If you have ever looked at the terminals of any trader, you would’ve observed certain colorful lines made up on a chart. These are technical indicators. As suggested by the name, these are signals that assist in technical analysis.
Technical indicators date back to the 18th century. They are created by using mathematical calculations. Once created, they form self-contained or independent systems used for trading all kinds of asset classes, which an analyst can chart,
Technical indicators are widely accepted today, and several market participants use them for their day-to-day trading activities.
In this blog, we’ll go through a few widely-used technical indicators and understand how to use them. Charts are taken from the Trading View website.
What are the Commonly Used Technical Indicators?
Volume tells us the number of shares bought and sold over a particular period. For example: If I sell you 100 shares of reliance at Rs. 2,000. You and I have together created a volume of 100.
It is meaningful to compare a stock’s volume to its average value for a certain period. A trader can use this to understand and predict the movement of the stock shortly since volumes give an insight into the perception of the market participants at a particular period.
Volume plays an essential part in the conformation of a trade. Using volume explicitly might not be a good idea, but it goes very well with other indicators and patterns.
Even though the price is increasing, buyers are not hesitating to show the increase in demand. This indicates that the upward trend may continue shortly.
If the price of the stock decreases and the volume increases, it signifies that a strong supply is coming in at the price level and thus, the stock may continue to go down or turn bearish in the near term.
Similarly, if the price of the stock decreases and the volume decreases as well, this means that the last bit of selling is about to end, and the price may start going up from here.
(Related blog: Largest stock exchange in the world)
Example of volume analysis on Reliance daily chart
While doing volume analysis, a trader should look at the periods with abnormally low and abnormally high volumes and volume spikes.
Volume spikes are often seen when:
There is some news related to the company
The company has made announcements, like earnings announcements
There is a change in the company’s ratings by various analysts.
There is institutional buying/ selling since institutions usually buy/ sell in large quantities.
Support and Resistance
A stock’s price often respects certain levels attributed to the demand and supply of the stock around them.
Support: Support, as the name implies, is something that keeps the price from slipping even further. The support is the place where the maximum amount of demand can be expected. There is a high probability of reversal towards the upside here. The actual stock price is always above the support price level.
Resistance: opposite to support, resistance is something that keeps the price from going any further up. A maximum amount of supply can be expected at these levels providing a high probability of reversal towards the downside from here. The actual stock price is always below the resistance price level.
For the example given below, ITC has very strong support at 200 and price, once at 200 will almost certainly go up. It has moderately strong resistance at 235.
Factors affecting strength/ weakness of support and resistances are:
The number of times it has been respected.
Volume around those levels.
Once, support is broken it becomes a resistance with equivalent strength and vice-versa. As can be observed from the chart below, 200 acted as a resistance for ITC four times and then acted as its support six times later on.
Example of Support and Resistance analysis on ITC daily chart
Basic Trading Strategy: If price @ support, buy, If price @ resistance, sell.
Relative Strength Index (RSI)
Relative Strength Index or RSI is a widely-used indicator developed by J.Welles Wilder. It is a momentum indicator and is used to find out trend reversals.
The RSI indicator tells a trader about the internal strength of a security using the average points gained by the security and the average points lost by the security in the 14 earlier time periods. 14 time periods is the empirically tested time period taken to be the standard.
For, this purpose it uses the following formula:
RSI = 100 - 100/ (1+RS), RS= Average Gain/ Average Loss
The RSI indicator obtains a value between 0 and 100 and decisions of buying/ selling are taken according to this value.
There are two zones associated with RSI:
Overbought Zone: A security is in the overbought zone if its RSI is greater than 70/80. This is because it has already been bought a lot and some selling can be expected in the next periods.
Oversold Zone: Contrary to the overbought zone, if the RSI is less than 30/20, then the stock is said to be in the oversold zone and a buying position can be made.
Example of RSI analysis on DLF daily chart
Example of RSI analysis on Nifty daily chart
Basic Trading Strategy: If RSI>70/80, sell. If RSI<30/20, buy.
Moving Averages Convergence Divergence (MACD)
MACD was developed by Gerald Appel in the late 1970s. Just like RSI, MACD is a momentum trader as well. As the name implies, MACD looks at the convergence and divergence of two moving averages.
As per the convention, the moving averages used are exponential in nature and the time periods used are 26 and 12. Exponential move averages give more weightage to the recent data.
The formula to calculate MACD is:
MACD value = 12 day EMA - 26 day EMA
Using MACD values, a MACD line is drawn and a signal line is also drawn by taking a 9-day exponential moving average of these values. If the MACD line crosses the signal line downwards, a selling position can be considered and when the MACD line crosses the signal line upwards, a buying position can be considered. In the example below and usually as well, MACD line is shown in blue and signal line in red.
Example of RSI analysis on Nifty daily chart
Basic Trading Strategy: @ MACD>Signal, buy. @ MACD<Signal, sell.
Bollinger Bands is named after John Bollinger who discovered them in the 1980s. Similar to the RSI, it can be used to determine the overbought and oversold zones.
There are three components of the Bollinger bands:
Middle Line: 20 periods simple moving average of the closing prices.
Upper Band: +2 standard deviations of the middle line.
Lower band: -2 standard deviations of the middle line.
The principle behind Bollinger bands is that if a security goes as much as 2 standard deviations or more away from its 20 periods simple moving average, it should come back to its average and then continue on its journey.
Example of Bollinger Bands analysis on Nifty Bank daily chart
Basic Trading Strategy: if price >= upper band, sell. If price <= lower band, buy.
(Also check: What is Fundamental Analysis?)
A Fibonacci retracement is a term used in technical analysis to refer to the areas of support and resistance.
Fibonacci Series: 0,1,1,2,3,5,8,13,21,....
Golden Ratios: Ratios between any two consecutive Fibonacci numbers after 3, the ratio between one number and the second to its right, the ratio between one number and the third to its right,.....
When drawing Fibonacci retracements, golden ratios are plotted on the graph along with 0.5. The most commonly used ratios include 23.6%, 38.2%, 50%, 61.8% and 78.6%. These ratios are plotted with respect to the highest and lowest values which are taken as 0 and 1, in a particular time period.
There is no proper rationale behind Fibonacci numbers. Some traders attribute these numbers to be a self-fulfilling prophecy, others just believe it to be in nature. In any case Fibonacci ratios work wonders.
Example of Fibonacci Retracement analysis on State Bank of India’s daily chart
Basic Trading Strategy: Treat ratios as supports and resistances.
In this blog, we discussed quite a few widely-used technical indicators. Some other technical indicators which can be looked upon by the readers include KDJ, ADX, VWAP, Super Trend, etc.
After reading this blog, you can use technical indicators to understand trading using technical analysis. It should however be understood that most of the profitable traders have a system in place wherein they use multiple indicators or no indicators in a variety of ways to make profitable trades post understanding what type of trades make them comfortable.