1978. It is used to identify overbought and oversold zones of an asset. It is displayed as an oscillator and has readings ranging from 1 to 100.

When the RSI is above 70%, an asset is considered to be overbought whereas an asset is considered to be oversold when RSI is below 30%. Overbought and oversold zones are a possible sign of trend reversal or some retracement in an asset.

How to calculate RSI manually:-

RSI = 100 – 100 / [1 + (Avg.Gain/Avg. Loss)]

Let’s suppose the market closed at an average loss of 3 percent in the last 7 days and an average gain of 5 percent in the last 7 days.

RSI = 100-100 / [1+5/3]

= 100-100 / [8/3]

= 100-37.5

= 62.5

RSI Divergence:-

A bullish RSI divergence is formed when RSI forms a higher low in the oversold zone which corresponds to lower low price action. For taking fresh long positions one should wait for the RSI to cross the oversold territory.

A bearish RSI divergence is formed when RSI forms a lower high in the overbought zone which corresponds to higher high price action.

On-Balance Volume (OBV)

On-Balance Volume is a momentum indicator that is used to predict changes in asset prices with the help of a volume indicator. If volume increases without a change in the price of an asset, then it shows that volatility can be on either side.

It is prone to give false signals, so in order to produce accurate findings, it can be used with lagging indicators like moving averages.

How to compute On-Balance Volume:-

OBV = OBVprev + volume, if close > closeprev
OBV = OBVprev + 0, if close = closeprev
OBV = OBVprev – volume, if close < closeprev

Here,

OBV = current on-balance volume level

OBVprev = previous on-balance volume level

Fig:- Charts depicting the on-balance volume indicator.

Fibonacci Retracement

This is also a leading indicator that is used to identify potential reversal levels. These are horizontal lines that indicate where supports and resistances are likely to occur. These are the ratios that are found in the Fibonacci sequence. Most popularly used Fibonacci retracement levels are 61.8%, 38.2%, 23.6%.

Understanding Fibonacci retracement

Fibonacci Series:- It is a sequence of numbers starting from 0 arranged in such a way that the value of any number in the series is the sum of the previous two numbers.

The fibonacci sequence is 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144………..

21/13 = 34/21 = 55/34 = 89/55 = 144/89 = 1.618

1.618 is called the golden ratio and it is also called phi.

When a number in the Fibonacci series is divided by its immediate succeeding number, then a unique pattern is also found;

8/13 = 13/21 = 21/34 = 34/55 = 55/89 = 89/144 = 0.618 i.e 61.8%

Similarly, when a number in the Fibonacci series is divided by a no. two places higher;

13/34 = 21/55 = 34/89 = 55/144 = 0.382 i.e 38.2%

Similarly, when a number in the Fibonacci series is divided by a no. three places higher;

13/55 = 21/89 = 34/144 = 0.236 i.e 23.6%

Whenever an asset moves either upward or downward sharply, it tends to retrace back before its next move. Let suppose an asset moves upwards quickly and a trader missed a chance of entry earlier, he can enter the trade after a pull-back or retracement. The first retracement level to watch out will be 23.6%, then 38.2%, and then 61.8%.

Important terms:-

Swing High:- A swing high is when an asset makes a high and is followed by two consecutive lower highs.

Swing Low:- A swing low is when an asset makes a low and is followed by two consecutive higher lows.

If an asset is in a downtrend, then start with the swing high and move the cursor all the way down to swing low while if it is in an uptrend, then start with the swing low and move the cursor all the way up to swing high.

How to use the Fibonacci retracement tool?

Identify swing high and swing low first.
Select the Fibonacci retracement tool.
In the case of an uptrend, connect the swing high from swing low and connect swing low from the swing high in case of downtrend using the Fibonacci retracement tool.
One can change from settings that retracements levels to display or which do not.

Note:- This indicator produces the best results when coupled with other technical indicators.

Pivot Points

It is a leading indicator that is used to determine the overall trend of an asset and can be applied to all time frames. It is the average of high, low, and closing prices of an asset. On the basis of pivot points, support and resistance can be computed for an asset.

If an asset is trading below the pivot point, it indicates bearish sentiments while it indicates bullish sentiments if an asset is trading above the pivot point.

How to calculate pivot points?

Calculate the average of High, low, and closing price of an asset. It will work as pivot points for the next day.

With the help of Pivot Point (P), calculate S1, S2, S3, R1, R2, and R3 using the below formula:-

P = (High+Low+Close) / 3

S1 = P*2 – High

R1 = P*2 – Low

S2 = P – (High-Low)

R2 = P + (High-Low)

S3 = Low – 2(High-P)

R3 = High + 2(Low-P)

Fig:- Charts showing pivot points and S1, S2, S3, and R1, R2, R3.

Closing Thoughts

With the help of Technical indicators, one can understand the proper entry and exit price of an asset, with which one can easily maximize their profits. We would love to respond to any queries you may have. Feel free to reach out to us by commenting on this article.

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Guide to Technical Analysis: What are indicators and How to use them