Essential Technical5Indicators to Master

Mastering the basics of technical indicatorsTechnical indicators can appear arcane, opaque and difficult to understand. But it needn’t be this way and once mastered they are indispensable tools for traders.

Whilst the construction of indicators and oscillators is often complex, applying them and understanding how to use them to generate valuable trading signals is a lot

more straightforward. In this short guide we will examine five different indicators and explain how to use them.

Indicators can generally be divided into two camps – trend following and momentum. Trend following indicators tend to lag price action. Momentum measures the rate

that prices change and is said to lead price action.

The first two indicators in this guide are trend-following in nature. These are the different moving averages and Bollinger Bands. Our final two indicators – the RSI and

Stochastics – are momentum indicators. The exception and one that we deal with third is the MACD, or moving average convergence divergence, which combines aspects of

trend-following and momentum to produce one of the most popular and valuable technical indicators.

1 Moving AveragesA moving average is one of the simplest and most popular indicators that traders use. The aim is to filter out ‘noise’

by smoothing short-term fluctuations in price action. A moving average is a lagging indicator – it is good at showing a

trend but signals tend to be given after a change in the price action.

There are 3 major types of moving average - the Simple or Arithmetic, the Weighted and the Exponential. These vary in

their construction and tend to produce differing results using the same inputs, but their purpose is exactly the same.

Time frames for moving averages vary and can be based on hours, days, weeks or even years. Intervals can also be

changed, depending on the type of security being traded and the approach of the trader. For example, in equities

trading 50-day and 200-day averages are common. In commodities, 4-day, 9-day and 18-day averages have become

quite standard.

Commonly closing prices are used but it is possible to use open, high, low or even typical prices as the basis for the

average.

In addition to providing trading signals, averages can act as support and resistance levels when determining price

targets.

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Simple Moving Average

This simply takes an average of the closing price (for simplicity we’ll assume the close in all our examples) for each of the last n days of

the average. So if you have a 20-day moving average, the SMA is the sum of all the closes divided by 20. The simple average reacts the

slowest of the three – this means signals tend to be generated later, but it produces fewer false signals or ‘whipsaws’.

The below chart shows a simple 20-day moving average plotted against price action.

Source: ETX Capital

FTSE 100 moving around its 20-day simple moving average

A weighted moving average differs by adding a weighting to each

day’s price. Usually this gives extra weight to the most recent day,

and diminishing weighting to the preceding days.

For example, a 6-day weighted moving average could be weighted

in sixths: the most recent day gets a weighting of 6/6, the fifth day

is weighted 5/6, the fourth 4/6 and so on. In order to get to the

moving average you multiply the input of day six by 6, the input

of day five by 5, the input of day 4 by four and so on. These values

are then added together and the sum divided by the sum of the

multipliers – in this case 21.

You don’t need to know how to calculate it; the point is just to

understand that a weighted moving average set up like this gives

added importance to the most recent day’s price action and as a

result can produce signals sooner as changes in the trend appear

earlier.

Weighted Moving Average

Exponential Moving Average

An exponential moving average gives less weighting to older inputs

but never fully loses any of them. Although it is a good all-rounder,

it is not as precise as a simple moving average it depends entirely

on when the starting point is. EMAs are often the basis for more

advanced indicators, which we will come to later.

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Moving averages are useful in viewing trends and revealing

potential reversals. A market that is above its moving average is

said to be in a rising trend. One that is below a moving average may

be said to be in a falling trend. Sideways trends can be identified

when a market moves either side of a moving average.

Signals can be generated when prices move through a moving

average: a ‘buy’ signal when the security prices moves up through

the average; a ‘sell’ signal if it falls beneath. However these are

unreliable in isolation and most traders would seek confirmation,

such as by looking at price patterns or applying filters; for instance

a trader may decide that they need to see the market price close

above the moving average for two consecutive days to consider

the signal valid.

As moving averages are lagging indicators, signals may be missed

(applying filters can further delay signals being acted upon).

