The Term of Technical Analysis is done with the help of indicators. There are many indicators prevalent in the market with the help of which we can indicate the momentum, trend, volatility etc of the market in general or an individual stock. One can use as many indicators in combination as they can, but too many indicators when used in combination can generate ambiguous signals, which makes it difficult to understand and initiate a clear action.
Use of Indicators in Different Market Conditions:
No one indicators is suited all market conditions. Trend indicators lose money during a ranging market, as fluctuations in a narrow price range whipsaws traders go in and out of positions. In a trending market, momentum indicators give too many signals and should only be used to confirm trend indicators.
Three main functions of Indicators:
Indicator Time Frame’s :
- Indicators should be adjusted to reflect the cycle being studied.
- The same general rule supplies to moving averages and oscillators.
- With trend indicators, make the window period longer;
- With oscillators, make the period shorter.
Types of Indicators:
Most Indicators are categorized into two main types. They are
- Leading Indicators
- Lagging Indicators
These type of indicators are lead the prices i.e. Price follow the movement in such indicators. They generate more signals and allow more opportunities to trade.
Some of the most popular leading indicators are:
Relative Strength Index (RSI)
Price Rate of Change (ROC)
Benefits and Drawbacks of Leading Indicators:
- Early signaling for entry and exit is the major benefit.
- Leading Indicators are making additional signals and allow more chances to trade.
- In a market trending up, they help identify oversold conditions for buying opportunities.
- In a market that is trending down, leading indicators can help indentify overbought conditions for selling opportunities.
- Early signals and more signals can also mean false signals and whipsaws, which means greater risk.
Lagging indicators are also known as trend following indicators as they follow the price action.
They are designed to keep traders in keep them in till the trend is intact.
Trend following indicators work best when stocks and market develops strong trends. They are not effective in trading and sideways markets.
The most popular lagging indicators are
- Moving Averages
Benefits and Drawbacks of Lagging Indicators:
- One benefit of trend following indicators is the ability to catch a move and remain a move.
- The longer the trend, the fewer the signals and less trading involved.
- The disadvantage of trend following indicators is that signals be inclined to be belated. Late entry and exit points can skew the risk/reward ratio.
- Both leading and lagging indicators perform different functions. Some indicators act as momentum indicators, whereas some function as trend indicators.
Many leading indicators come in the form of momentum oscillators. Commonly momentum measures the rate of change of a security’s cost.
As the cost of a security increases, price momentum rises. The faster the security increases, the larger the increases in momentum. Once this rise begins to slow, momentum will also slow. As a security starts to trade level, momentum starts to actually decline from previous high levels. However declining momentum in the face of sideways trading is not always a bearish signal.
Trend indicators attempt to provide an objective measure of the direction of the trend. Price data is smoothed and a single line, as in the case of a moving average, represents the trend. Because of the smoothing process the indicators tend to lag price changes and so they are called trend following indicators.