There are over 180 indicators available to the Technical Analyst all attempting to determine what the share price is likely to do next, with the MACD & Moving average the most widely used. It is a testament to the human mind that we can take 5 pieces of information, the open, high, low, close and volume information and create all these different indicators.
Indicators work like magnifying glasses allowing a trader to closely examine the information available to them. The indicator however tells the trader no more than what they can see in a candlestick or bar chart. It is based on the same information.
Indicators are the last thing to consider when analysing a share. It is important to first answer the question would I trade this share, before examining exact entry or exit details. Looking at an indicator before looking at a share is like looking through a microscope or telescope on ultrahigh magnification. If you have attempted this you will usually see nothing!
The telescope or microscope ends up focused on the space between what it is that you want to observe. When using a microscope or telescope the first lens used is low magnification. This allows you to make sure that the object you are looking at is in the centre of the view finder before moving up to a higher level of magnification.
Looking for the Best Trading Filters
When trading shares the same applies. Your first filter could be fundamental to determine whether you would trade the share at all. Then a technical filter could be applied like whether the market and sector the share is in is going the right direction. If the share passes this test then the next thing to consider is the history of the share.
How does it behave and would you consider trading this share. What are the overall trend, behaviour and liquidity of the share. Next the focus comes down to the more immediate price action to determine when to buy the share. Look at candlestick patterns, support, resistance, chart patterns and volume to decide whether now is the right time.
Once all these tests have been passed then indicators can be used to confirm a decision that has been 95% made.
Finding the Perfect Combination of Indicators
Many traders will start searching for the perfect combination of indicators that will always pick the share at the correct time. This search for the Holy Grail can take months or years, so to save you a lot of time, it does not exist.
A well researched trading strategy will be both right and wrong and it is vitally important that a plan is developed for both situations. This article will look at two of the most common indicators the moving average and the MACD (which is based on two moving averages).
A moving average is a method of calculating the average value of a share’s price, or indicator, over a period of time. As the share’s price changes over time, its average price moves up or down. A moving average has the effect of smoothing out fluctuations in the price.
A simple, or arithmetic, moving average is calculated by adding the closing price of the share for a number of time periods (e.g., 12 days) and then dividing this total by the number of time periods. The result is the average price of the share over the time period. The only significant difference between the various types of moving averages is the weight assigned to the most recent data.
The number of days the average is to be calculated over varies depending on the time frame of the investor.
If the share price is above its moving average the share is rising, if the share price is below its moving average it is falling. A buy signal is generated when the share’s price rises above its moving average and a sell signal is generated when the share’s price falls below its moving average.
To improve the performance and reliability of moving averages analysts often use two or three moving averages simultaneously. When two moving averages are employed the longer one is used to identify trends and the shorter for timing purposes.
A buy signal occurs when the short term moving average, which is more volatile, crosses up through the long-term moving average, which is smoother. A sell signal occurs when the short term moving average, which is more volatile, crosses down through the long-term moving average, which is smoother.
The MACD Indicator
The MACD (Moving Average Convergence/Divergence) displays the distance between a 26 period moving average and a 12 period moving average. A 9 period moving average (the “signal line”) is normally displayed on top of the MACD indicator line.
The MACD is a trend indicator indicating whether the share is in an uptrend or downtrend. A buy signal occurs when the MACD rises above its 9 period signal line and a sell signal occurs when the MACD falls below its 9-period signal line.
The MACD can also be displayed as a histogram and then a 9-period moving average of the indicator is overlayed. This will often signal a change in trend before it happens viewed as a series of lines becoming shorter and shorter as the share begins to move higher.
Ideally you will want to look over hundreds of charts with the MACD and/or Moving averages applied to get a feel for the time period to use and how those indicators fit in with your entry or exit strategy.
Whilst this does take time you can be rest assured it is time well spent.