In the world of trading, indicators are sets of tools used on trading charts to help accurately and qualitatively analyze the market. For example, they can confirm market flat or trends, and provide precise market information and signals about potential reversals when an asset is oversold or overbought.
Types of Indicators
Indicators can come in two forms:
- Overlayed on price charts: Examples include Bollinger Bands or moving averages.
- Placed in a specific area below the price chart: Examples include the MACD (Moving Average Convergence Divergence) or the Stochastic Oscillator.
Lagging and Leading Indicators
There are a multitude of different types of indicators, but they generally fall into two broad categories:
- Leading Indicators: These give signals before price behavior changes.
- Lagging Indicators: These give signals that confirm price behavior.
Leading Indicators
Leading indicators measure the momentum of price changes and pinpoint moments of acceleration or deceleration in price movement. They provide advance signals, while lagging indicators are used to confirm price movements (e.g., trend strength).
For example, if price movement accelerates and then slows down, a leading indicator will record these changes and provide signals about potential reversals.
Lagging Indicators
Lagging indicators are typically used to confirm price changes. For instance, they can provide signals about the emergence and strength of a trend. They’re called “lagging” because they trail behind price movement.
Categories of Indicators
Indicators generate trading signals, each doing this in their unique way. Everything depends on the calculation of price movement to generate these signals. Also, indicators are divided into:
- Range (oscillators): They are most effective in range-bound or flat markets.
- Trend: They are most effective in trending markets.
Trend Indicators
It’s not always possible to clearly identify a trend and its strength on a chart. However, trend indicators are excellent aids for this purpose. Trend indicators are lagging, which helps to identify entry and exit points in the market.
Therefore, indicators give traders the ability to:
- Determine whether the market is trending.
- Know its strength and direction.
- Find entry and exit points in the market.
Oscillators
During the price movement within a channel, an oscillator helps to identify the lower and upper bounds of the channel. It also signals oversold or overbought conditions. These indicators will oscillate between a lower and upper level. Oscillators are leading indicators.
If an oscillator signals an overbought condition for an asset, a trader will likely attempt to open a short position. If it signals an oversold condition, a trader will likely attempt to open a long position.
When to use Oscillators and Trend Indicators
The type of indicator used depends heavily on the trading system and individual trader preferences. However, oscillators tend to be useful in range-bound or flat markets, while trend indicators are helpful in trending markets.
For instance, if you prefer trading in a flat market, oscillators such as the Stochastic Oscillator, Relative Strength Index (RSI), or Commodity Channel Index (CCI) would be best suited for you. On the other hand, if you prefer trading in a trending market, trend indicators like the Average Directional Movement Index (ADX) or the Moving Average Convergence Divergence (MACD) might be your best bet.
How to Properly Combine Indicators
Understanding how to properly combine oscillators and indicators can be a significant advantage for traders.
Market conditions continuously shift from trending to range-bound and vice versa. This means you can employ any given indicator in any particular situation depending on its applicability.
Overuse of Indicators
As you fully comprehend the benefits that indicators offer, you may feel tempted to use more and more indicators. For example, a trader might add three or more oscillators to a chart, but these indicators tend to give the same signal.
Reliability doesn’t necessarily increase with the use of multiple indicators giving the same signal. They may only show overbought or oversold conditions in different variations while occupying a lot of space on the chart. This can lead to clutter and confusion, obscuring the price action you should be focusing on.
Remember, indicators are tools to help you make trading decisions, not to make decisions for you. Over-reliance on them can limit your ability to read the market effectively. The key is to find a balance and use them in conjunction with other aspects of technical analysis.