One common practice to compensate for this characteristic is to

advance the average by a number of periods. This can be done

by using the ‘Horizontal Shift’ function when creating the moving

average. In most markets the standard practice is to advance

the moving average by 3 periods, but it is a matter of personal

preference.

Using more than one average is a common approach. Having a

shorter and a longer time frame can help reveal more information

about a change in trend. For example, many traders employ 50-

day and 200-day moving averages.

Strong signals can be generated by employing more than one

average. For instance when a shorter moving average moves up

through a longer average that is also rising, it is known as a ‘golden

Key points about using moving averages

cross’ and signal significant strength in the market. A shorter

average falling through a longer average that is also falling is called

a dead cross and signals weakness.

Source: ETX Capital

As we will explore in the next two chapters, it is possible to create indicators from moving averages.

An example of a ‘golden cross’ when the 50-day SMA moves from below to above the 200-day SMA

2Bollinger BandsBollinger Bands make use of moving averages to produce trading signals based on market volatility. Devised by John

Bollinger, they are among the simplest technical indicators to use.

A 20-day simple moving average of the security is plotted. Above and below these are the bands, which are 2 standard

deviations away from the moving average. You don’t need to know about standard deviations to understand the

indicator; suffice to say that this methodology ensures around 95% of all price action remains within the two bands.

Construction of Bollinger Bands

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The most obvious way to look at Bollinger Bands is as an indicator

of whether prices are overextended. Generally, you would say that

as prices reach and then move beyond the upper and lower bands

the market is becoming respectively overbought or oversold.

However, it is worth noting that as prices touch bands they are as

likely to continue to move beyond the bands as they are to move

back within the range.

You can use the bands for signals. For example if a reversal pattern

on the price chart – such as a double top, head and shoulders,

double bottom – occurs at the extreme of the band, it can be a

stronger signal than if it occurs in the middle of the bands.

For example, a double top with a first top beyond the upper band

limit, with the second top forming below the upper band, may

be considered a fairly strong signal that the market is about to

reverse. (See chart opposite)

Using Bollinger BandsOVERBOUGHT/OVERSOLD

SIGNALS

Source: ETX Capital

USDJPY head and shoulders reversal pattern

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Bollinger Bands tend to widen as volatility increases and narrow

when volatility recedes. Usually you can expect a sharp move

in the price of the security when the bands tighten. But while a

narrowing of the bands foreshadows a big move, it is unclear from

Bollinger Bands are useful in determining specific price targets.

This is because prices have a tendency to swing from one extreme

to the other. Therefore if the security’s price touches the upper

band, a reasonable price target would constitute the lower band

level. However, as with oversold and overbought indicators, it is

worth noting that prices are as likely to continue to move beyond

the bands as they are to retrace back between the two bands.

Indeed, according to John Bollinger, when markets move outside

the bands, a close outside the bands act as continuation signals,

not reversal signals.

NARROW/WIDE

PRICE TARGETS

the indicator in which direction you can expect this move to occur.

Therefore it is useful to use this in conjunction with other technical

tools, such as momentum indicators, chart patterns, candlestick

formations, etc.

Source: ETX Capital

USDJPY price action showing how tightening of bands can predict a sharp move

Bands narrow

Sharp move lower

3 MACDMoving average convergence divergence – MACD – is one of the most popular tools for traders. It incorporates trend

following and momentum characteristics.

This indicator shows the relationship between two moving averages to identify changes in market trends.

The MACD line shows the difference between two exponential moving averages (EMAs). Usually this involves subtracting

the 26-day EMA from the 12-day EMA.

A nine-day EMA of the MACD line is the third element and this is known as the Signal or Trigger line. When the two lines

crossover it’s taken as a signal that a change in trend is likely.

When adding your MACD indicator to your chart, you have the option of defining these moving averages according to

your own desired time frames, however most people stick to the 26-12-9

Construction of MACD

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If the security price diverges from the MACD, it can indicate the

end of the current trend. For example, if a security keeps rising

and the MACD line starts falling, it could mean the rally is about to

end.

This does not need to mean all-time highs and lows. Typically,

a bullish divergence can occur when the security falls to a new

reaction low, and the MACD line fails to follow suit and sets higher

lows.

