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7 Technical Indicators to Build a Trading Toolkit

Sebencapital

Published
02/10/23
7 Technical Indicators to Build a Trading Toolkit

Technical indicators are tools traders use to understand the dynamics of the securities market and investor sentiment. They are a fundamental part of technical analysis. Indicators like trading volume offer hints about whether a price trend will persist. Traders use these indicators to decide when to buy or sell securities.

Seven of the best indicators for day trading are:

1. On-balance volume (O.B.V.)

2. Accumulation/distribution line

3. Average directional index

4. Aroon oscillator

5. Moving average convergence divergence (MACD)

6. Relative strength index (R.S.I.)

7. Stochastic Oscillator

You don't have to use every indicator; instead, select a few that you find valuable for improving your trading decisions. Understanding how these indicators function and how they can enhance your success in day trading is essential.

  • Key Takeaways

Technical traders and chartists utilize diverse indicators, patterns, and oscillators to create trading signals. These tools can analyze price history, trading volume, and momentum. Traders often use them in combinations. In this overview, we'll explore seven essential tools market technicians use, which you should understand if you intend to engage in technical analysis.

Tools of the Trade

Day traders and technical analysts rely on various charting tools that provide buy/sell signals, trend identification, and pattern recognition. These tools fall into two primary categories:

  • Overlays: These technical indicators share the same scale as prices and are plotted directly over the price chart. Examples include moving averages, Bollinger BandsĀ®, and Fibonacci lines.
  • Oscillators: Oscillators are technical indicators that fluctuate within a defined range and are typically plotted below or above a price chart. Examples include the stochastic oscillator, Moving Average Convergence Divergence (MACD), and Relative Strength Index (R.S.I.). In this article, we'll primarily focus on oscillators.

Traders commonly use a combination of multiple technical indicators when analyzing a security. With many indicator options available, traders must select those that align with their trading style and gain a deep understanding of their functionality.

Traders often complement technical indicators with subjective forms of technical analysis, like studying chart patterns, to develop trading strategies. Automated trading systems can also incorporate these technical indicators because of their quantitative and rule-based nature.

1. On-Balance Volume

The on-balance volume indicator (O.B.V.) is a valuable tool for gauging the volume flow in a security over time. It calculates a running total by subtracting down volume (volume on days when the price falls) from up volume (volume on days when the price rises). Each day, volume is added or subtracted based on the price movement.

Buyers Are Active when O.B.V. is rising, driving the price upward. Conversely, a falling O.B.V. indicates that selling volume surpasses buying volume, suggesting lower prices. O.B.V. serves as a confirmation tool for the trend. If both price and O.B.V. increase, the likelihood of a continuing trend is reinforced.

Traders who utilize O.B.V. also pay attention to divergence. This happens when the indicator and price move in opposite directions. For example, if the price rises while O.B.V. falls, it might signal a weak buyer presence and the potential for a trend reversal.

On-Balance Volume

2. Accumulation/Distribution Line

The accumulation/distribution line is a widely used indicator for assessing money flow into and out of a security. It shares similarities with the on-balance volume indicator (O.B.V.). Still, it considers the closing price and the trading range during a specific period. Additionally, it considers the position of the close relative to the range. For instance, if a stock closes near its high for the period, the indicator assigns more importance to volume than if the close is near the midpoint of the range. This distinction means that O.B.V. may perform better in some situations, while A/D may be more effective in others.

When the A/D line is upward, it signifies buying interest because the stock is closing above the midpoint of its daily range. This reinforces an existing uptrend. Conversely, if the A/D line declines, the price finishes closer to the lower end of its daily range, indicating negative volume. This strengthens a downtrend.

Traders who use the A/D line also keep an eye out for divergence. If the A/D line starts falling while the price rises, it suggests that the trend is potentially weakening and might reverse. Similarly, if the price is in a downturn and the A/D line begins to rise, it could indicate a likelihood of higher prices ahead.

 Accumulation/Distribution Line

3. Average Directional Index

The average directional index (A.D.X.) is a trend indicator utilized to gauge the strength and momentum of a trend. When the A.D.X. value is above 40, it signifies a trend with considerable directional strength, upward or downward, depending on the price movement's direction.

If the A.D.X. indicator falls below 20, it suggests a weak or non-trending trend.

The A.D.X. serves as the primary line on the indicator, typically displayed in black. Two additional lines can be optionally included: DI+ and DI-. These lines are often colored in red and green, respectively. All three lines collaborate to convey the trend's direction and momentum.

  • A.D.X. above 20 and DI+ above DI-: Indicates an uptrend.
  • A.D.X. above 20 and DI- above DI+ Indicates a downtrend.
  • A.D.X. below 20 represents a weak trend or a ranging phase, often marked by frequent crossovers between DI- and DI+.
Average Directional Index

4. Aroon Indicator

It is a technical Indicator used to determine if a security is trending and, more specifically, if it's making new highs or lows within a set period, often 25.

