Introduction to Chart Indicators
Chart indicators are mathematical calculations that are preformed on a stock's price and/or volume data and the resulting values are plotted on the stock's chart. The basis for this analysis is to provide an indication of the probable direction that the stock's price may trade.
While there are numerous charting indicators, some which are quite complex, most are best suited to short-term trading or for investors timing their entry or exit. However some indicators also work well for locating long-term trends.
The primary purpose of chart indicators is to alert the stock investor or trader to the possibly of a reversal of the stock's trending direction.
While some indicators are used to determine the strength of a trend, most indicators are used to determine when a trend is likely to reverse direction. They can be used to determine both the start of a trend and the end of a trend.
Some indicators are plotted as a line that overlaps the price data. These indicators are known as price overlay indicators. There are other indicators which are plotted as a line chart in their own separate chart pane in the same way as volume is usually plotted in its own separate chart pane. Most of these indicators are oscillating indicators where the plotted line alternates up and down around a zero neutral line. With an oscillating indicator, a trend change is signaled when the indicator value exceeds a certain value.
Indicators can be classified as either Leading indicators or Lagging indicators. Leading indicators are designed to provide an early indication that a trend is about to reverse before the actual trend reversal occurs. Lagging indicators are designed to follow the trend and are used to confirm a trends direction.
Chart indicators require historical data in order to perform their calculations and this allows the trader to analyze how an indicator performed in the past (this is known as back testing). By back testing an indicator the trader can get a good indication of an indicator's predictability and reliability.
Generally all modern charting software applications include a vast array of indicators that can be easily selected and plotted on a stock chart and as such they do not require any calculations to be performed manually. However, the indicators can be calculated using a spreadsheet application if so desired.
Modern charting software allow the trader to
easily plot a wide variety of indicators
There is no one single indicator that is perfect and all indicators have advantages and disadvantages. One problem all charting indicators have in common is they provide a certain number of false reversal signals. This means that the indicator signaled that a trend was likely to reverse but the stock continued trading along its existing trend rather than having reversed. Sometimes a Leading indicator misses a trend reversal altogether. Also Lagging indicators can be quite late at confirming a new trend direction.
So why bother even considering using an indicator. While charting indicators do have some disadvantages, when used properly they do a fairly good job of locating trend reversals. Most of the disadvantages revolve around using only one single indicator. As no indicator is perfect, it is best to use several indicators concurrently. It is also generally better to use charting indicators in conjunction with other technical analysis techniques rather than in isolation.
Stock investors can make good use of chart indicators as a timing tool to help them with their buying and selling decisions. For a value investor looking to take a position in a falling stock, chart indicators can provide them with a signal that the downtrend may be reversing. A growth investor who is looking to sell an excessively overvalued stock can use chart indicators to remain with the uptrend until a signal is given that it may have ended.
A few of the simple and most useful indicators for stock investors and beginner stock traders will be covered in the following articles.
Price Overlay Indicators
Simple tactics for tracking a stock's trending behavior
Price overlay indicators are drawn on a stock chart so they appear on the chart along with the price data. This allows the price data to interact with the indicator line such as crossing over the line. The indicator line can also act as a calculated trend-line that can curve and follower the price data.
The Moving Average is an extremely simple and very useful indicator that visually highlights the uptrends and downtrends on a stocks chart.
Moving Averages work best with stocks that are trending strongly. They do not work well with stocks that are randomly fluctuating or are stuck in a broad consolidation range.
The Moving Average is known as a trend following indicator and is a lagging indicator. The Moving Average is an averaging calculation that is performed on the closing stock prices which is plotted as a second line on a stock chart. This moving average line smoothes out the daily fluctuations in the closing price and makes trends more visually obvious. One of the most common uses of the moving average is to determine when an uptrend as topped out and a new downtrend has started.
