Technical analysis focuses primarily on price, believing that every factor affecting the value of a market - weather, politics, supply/demand, government reports, statistics, trader sentiment - is reflected in price. Therefore, technical analysts concentrate on price charts.
But analysts and traders, in their quest to get an edge on price movement, have expanded their studies of price far beyond the basic patterns and trendlines as price action leaves its tracks on charts. They have massaged and manipulated prices to develop a number of technical indicators that provide more insight into price action than what is visible on the surface.
Bar or candlestick charts can reveal a lot of information about a market at a glance, but an indicator can put a number on those observations and confirm whether a market is strengthening or weakening or becoming overbought or oversold before it becomes evident on a chart. Many analytical software packages now include a variety of indicators as the computation capabilities of computers have evolved.
Before getting too wrapped up in the power and potential of technical indicators, keep in mind several things that apply to indicators in general:
- No single indicator is the Holy Grail of trading. Most traders who look at indicators look at several different indicators to confirm or corroborate what they see on a chart or in the price data.
- An indicator that works well in one type of market condition may do poorly in another market condition. There is no perfect indicator for every market in every time period in every market condition.
- Most indicators look only at the same thing, price - that is, they may look a little different from one another, but they are usually just another spin of the same data source.
- Indicators may be subject to subjectivity. The time frame and indicator parameters may be curve-fit to produce the best performance on historical data but may not work as well in real trading.
- The best clues from indicators may come from divergence - prices make a higher high but the indicator makes a lower high. In many cases, the indicator underlying market action may provide the best insight for future price movement.
Types of technical indicators
Technical indicators can be categorized into several types, depending on how they present the data and the kind of market conditions for which they are best suited.
Trending Indicators, as their name suggests, are most useful in identifying or confirming price trends and in spotting points when a trend may be ending or a new trend may be starting to emerge.
Momentum indicators are most useful in detecting shifts in trading activity in trading or non-trending market conditions where markets spend much of their time. They are also often known as oscillators and can be split further into those that are based on a neutral center or zero line with no limit on the extent of the indicator reading and those that are confined to a limited range by boundaries or thresholds, often set at 0 and 100.
Volatility Indicators measure the degree of variation in price movement within a given period of time and how it compares to historical price movements.
Strength and Sentiment Indicators are used in conjunction with price-based indicators to get clues about traders' responses to price activity or perceptions about future price movement.
Stock market indicators provide readings that are specifically related to trading activity in stocks and offer insights into potential price movement based on the opinions and actions of traders.