Technical indicators are basically mathematical formulas based on price activity. Technical indicators should be used together with chart patterns to get the best idea of what’s happening with a stock, currency or anything else and what sort of change could be expected.
The primary input for technical indicators is close price, less often also open, low or high.
Technical indicators can be mainly used to
· Measure strength of a trend
· Find support and resistance areas in trends
· Get trend reversal „confirmations”
· Understand the direction of a trend at all
When talking about technical indicators, the indicators are usually divided into two different types. Moving averages mainly meant for long-term investments and Oscillators in mainly short-term trading.
Moving averages means basically that you take past 20 days close price, sum it up and divide it by 20. The length of the average and whether the close price or anything else is used, are variables here of course. Note that on a chart the different points that are constructed of the close prices are calculated as eg. 20 days to that point, the next day it will be 20 days to this point, etc – the first day in the past is taken away from the calculation. Eg...first average point is construced from 1. october til 25th october, the second 2. october to 26th, etc. Just to explane it a bit.
Moving averages have different...averages. For examples, simple moving average gives the same weight or importance to each number/date in the average.
In addition to the simple moving average, there are types of moving averages that don’t consider all days/prices equal. Often the most recent days/prices count for more than anything else. That’s so for example in case of Weighted moving average (front-load weighted average). It is also possible that the weighted moving average (step-weighing) gives each day/price a different strength through fixed increments, eg. 3,5,7 (increment by 2) or increasing %. Front-weighted moving averages are more useful for short-term traders because they tend to show changing trend the fastest while simple moving averages are mainly for long-term investments.
There are also exponentially weighted moving averages which, while days go by, the days in the past are not cut off from the beginning of the line, rather they are just given less and less value each time the average is re-calculated. This average is used in quite popular moving average covergence-devergence indicator (MACD).
200-day moving average
This is mainly used for following a long-term trend. This average is also used in case of S&P 500 index where, if the 200-day moving average of the index is trending higher, it is up and if lower, it is down.
Moving average crossovers
Two different averages can be put on a chart, for example 50 days and 200 days. If the shorter average is moving above the long average then it indicates upwards movements and suggest the long buy of stocks. For short-term testing, averages of 5 and 9 days are usually used.
Overbought & oversold
When market is overbought then this means that the prices are increasing in a manner very different from the usual and oversold when when prices are declining a lot faster than the usual for this market. And if the prices for example increase like never before, then the price is very sensitive to corrections.
The bigger the difference between long term and short term average is going, the better indicator it is that the downside or upside momentum is rather strong. However, if the increase is very strong, it is likely that there will soon also be a strong counter-movement. One market extreme is often followed by another.
Oscillators are discussed in Introduction to technical indicators II .