The number of days used for the averaging calculation is typically 10 days or 20 days for the short-term trends and 50 days for intermediate-term trends. A 260 day moving average (one year) is suited for long-term trends. The number of days used in the calculation is somewhat arbitrary.
The moving average line will more closely follow the stock price when fewer days are used, but will also be more volatile. A greater number of days will provide a smoother line, but will also lag any trend direction change.
The simple moving average is usually referred to as either SMA or MA, thus a 50-day simple moving average is referred to as either a 50-day SMA or a 50-day MA and is often simply referred to as a 50MA.
An example of a simple moving average is shown below in Chart 1.
Chart 1. 50-day Simple Moving Average
With an uptrend, the moving average slopes upwards and the price data essentially remains above the moving average line. Conversely with a downtrend, the moving average slopes downwards and the price data essentially remains below the moving average line.
The end of an uptrend is signaled when the price data trades below the moving average line which then turns and begins to slope downwards to confirm the new downtrend.
The converse applies to a downtrend which ends when the price data trades above the moving average line which then slopes upwards to confirm the new uptrend.
Exponential Moving Average
The standard Moving Average discussed above is referred to as a Simple Moving Average. For a 10MA this is a simple average calculation of the past say 10 days. One criticism of this simple moving average is that it lags the price data and is therefore slow to confirm a trend direction.
All price overlay indicators are lagging indicators,
with some lagging more than others
The solution to this problem was solved by more heavily weighting the more recent data and placing less emphasis on the older price data used in the calculation. Thus with a 10-day moving average, the current day carries more weighting in the averaging calculation than does the 10th day. This weighted moving average is known as an Exponential Moving Average. A 10-day Exponential Moving Average is usually referred to as a 10EMA.
An example of an Exponential Moving Average is shown below in Chart 2. The chart also shows a Simple Moving Average for comparison.
Chart 2. 50-day Exponential Moving Average
At first glance there is not much difference between an Exponential Moving Average and a Simple Moving Average, but the Exponential Moving Average does follow the price data more closely and changes direction sooner than the Simple Moving Average.
Moving Average Cross Over
This trend following indicator uses two moving averages each with a different number of days for the calculation. A popular Moving Average Cross Over uses a 10-day and a 30-day exponential moving average (10EMA and 30EMA). When the 10-day exponential moving average line crosses over the 30-day exponential moving average line, it indicates the likelihood that the trend direction has changed.
Either the simple moving average or the exponential moving average can be used with the cross over indicator. Basically, the exponential moving average will respond quicker but will also provide more false signals. This is a tradeoff with all charting indictors; a quicker response leads to an increase in the number of false signals.
An example of the moving average cross over indicator is shown below in Chart 3.
Chart 3. Exponential Moving Average Cross Over indicator
So far the discussion has revolved around daily charts covering a relatively short timeframe, which is well suited to trading and also for investors looking to time their buying and selling.
Moving averages can be applied to any timeframe ranging from intraday charts with 5-minute bars right through to the longer timeframes typically used with investing. These long timeframes can use weekly bars or even monthly bars and for very long timeframes quarterly bars can be used.
When using bars other than daily bars they are referred to as a Period rather than a Day. So a 50-week simple moving average is still stated as a 50MA but is applied to a bar chart with weekly bars (ie. the period is 50 weeks). Now this 50 week MA consists of 250 days (ie. 5 trading days per week). Thus a 50-week MA on a weekly chart is the same as a 250-day MA on a daily chart.
An example of a weekly chart with a 10EMA and 30EMA cross over is shown below in Chart 4.
Chart 4. Weekly Moving Average Cross Over indicator
The cross over indicator is based on moving averages which by their nature are trend following indicators and as such are lagging indicators. This means that the cross over indicator will always be late in generating a reversal signal. Also being a moving average system means that it is only suited to trending stocks. If the stock is not trending, moving average indicators will generate a large number of false reversal signals. This indicator works well for trade entries in the direction of the trend.