A centreline crossover occurs when the MACD Line moves either

above the zero line to turn positive or below to turn negative. A

bullish centreline crossover occurs when the 12-day EMA of the

security moves above the 26-day EMA. A bearish crossover occurs

when the 12-day EMA moves below the 26-day EMA.

Using MACDDIVERGENCE

CENTRELINE CROSSOVER

This type of crossover occurs when the MACD line crosses the red

signal/trigger line. A bullish crossover occurs when the MACD rises

SIGNAL LINE CROSSOVER

above the signal line. A bearish crossover occurs when the MACD

turns down to cross below the signal line.

Bearish signal line crossover on EURGBP

Source: ETX Capital

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Also watch for the MACD moving further away from the centre line

(in either direction). This suggests the shorter 12-day average is

accelerating away from the 26-day EMA, and therefore points to a

strengthening trend.

In this way it can also be used to define overbought or oversold

conditions, although unlike other indicators like the Relative

OVERBOUGHT/OVERSOLD

MACD signal line crossover on the DJIA

Source: ETX Capital

The MACD is also plotted as a histogram along the zero line, with

the bars displaying the difference between the MACD and the

Signal Line. Signal line crossovers are indicated by a crossing of

the zero axis on the histogram. The advantage of the histogram is

that signals are given earlier than on the chart, so a crossing of the

zero axis can predict a signal line crossover.

HISTOGRAM

Strength Index, it can be hard to define precise levels of where

a market may be regarded as overextended. Looking at historic

levels and comparing is often a good way to judge if a market is

overextended.

You can combine crossover signals with overbought and oversold

indicators – indeed crossovers in overbought or oversold territory

can produce stronger signals. For example, in the below chart of

the Dow Jones industrial average, the MACD line looks extremely

overbought by historic standards, rising above 465. When the

bearish signal line crossover occurred in such heavily overbought

territory on Jan 29th, it proved a very reliable sell signal.

4RSIThe Relative Strength Index (RSI) is one the simplest ways to gauge momentum. Developed by J. Welles Wilder in the

1970s, it’s based on the simple notion that prices will tend to close higher in an uptrend and close lower in a downtrend.

RSI is constructed by comparing the average gains on up days and average losses on down days over a given period,

usually 14 days. A shorter time period may be appropriate for less volatile markets.

The reading is a number between 0 and 100. Rising markets will produce readings closer to 100, while falling markets

will result in readings closer to zero.

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The RSI is very useful for determining whether a market is overextended. Markets are said to be overbought if the RSI rises above 70 and oversold if it falls below

30. This can be modified to 80/20 for a market that is a strong trend.

Using RSIOVERBOUGHT/OVERSOLD

In a rising market, the RSI tends to look overbought at times

Source: ETX Capital

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Example of a bearish failure swing predicting reversal

Source: ETX Capital

Divergence is the most important characteristic of the RSI. By

divergence, we mean the indicator moving in an opposite direction

(diverging) from the security. For instance, if the RSI starts to fall but

the security keeps setting new reaction highs, it can foreshadow a

reversal.

For a bearish failure, or failure swing top, the RSI enters overbought

territory – above 70 – and then makes a lower high, which may or

may not be below 70. The security continues to rise and makes a

higher high. This creates bearish divergence with a trading signal

coming when the RSI lower reaction low.

FAILURE SWINGS BEARISH FAILURE SWING

But the RSI indicator provides a more precise version of divergence

known as ‘failure swings’ which offer a confirmation of the trend

change signalled by divergence.

Market continues to makehigher highs

RSI is overbought butmarket lower highs

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For a bullish failure swing, also known as a failure swing bottom, the RSI enters oversold territory – below 30 – and then makes a higher low, often but not always above the 30 level. At the same time the

security continues to fall and makes a lower low. This situation would be termed simple bullish divergence. The signal comes when the RSI forms a new higher reaction high.