This indicator can also help identify the beginning of a new trend. The Aroon indicator includes two lines: the Aroon Up line and the Aroon Down line.

When the Aroon Up line crosses over the Aroon Down line, it's an initial signal of a potential trend change. If the Aroon Up reaches 100 and remains near that level while the Aroon Down stays close to zero, it strongly confirms an uptrend.

Conversely, if the Aroon Down line crosses over the Aroon Up line and remains close to 100, it indicates a firmly established downtrend.

Aroon Indicator

5. MACD

The moving average convergence divergence (MACD) indicator is a tool that helps traders determine the direction of a trend and its strength. It also offers various trading signals.

When the MACD is above zero, it signifies an upward trend. If the MACD falls below zero, it indicates a bearish period.

The MACD comprises two lines: the MACD line and a slower-moving signal line. When the MACD line crosses below the signal line, it suggests a price decline. On the other hand, when the MACD line crosses above the signal line, it implies a price increase.

Checking which side of zero the indicator is on helps determine which signals to follow. For instance, if the indicator is above zero, traders should look for the MACD line crossing above the signal line as a potential buy signal. Conversely, if the MACD is below zero, a trade signal may be generated when the MACD line crosses below the signal line.

MACD

6. Relative Strength Index

The relative strength index (R.S.I.) serves at least three primary purposes. This indicator ranges from zero to 100, reflecting recent price gains against recent losses. R.S.I. levels provide insights into momentum and trend strength.

The first major use of R.S.I. is to identify overbought and oversold conditions. When the R.S.I. surpasses 70, the asset is overbought and could decline. Conversely, when the R.S.I. falls below 30, it suggests that the asset is oversold and could experience a rally. However, it can be risky to rely purely on this, so some traders prefer to wait for the R.S.I. to rise above 70 and then drop below it before selling or drop below 30 and then rise above it before buying.

Divergence is another valuable application of the R.S.I. When the R.S.I. moves in a different direction than the price, the current trend is weakening and might reverse soon.

The third function of the R.S.I. is to identify support and resistance levels. A stock typically remains above 30 during uptrends and often reaches 70 or higher. Conversely, the R.S.I. tends to remain below 70 in a downtrend and frequently drops to 30 or lower.

Relative Strength Index

7. Stochastic Oscillator

The stochastic oscillator is an indicator that assesses the current price about the price range over a specific number of periods. It is typically plotted on a scale from zero to 100. The underlying concept is that prices should consistently hit new highs in an uptrend, while prices tend to reach new lows in a downtrend. The stochastic oscillator tracks these price movements.

The stochastic oscillator fluctuates relatively quickly because it's uncommon for prices to maintain a constant high or low. Hence, it's frequently used to identify overbought and oversold conditions. Values above 80 are considered overbought, and levels below 20 are seen as oversold.

When interpreting overbought and oversold levels, it's crucial to consider the overall price trend. For instance, if the indicator drops below 20 and rises above it during an uptrend, it may signal a potential buying opportunity. However, in an uptrend, rallies above 80 are less significant because it's common for the indicator to surpass 80 regularly. Watch for the indicator to rise above 80 in a downtrend and fall below, suggesting a possible short trade. The 20 level carries less importance in a downtrend.

Stochastic Oscillator

F.A.Q.s

1. Is Technical Analysis Reliable?

Technical analysis involves assessing market sentiment by examining chart patterns and signals. While several empirical studies have suggested its effectiveness, the degree of success varies, and its accuracy is still debatable. It is advisable to employ a combination of technical tools and indicators alongside other techniques, such as fundamental analysis, to enhance reliability.

2. Which Technical Indicator Can Best Spot Overbought/Oversold Conditions?

The relative strength index (R.S.I.) is one of the most widely used technical indicators for identifying overbought or oversold stocks. The R.S.I. is constrained within a range of 0 to 100. Traditionally, a reading above 70 suggests that a stock is overbought, while a reading under 30 indicates that it's oversold.

3. How Many Technical Analysis Tools Are There?

Numerous technical analysis tools are available, including various indicators and chart patterns. Market analysts continually develop new tools and improve existing ones.

The Bottom Line

The objective of every short-term trader is to identify the momentum direction of a particular asset and aim to profit from it. Numerous technical indicators and oscillators have been created for this purpose, and this article has presented a selection for you to begin experimenting with. Use these indicators to formulate new strategies or consider integrating them into your existing ones. To decide which ones to utilize, test them in a demo account. Choose the ones that resonate with you the most and discard the rest.

Written by Sauravsingh

Techpreneur and adept trader, Sauravsingh Tomar seamlessly blends the worlds of technology and finance. With rich experience in Forex and Stock markets, he's not only a trading maven but also a pioneer in innovative digital solutions. Beyond charts and code, Sauravsingh is a passionate mentor, guiding many towards financial and technological success. In his downtime, he's often found exploring new places or immersed in a compelling read.

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