The Parabolic SAR is a trend following indicator which plots dots for each day rather than a line. The indicator plots dots below the price bars when the stock is in an uptrend and plots the dots above the price bars when the stock is trending downwards. SAR stands for "Stop and Reverse" and is essentially a trailing stop indicator.
An example of the Parabolic SAR indicator plotted on a daily chart is shown below in Chart 5.
Chart 5. Parabolic SAR indicator
The SAR indicator plotted in Chart 5. above used the standard parameters of (0.02,0.2) which follows the short-term trends.
The parameter values can be altered so that the SAR indicator follows longer term trends. Chart 6. below shows the chart again with the second parameter changed from 0.2 to 0.02. This has the effect of slowing down the response so that it follows the longer trend.
Chart 6. Slow SAR indicator
The slowed down SAR indicator with its altered second parameter value makes this indicator quite effective at following trends on a weekly chart, which is more suited to investing.
An example of the slowed SAR indicator applied to a weekly chart is shown below in Chart 7.
Chart 7. Weekly SAR indicator
Like all trend following indicators, the Parabolic SAR works particularly well with stocks that are trending strongly but will generate a large number of false signals with a stock that is consolidating.
While the Parabolic SAR is a lagging indicator since it is a trend following indicator, it is quite responsive with strongly trending stocks and produces minimal lag. However with stocks that are fluctuating, the lag is much more noticeable and the indicator will be late in signaling a reversal. The Parabolic SAR works well when combined with the Average Directional Index which is an indicator that determines the strength of a trend rather than the direction of the trend.
Unbounded Oscillator Indicators
More complex indicators for tracking a stock's price behavior
Moving Average Convergence Divergence (MACD)
The Moving Average Convergence Divergence is known as the MACD and consists of two indicators.
The first indicator is referred to as the MACD Line and is simply the difference between the values of two separate exponential moving averages of different time frames. Typically, the shorter time frame is 12 days and the longer time frame is 26 days. The MACD Line is the difference between these two moving averages.
The second indicator is referred to as the Signal Line and is simply a 9-day exponential moving average of the MACD Line.
Both the MACD Line and the Signal Line are plotted in a separate chart pane and these two lines are referred to as the MACD indicator which is essentially a cross over system.
With an up trending stock a reversal signal is given when the MACD Line turns down and crosses below the Signal Line. The MACD Line must be above zero. This reversal signal can be used as a signal to sell the stock. For a stock in a downtrend a reversal signal is given when the MACD Line turns up and crosses above the Signal Line. The MACD Line must be below zero. This reversal signal can be used as a signal to buy the stock.
An example of the MACD indicator is shown below in Chart 1.
Chart 1. MACD indicator with up trending stock
It is common to also display a histogram of the MACD. The histogram values are determined by subtracting the Signal Line from the MACD Line. A histogram value above zero means that MACD Line is above the Signal Line. When the MACD Line drops below the Signal Line, the histogram value becomes negative.
The MACD indicator is one of the simplest indicators but is quite effective with strongly trending stocks. However, the MACD is still based on moving averages and as such has their disadvantages and the MACD can give false signals.
While the MACD determines the direction of the trend, it goes one step further than the moving average and gives an indication of the strength of the trend. The greater the positive or negative value of the MACD Line then the stronger the trend.
The MACD can also be applied to a weekly chart using the same parameter values. Thus the two moving averages become a 12-week EMA and a 26-week EMA and the signal line becomes a 9-week EMA.
An example of the MACD applied to a weekly chart is shown below.
Chart 2. MACD indicator with Weekly chart
The longer time frame of the weekly chart allows that the MACD to capture the longer term trends which makes it more suited to investing.
Average Directional Index (ADX)
The Average Directional Index is known as the ADX and consists of the ADX and two additional indicators.
The first indicator is referred to as the ADX which is a calculation based on the recent price move and determines the strength of a trend. The next two indicators are trend directional indicators which are referred to as the Plus Directional Movement (+DM) and the Minus Directional Movement (-DM). The values for the two directional movement indicators are also based on the recent price data.
