Choosing Technical Indicators to Analyze Stocks

August 31, 2023 Beginner
When analyzing stocks, there are several technical indicators available, including those for trend, momentum, and breakouts. Here's how to decide which technical indicators to use.

With hundreds of technical indicators available, it can be difficult for traders to select one or more that applies to their trading strategy.

Adding indicators to a price chart often starts by identifying stocks. Traders can use the Scan tab on the thinkorswim® trading platform to create a list of potential stock candidates. They can add indicators to the scan criteria to narrow the list of stock candidates and help them determine entry and exit points. While there are a number of technical indicators on thinkorswim, we're only focusing on four: moving averages, on-balance volume, stochastic oscillators, and the Relative Strength Index. 

Moving averages

There are many trend indicators on thinkorswim that can help traders identify market conditions. One traders commonly use is the moving average1. There are three main types of moving averages: simple, exponential, and weighted.

When using trend indicators, some traders prefer to start with a broader index like the S&P 500® index (SPX) to determine whether the index is trending or consolidating. Let's look at an example using the SPX and a simple moving average (SMA).

On the thinkorswim platform, select the Charts tab and enter SPX in the symbol box. Then select Studies > Add Study > Moving Averages > SimpleMovingAvg. This places a moving average overlay on the price chart (see image below). The default parameter is nine, but that can be changed. Select the indicator, then Edit Study SimpleMovingAvg (CLOSE, 9, 0, no) to change the inputs and display. Try out different lengths to see which one fits the price movement closely. A trader might also add breakout signals to the chart display. These signals show a green up arrow when price moves above the moving average and a red down arrow when price moves below it.

Chart illustrates using a moving average overlay on thinkorswim to determine which direction the overall market is moving. The chart includes a breakout signal and shows a price chart over several months.

Source: thinkorswim platform

For illustrative purposes only. Past performance does not guarantee future results.

It's possible to use more than one moving average on a price chart. For example, a trader could add the 25-day and 50-day moving averages. When the averages cross over each other, it can help a trader identify entry and exit points for a trade.

There's no way to tell how long a trend will last. However, with the help of moving averages, traders can observe the direction of the broader market.

On-balance volume

Traders often worry that once they place a trade, the market will reverse, resulting in losses. Because market reversals are always a possibility, a trader might consider using more than one indicator in their trading analysis.

On-balance volume (OBV) is an indicator that appears below the price chart as a subchart (see image below). To add OBV on a chart, select Studies > Add Study > Lower Studies (Popular) > OnBalanceVolume. If OBV is trending up, it's likely prices will also trend up. If prices aren't trending up but OBV is, that's a potential indication that prices could start trending up. If OBV starts flattening or reverses, prices might start trending lower. However, trends are never guarantees, so traders should proceed cautiously with their analysis.

Chart illustrates the on-balance volume indicator plotted below a price chart over several months. It includes a trendline for prices and illustrates how to identify a potential break in trend.

Source: thinkorswim platform

For illustrative purposes only.

Past performance does not guarantee future results.

When looking at the chart above, a trader might notice the price action when OBV moved below the yellow trendline. The 20-period moving average was still sloping upward, and without OBV as a guide, a trader might've thought the trend would continue up. As you can see, about a week later, the price fell below the moving average. But the OBV signal came earlier.

At the extreme right of the chart, the moving average is trending down slightly, but OBV looks like it's trending up. The OBV uptrend could potentially indicate price may start rising and might be something for a trader to monitor.

Stochastic oscillators

When reviewing stocks on a scan list, it might appear that some are moving in a tight range. Even in this scenario, it's possible to find potential trading opportunities.

The stochastic oscillator can be used when markets are trading "sideways." There are different types of stochastic oscillators—fast, full, and slow. It's possible to use thinkorswim to test the oscillators to see which might fit various strategies and trading styles.

The chart below shows the full stochastic added below the price chart. The 10-period weighted moving average is overlaid on the price chart as a confirmation indicator.

The chart illustrates the stochastic oscillator as it moves up and down between oversold and overbought zones. When the %k line (yellow line) moves above the %d (purple line) after moving above the oversold line, it could indicate upward price movement. Conversely, if the %k line crosses below the %d after moving below the overbought line, it could indicate downward price movement.

Source: thinkorswim platform

For illustrative purposes only. Past performance does not guarantee future results.

The stochastic displays two lines—%k (yellow line) and %d (purple line)—and mostly moves between overbought (top horizontal line) and oversold (bottom horizontal line) levels. But sometimes it moves outside these levels, and that might offer insight into an idea. When the %k crosses above the oversold level and the %d line, it could indicate prices are moving up. If that coincides with price moving above the moving average, it's additional confirmation. Similarly, when the %k crosses below the overbought level and the %d line, it could indicate prices are moving down. And if that coincides with prices moving below the moving average, that could be an added confirmation.

However, these are examples and not guarantees. An exit strategy can be useful for traders who might need to exit a trade if prices don't move in line with an indicator.

Relative Strength Index

Prices typically don't stay within a range forever. Instead, they're likely to break out to the upside or downside. A breakout that happens with significant momentum can potentially present trading opportunities. A momentum indicator to consider for identifying breakouts is the Relative Strength Index (RSI)2, which shows the strength of the price move. It behaves like an oscillator, generally moving between oversold and overbought areas (see image below). The RSI can offer traders an idea of the potential strength of the trend as it breaks out of a range. 

Chart illustrates the Relative Strength Index (RSI) plotted below the price chart and suggests the strength of the trend as it breaks out of a trading range. The chart shows the price broke above the range well before the RSI indication, but RSI indicated a possible increase in momentum after the initial pullback in price.

Source: thinkorswim platform

For illustrative purposes only. Past performance does not guarantee future results.

In the above chart, the price was moving within a trading range. When it broke above the upper range, even though the RSI was trending up, it didn't break above the overbought level. The RSI remained within the overbought and oversold levels while it was consolidating. It wasn't until the RSI started approaching the overbought level (indicated by the cyan line changing to red) that it indicated a possible increase in momentum. But it didn't remain long. It fell back below the overbought level, moved back above it, and stayed there for a longer time—an indication of a trend continuation.

An indicator can act as a guide, but it's just one part of the trading analysis process.

Test out indicators

With hundreds of indicators available on the thinkorswim platform, some traders find it helpful to categorize them into trending, trading range, and momentum and create a technical indicator list including tools from each category. However, traders should consider selecting indicators that are calculated differently so that when the indicators confirm each other, the trading signals are stronger.

1A technical indicator that's calculated by adding the closing price of a stock or other security over a specific period of time and dividing the total by the appropriate number of trading days. For example, a 20-day moving average is the average closing price over the previous 20 days.

2The Relative Strength Index (RSI) is a technical analysis tool that measures the current and historical strength or weakness in a market based on closing prices for a recent trading period. The RSI is plotted on a vertical scale from 0 to 100. A reading above 70 is considered overbought, while an RSI below 30 is considered oversold.

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The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

While this article discusses technical analysis, other approaches, including fundamental analysis, may assert very different views.

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Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

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