Emini Trading Blog

Overview of Indicators

You would think that any activity based on just two groups of people – Buyers and Sellers – would be a simple affair. After all, just determine who is dominant in the current market, the sellers or the buyers, and them act accordingly. Just start up the charting software and observe the prices and volume. What are the charts saying besides buying and selling? How can we approach this numerical Babel in an organized, coherent manner? Our objective is to take this chart information and be able to read them like a book. Is this series of movements a trend? How far down should I allow this price go before I consider buying? How do I formulate my stops? These are the vital questions that indicators can answer. If I didn’t have the power of technical indicators I would be guessing, trading by whim, by instinct, by emotion. Technical indicators represent the “control panel” of my analysis engine. Let’s take a quick overview of what technical indicators are and how they should be used.

Types of Indicators

There are two broad categories: Technical and Market indicators. Technical indicators function at the “micro-level” of our charts. We use technical indicators to interpret current time data. They provide us with information at time specific intervals, i.e., three minute, one hour or one day charts. On the other hand Market indicators function at the “macro-level” of our analysis. Instead of focusing on a series of three minute price movements, market indicators interpret entire sectors, markets, economies. As such, market indicators follow a more comprehensive time frame of weeks, quarters, years. Examples of market indicators include the unemployment rate, consumer sentiment, housing starts and Consumer Price Index.

Technical Indicators

Technical indicators have a limited function: they Alert, they Validate and they Anticipate. If we accept this premise then we will avoid the unfortunate habit of basing our trading decisions solely on technical indicators. We will also avoid the habit of allowing technical indicators to become an end in themselves. There are hundreds of indicators and oscillators with new ones being written each week. Leave the indicator search to the Don Quixote’s who believe that the one, true method is only an equation away. If we confine our use of indicators to alerting, validating and anticipating, we are on our way to good trading set-u8ps based on solid analysis of the price/volume data.

What Indicators and When?

Ironically, the most reliable technical indicators are those that have been around the longest. Indicators fgenerally fall into four categories and we will review each category with example indicators for each.

Trend Indicators

The primary tool for detecting and monitoring trends are Moving Averages. Moving averages come in a variety of flavors from the very simple (simple moving averages) to the more complex (exponential moving averages). They primarily follow price/volume data, helping to smooth out spikes in price behavior. They are excellent tools for identifying and confirming trends in the market, but since they are lagging indicators (follow prices) they are not good predictors of price activity unless they are used with another, complementing technical indicator.

Momentum Indicators

Momentum indicators allow us to measure the speed at which prices and volume are changing. Momentum indicators take the form of oscillators, that is, they represent values that range above and below a centerline, normally valued at zero. Commonly used momentum oscillators include “Rate of Change” (ROC), “Relative Strength Index” (RSI) and “Stochastic’s” developed by Dr. George Lane.

Volume Indicators

Volume indicators are used to confirm the robustness and strength of a trend. Examples of volume indicators are the “Volume Oscillator”, the “Price and Volume Oscillator”.

Volatility Indicators

Lastly, the volatility indicators are used to validate price behavior. Volatility indicators are often used with volume indicators to validate price behavior. “Bollinger Bands”, C”Chaiken Volatility” and “Keltner Channels”.

General Guidelines for Using Indicators

Given the enormous number and variety of technical indicators, a specific explanation of each is beyond the scope of this article. However, some general guidelines will assist the beginning trader as he or she builds their analytical muscle:

1) Select just two or three indicators and master their use and interpretations

2) Avoid using indicators that are so similar that their conclusions lead to false signals and inaccurate information on Price/Volume activity. Always use indicators that help analyze different components of price/volume behavior. For example, don’t use two momentum oscillators as a basis for your trade decision since they are focused on basically the same aspect of price/volume behavior.

3) Indicators that complement each other but are not based on the same data will often not correlate and will sometimes contradict. This makes a conclusion more reliable when they do agree.

4) Most of the most popular indicators and oscillators are built into charting software. Plan to spend some time learning how to setup and display these indicators to fit your trading style. Remember, each trader is different and developing your own way of analyzing the charts will help you as you solidify your trading style and experience.

The Big Picture

Using technical indicators give you a lorgnette into the continuing drama of the market (I’ve always wanted to use “lorgnette” in a sentence – word for the day). Use your indicators as a mechanic uses her Snap-On tools or as a stylist uses his shears and you will be part of that small 10% of all traders who actually makes money.