An example of the ADX indicator is shown below in Chart 3.
Chart 3. ADX indicator with up trending stock
Refreing to Chart 3. above, the Black Line in the lower pane is the ADX which shows the trend strength. The Green Line is the Plus Directional Movement (+DM) and the Red Line is the Minus Directional Movement (-DM).
With the ADX indicator, strong trends have an ADX value of 25 or more. The higher the value then the stronger the trend is. An ADX value below 20 suggests that the trend is very weak or none existent. Directional signals are only taken if the ADX is above 20.
If the +DM line crosses above the -DM line and the ADX is above 20, an uptrend is signaled. If an uptrend is already in place, then it signals a continuation of the uptrend. This can be seen with the two buy signals shown in Chart 3. above.
If the -DM line crosses below the +DM line and the ADX is above 20, a downtrend is signaled. If a downtrend is already in place, then it signals a continuation of the downtrend. This can be seen with the two sell signals shown in Chart 2. above.
The ADX indicator works just as well with a weekly chart and an example is shown below in Chart 4.
Chart 4. ADX indicator with Weekly chart
The ADX strength indicator can lead to missed signals since it acts as a filter for the trends strength. Also the directional movement crossover indicator can also produce false signals. The ADX can be used in conjunction with other indicators such as a moving average to assist in filtering the false signals.
Rate of Change (ROC)
The Rate of Change indicator (ROC) is also simply referred to as Momentum. This indicator simply measures the percentage change in price.
The primary purpose of this indicator is to identify the extremes of a trend by identifying when a stock is overbought or oversold. The ROC is an indicator that is suited to stocks that are already in an uptrend. The ROC indicator provides a signal when a pullback in the uptrend is overdone and the uptrend is likely to resume.
An example of the ROC indicator is shown below in Chart 5.
Chart 5. ROC indicator with up trending stock
The ROC is commonly set to a 20-day period and the overbought and oversold levels are usually set to +10% and -10% respectively.
With an up trending stock, a buy signal is given when the ROC line drops below -10%. An ROC value above +10% is often ignored for sell signals as this indicator is more reliable when trading with the trend. Using the ROC to signal a reversal of the uptrend tends to produce a large number of false reversal signals. The ROC indicator is best used in conjunction with other trend reversal indicators.
The ROC indicator can also be plotted on a weekly chart as shown below.
Chart 6. ROC indicator with a Weekly chart
The ROC can give false signals which can be reduced by plotting a 5-day simple moving average of the ROC line with the ROC and using this line as the indicator line for the signals. The ROC can also be used for stocks that are trading in a broad consolidation range.
Bounded Oscillator Indicators
These indicators work best with range bound stocks
Oscillator indicators are plotted in a separate chart pane. They are referred to as oscillators since the plotted line or lines alternate up and down about a zero line which means that the values can be either positive or negative. The reference to Bounded means that these indicators have a minimum and a maximum value. The minimum is usually zero and the maximum is usually 100. The values of a bounded oscillator are contained within these limits. The indicator value cannot go above 100 or drop below zero.
Relative Strength Index (RSI)
The Relative Strength Index is known as the RSI and is an indicator based on the recent price action which is usually over the last 14 days. The RSI fluctuates between zero and 100. A value of zero means that the stock's price closed lower on all of the last 14 days. A value of 100 means that the stock's price closed higher on all of the last 14 days.
An RSI value above 70 is considered overbought and a value below 30 is considered oversold. The RSI indicator using the overbought and oversold signals is more suited to stocks that are trading in a broad consolidating range since this indicator produces many false reversal signals with trending stocks. While the RSI indicator can be used to generate buy and sell signals, the RSI is probably better used to determine likely overbought and oversold levels and to use other technical analysis techniques to determine the actual buy and sell signals.
