Upbeat music plays throughout.
Narrator: Technical indicators are trading tools that use historical price data to help investors identify things like a security's trend and potential entry and exit signals. There are hundreds of them, so it can be difficult to determine which to use. Some new traders add numerous indicators to a chart and get stuck in analysis paralysis. By understanding the different types of technical indicators and their purposes, you can zero in on a few indicators to help you make trading decisions or even build a consistent, rules-based trading system.
We'll discuss four major indicator categories including trend tracking, oscillators, sentiment, and flow-of-funds. Trend tracking and oscillator indicators are generally used for creating trading systems, while sentiment and flow-of-funds indicators are commonly used for determining the strength of the broad market trend. Let's break these groups down and determine when you might use them.
We'll start with trend-tracking indicators. One of the basic tenets of technical analysis is "the trend is your friend." This means a trader should consider using bullish strategies in uptrends and bearish strategies in downtrends. One of the most common trend-tracking indicators is moving averages.
Animation: [A chart appears that shows a nine-month moving average on an uptrending security.]
A moving average tracks a security's price over a certain time period and plots it on a graph.
For example, the 50-day moving average takes the average price for the previous 50 days and charts it. If the line is going up, the trend is up. If the line is going down, the trend is down.
Long-term investors may choose a 200-day moving average while short-term traders may choose a 20 day.
The moving average can also be used to help determine buy signals. If the trend is up, investors may buy when the stock price moves above the line and sell when the price moves below the line.
Other common trend-tracking indicators include linear regression, envelops, and Bollinger Bands®.
Often, trend traders look at other indicators to confirm a buy or sell signal. This is one use for the next group of indicators: oscillators. Oscillators typically measure how quickly a security's price is changing and chart it in a range to identify extreme values. Extreme values may suggest that a security is overbought or oversold, which could mean it's ready to reverse direction.
Animation: [Oscillating chart shows a hypothetical security price movement within a channel, highlighting the line as overbought when it moves above the channel and as oversold when it moves below the channel.]
Like watching a ball thrown in the air, you can tell it's about to start falling when its rise slows.
A commonly used oscillator is the stochastic indicator. The stochastic measures momentum by comparing a stock's current price to its range of movement over a set time. If the stochastic line is rising, then this indicates that the price has bullish momentum. If the stochastic line is falling, then momentum is slowing.
Some traders identify the extremes of the stochastic indicator as "reversal zones." These reversal zones can suggest the security is overbought or oversold and can be used as trading signals. For example, the line crossing above 20 and out of the lower reversal zone could be a bullish signal. The line crossing below 80 and out of the upper reversal zone would be bearish. These signals can be used as confirmation with trend indicators like moving averages or as their own entry or exit signals for trading shorter-term swings.
Other common oscillators include the Relative Strength Index or RSI, moving average convergence divergence or MACD, and the Commodity Channel Index or CCI.
The next type of indicators—sentiment indicators—aren't commonly used to trade specific securities. Instead, they gauge investors' beliefs about the direction of the market. They tend to be popular with contrarian investors who are looking to pick market tops and bottoms. Many sentiment indicators are polls conducted by private companies to help determine if professional and retail investors are extremely bullish or bearish. Access to these polls often requires a subscription service.
However, the options market offers some popular sentiment indicators you can access from most charting platforms. One of these is the put/call ratio. This indicator compares the number of puts purchased versus the number of calls purchased on stocks in a broad index like the S&P 500®. Puts are commonly purchased when investors are bearish, while calls are commonly purchased when investors are bullish. If there were an equal number of calls and puts purchased, the ratio would be one. However, investors tend to be bullish more often, so the ratio tends to be below one most of the time.
Contrarian investors attempting to identify market extremes may interpret a ratio spike above one as excessive bearishness, suggesting a market bottom could be near.
Often, investors will rely on more than one indicator to determine tops and bottoms.
Other common sentiment indicators include the Cboe® Volatility Index or VIX, historical P/E ratios, the advance/decline line, and consumer sentiment.
Finally, there are flow-of-funds indicators. Flow-of-funds analysis attempts to track changes in supply and demand for investments. In other words, it's a way to see where people are putting their money.
One widely available flow-of-funds indicator is the Arms Index also known as the Short-Term Trading Index or TRIN. The Arms Index compares rising stocks, called advancers, to falling stocks, called decliners in a stock exchange. The first level of comparison is the number of advancers versus the number of decliners. If advancers outnumber decliners when the market is uptrending, then it suggests that the rally is broad-based and strong. If the decliners outnumber the advancers during an uptrend, the uptrend is weakening. Next, the Arms Index compares the volume for advancers to the volume of decliners. If advancers are seeing high volume, this means more money is flowing into bullish stocks. If the decliners are experiencing high volume, then money is flowing out of stocks and into other investments.
A measure of one or less suggests more money is going into advancers. A measure above one suggests more money is leaving stocks. It's not uncommon to see the Arms Index bounce above and below one. Large positive or negative spikes indicate extreme conditions and are often used by contrarians to signal a final surge before changing directions.
Other common flow-of-funds indicators include Chaikin Money Flow, on-balance volume, and the Commitment of Traders report.
When it comes to selecting which indicator to use, it starts by defining what it is you want to accomplish. If you're looking to build a trading system, you may want to consider focusing on a trend-tracking indicator and supplement it with an oscillator. If you're looking to trade short-term swings, you may want to focus primarily on an oscillator. Long-term investors may choose to focus on sentiment and flow-of-funds indicators to determine if the market is bullish, bearish, or neutral and to what degree. Once you've defined what you want to do, it's easier to determine which indicator may be best.
Whether you want to build a system or just enhance your decision-making process, there's probably a technical indicator that can help. The next step is to match the appropriate indicators with your investing goals.
On-screen text: [Schwab logo] Own your tomorrow®