BULLISH FAILURE SWING

EURUSD bullish failure swing predicts strong rally

Source: ETX Capital

market continues tomake lower lows

RSI is oversold butmarket higher lows

5 StochasticsStochastics is a momentum indicator that shows where the most recent closing price fits in relation to the price range

over a predetermined number of days, usually 14. The indicator is based on the premise that prices have a tendency to

close at or near highs in when the security is in an upward trend, and at or near lows when prices are trending lower.

A reversal signal is given on divergence. For example if the market continues to make new highs but prices are tending

to settle at the lows of the day, it can foreshadow a reversal in the uptrend. From a logical view point this makes sense

as if prices are not able to settle at the highs of the day it suggests buyers are losing interest and taking profits sooner.

Whilst you do not need to know the formulae used to work out the indicator, it is useful to how the basis of its

construction so you can apply it to your trading. The indicator usually incorporates two lines, the %K and %D lines

which oscillate between 0 and 100.

The %K shows the latest close in relation to the average range of the last 14 days. The %D line takes a 3-day moving

average of that line.

For ‘slow stochastics’, which is more commonly used, the data is further smoothed by taking a moving average (usually

3 or 5 days) of the moving average.

In this situation the %K line is the 3-day moving average of the simple 14-day stochastics (the original %D line), and the

%D line is a 3 or 5-day moving average of the new, ‘slow’ %K line.

Construction of stochastics

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Stochastics is useful in determining whether a market is

overextended. Usually we would say that the security is overbought

Using stochasticsOVERBOUGHT/OVERSOLD

Stochastics ranging between overbought + oversold conditions

when the %K moves above 80 and oversold when it falls below 20.

As with any indicator of this sort, a security can continue to rise

despite being overbought and continue to fall when it is already

oversold.

Source: ETX Capital

% K

% D

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Buy and sell signals are given on crossovers – when the %K line

moves above or below the %D line.

When the %K line (which is faster moving and more responsive

to short term movements in price) moves below the %D line, it is

considered a bearish crossover. A bullish crossover occurs when

CROSSOVERS

the %K line moves above the %D line. This agrees with the premise

of using multiple moving averages.

These signals are quite frequent and must be treated with caution

– usually traders look for other conditions to be met before a

simple crossover is seen as a strong signal.

If a crossover occurs whilst the market is considered overbought

or oversold, it can have greater validity. As an example, if a bearish

crossover occurs while the stochastics show overbought conditions

(i.e. above 80), the trader would then look for a move back below

80 for confirmation.

Bullish crossover as %K line moves above %D line and out of oversold territory

Source: ETX Capital

bullish crossover

oversold conditions

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Using the same chart pattern but applying the stochastics indicator

in addition to the MACD reveals how the stochastics crossover

provides an earlier signal of trend reversal. This agrees with

the principle that momentum leads price action, while moving

averages are lagging indicators that follow prices. The delay in the

MACD signal is noticeable versus that provided by the stochastics.

This is a good example of how it is useful to use more than one

indicator, with a particular emphasis on using indicators that are

based on different data inputs to derive their signals.

Stochastics can give earlier signals than MACD

Source: ETX Capital

As with other momentum indicators, divergence between the

stochastics and the security’s price action can signal a reversal.

Most often these may be used to confirm a crossover’s validity. For

example, a bullish crossover accompanied by bullish or positive

divergence would be a stronger signal. If the market is already

in oversold territory and moves above 20, at the same time as a

bullish crossover and positive/bullish divergence, it would be a

very strong signal.

DIVERGENCE

bullish signal

bearish signal

Using indicators on TraderPro

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To use the indicators on the TraderPro platform, select the

indicators list under the f button on the top left of your chart. Once

you hover over this you can scroll through the full list of indicators

available.When you select your indicator, a sidepanel will appear on the right of the chart that allows you to customise your indicator. This

sidepanel will also display any other indicators you have already selected.

For example, on the example shown, with the MACD indicator you can select the length of your moving averages. In this case the default

12, 26 and 9-day averages have been selected. You can also choose whether you wish the average to apply to the open, high, low or

closing price. In this example we have stuck with the close. You can also change the colours of the lines and of the histogram. Save the

settings to apply them to your chart.

Source: ETX Capital

Source: ETX Capital

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