An example of the RSI indicator with a buy and sell signal is shown below in Chart 1.
Chart 1. RSI indicator with trending stock
Chart 1. above illustrates the effectiveness of the RSI indicator while the stock is consolidating.
The RSI indicator can also be applied to a weekly chart as shown below in Chart 2.
Chart 2. RSI indicator with Weekly chart
The concept of divergence is often applied to the RSI indicator which works quite well with range bound stocks but gives many false signals with strongly trending stocks. A bearish divergence occurs with an up trending stock when the RSI becomes overbought and the RSI then falls and makes a lower high but the stock price continues to make a higher high.
The RSI is a useful indicator for range bound stocks but for trending stocks it is better to incorporate other trend following analysis techniques.
The Stochastic Oscillator is a two line indicator based on the recent price action which is usually over the last 14-days. The Stochastic uses the highest high and the lowest low over the 14-day period and the indicator is based on the percentage distance of the last close within this high-low range. This is the first line and is referred to as %K. The second line is a 3-day simple moving average of %K and is referred to as %D. If the last close is at the highest high in the 14-day period, then %K is at its maximum level which is 100. If the last close is at the lowest low in the 14-day period, then %K is at its minimum level which is zero.
An example of the Stochastic Oscillator is shown below in Chart 2.
Chart 3. Stochastic indicator with trending stock
The Stochastic Oscillator is used to identify when a stock is overbought or oversold. A stock is considered overbought when the Stochastic level exceeds 80 and is considered oversold when the Stochastic level drops below 20.
Referring to Chart 3. above, the Black Line is the %K in the lower chart pane and the Red Line is the %D.
A buy signal is given when the %K drops below 20 and then the %D line crosses over %K line. A sell signal is given when the %K rises above 80 and then the %D line crosses over %K line.
There are two versions of the Stochastic Oscillator, a Fast Stochastic version and a Slow Stochastic version. The version discussed so far is the Fast Stochastic version. The Slow Stochastic version uses the %D as %K which means that %K is now already smoothed. The Slow %D is calculated using a 3-day simple moving average of new Slow %K. The end result is that %K is smoothed and %D is double smoothed which has the affect of making the indicator less sensitive which helps in reducing the number of false signals.
An example of the Slow Stochastic Oscillator is shown below applied to a weekly chart with a 14-week period.
Chart 4. Slow Stochastic indicator with Weekly chart
The Stochastic Oscillator is an indicator that is well suited to stocks that are trading in a broad consolidating range. The indicator can also be used in uptrends but is more suitable for the buy signals since this indicator can generate a lot of false overbought signals. Divergence is often applied to the Stochastic Oscillator which works quite well with range bound stocks but gives many false signals with strongly trending stocks.
Money Flow Index (MFI)
The Money Flow Index (MFI) is an oscillator indicator that uses both price and volume. The MFI is similar to the RSI but incorporates volume into its calculation as well as the daily highs and lows.
The MFI Oscillator is used to identify when a stock is overbought or oversold. A stock is considered overbought when the MFI level exceeds 80 and is considered oversold when the MFI level drops below 20.
An example of the MFI Oscillator is shown below in Chart 5.
Chart 5. MFI indicator with uptrending stock
The MFI Oscillator can also be used with a weekly chart and an example is shown below in Chart 6.
Chart 6. MFI indicator with Weekly chart
The MFI Oscillator is sometimes used as an extreme overbought and oversold indicator. The extreme overbought value is 90 and the extreme oversold value is 10. While this significantly reduces the number of false signals and also misses some genuine signals, it does increase the reliability of the signals it generates.
The MFI works better in broad trading ranges than it does with trending stocks. With trending stocks, it is best if the MFI is used to locate overbought and oversold levels and to use other technical analysis techniques to confirm the entry or exit.
Divergence is often applied to the MFI Oscillator which works quite well with range bound stocks but gives many false signals with strongly trending stocks.