6 Key Technical Indicators of Stock Trading Every Investor Must Know

Birbahadur Singh Kathayat  |

Cracking the conundrum of stock markets and earning a huge fortune out of stocks and securities isn’t easy even for experts, much less for ordinary investors. For this reason, industry experts came up with certain technical market indicators that are used to predict the direction of major financial indexes or groups of securities.

These indicators apply a statistical formula to a series of data points to draw a conclusion. A thorough analysis of these indicators and statistics can help investors to get hold of an undervalued security at the right time and right price. No single indicator, however, can earn you big money overnight since there are other factors like “risk management” and “trading psychology” at work. But tweaking them here and there, you can have a better idea to create your own personal strategy to get your hands on quick cash.

Here we go with them one by one:

  • Relative Strength Index (RSI)
  • Moving averages (MA)
  • Moving Average Convergence Divergence (MACD)
  • Volume Weighted Average Price (VWAP)
  • On Balance Volume (OBV)
  • Average Directional Index (ADX)

Developed by J. Welles Wilder, the Relative Strength Index is a momentum indicator that measures the magnitude of recent price movements. The RSI provides a relative evaluation of the strength of a security's recent price performance, thus making it a momentum indicator.
The RSI oscillates between zero and 100. This indicator is basically used to identify overbought or oversold conditions in the trading of an asset. The default time frame for comparing up periods to down periods is 14, as in 14 trading days. The RSI is considered overbought when above 70 and oversold when below 30. It is recommended to buy near oversold conditions when the trend is up, and make short trades near overbought conditions when the trend is downward. The RSI is calculated using the following formula:

RSI = 100 – [100 / (1 + (Average of Upward Price Change / Average of Downward Price Change) ) ]

In an uptrend market, the RSI tends to stay in the 40 to 90 range with 40-50 zone acting as support. During the downtrend, on the other hand, the RSI remains between 10 to 60 range, with 50-60 zone acting as resistance.

  • Moving averages (MA)

As the name suggests, moving averages are used to gauge the direction of the current trend; that is, where the trend is moving. It is calculated by averaging a number of past data points. Because of based on the past prices, moving averages lag and do not predict the current or future price direction. Once plotted onto a chart, they give traders a smoothed data rather than focusing on day-to-day price fluctuations. If you are using MA to trade, it is important note the time frame. If you look at chart, first notice the angle of the MA. If it is horizontal for a long time, then the price is ranging rather than trending. On the other hand, if the graph is angled up, then you have an uptrend in the prices. The two most popular types of moving averages are the Simple Moving Average (SMA) and the Exponential Moving Average (EMA).

  • Moving Average Convergence Divergence (MACD)

MACD is one of the simplest and most effective momentum indicators in use today. It is atrend-following indicator that shows the relationship between two moving averages of prices. The MACD is calculated by subtracting the 26-day exponential moving average (EMA) from the 12-day EMA. The MACD fluctuates above and below the zero line as the moving averages converge, cross and diverge. It is all about conversion and divergence of the two moving averages. Convergence happens when the moving averages move toward each other, while in divergence, it is vice-versa. The 12-day moving average is faster and responsible for majority of MACD movements, and the 26-day MA is slower and less reactive to price changes.

When a new trend occurs, the fast moving average will react first and eventually cross the slower moving average. When this “crossover” occurs, and the fast MA starts to “diverge” or move away from the slower MA, it often indicates that a new trend has formed. Signal line crossovers provide additional buy and sell signals. The buy signal occurs when the fast line crosses through and above the slow line. A sell signal occurs when the fast line crosses through and below the slow line.

  • Volume Weighted Average Price (VWAP)

A Volume Weighted Average Price (VWAP) is an important indicator for traders, which is used to gauge whether a stock was bought or sold at a good price. VWAP essentially eliminates the noise that occurs throughout the day, so the traders can figure out what prices buyers and sellers are really trading at on the stock or the market. When prices migrate away from the VWAP, buyers are essentially paying a premium based on the average price of where the most volume has transacted to that point. The fact is areas of high volume attract buyers and sellers, and therefore price is often pulled toward these high volume areas, like the VWAP. When a stock breaks above or below the VWAP, there is a natural selling pressure on the trader. But if this happens multiple times throughout the day, traders and analysts can see that it is a good price to either buy or sell. The VWAP can also help traders and analysts gain insight into where the momentum is at a specific time frame.

  • On Balance Volume (OBV)

On Balance Volume (OBV) measures buying and selling pressure on a cumulative basis, which subtracts volume on down days and adds volume on up days. Thus, according to this theory, the volume is correlated with the change in prices. Developed by Joe Granville, OBV is one of the first indicators that measure positive and negative volume flow. A period's volume is positive when the close is above the earlier close. A period's volume is negative when the close is below the earlier close. It is often used to confirm price trend and also to look for divergence between price and OBV. During an uptrend, the OBV will follow the price direction and will keep on making a higher top and higher bottom.

The calculation of OBV is simple-

If the closing price is above the prior close price then:

Current OBV = Previous OBV + Current Volume

If the closing price is below the prior close price then:

Current OBV = Previous OBV - Current Volume

If the closing price equals the prior close price then:

Current OBV = Previous OBV (no change)

  • Average Directional Index (ADX)

The Average Directional Index (ADX) is an indicator used in the technical analysis as an objective value for the strength of a trend. It is derived from the smoothed averages of the difference between +DI and –DI. The Plus Directional Indicator (+DI) and Minus Directional Indicator (-DI) are derived from smoothed averages of these differences, and measure trend direction over time. The ADX is used to measure the strength or weakness of a trend and is therefore used alongside the plus directional movement (+DM) and the minus direction movement (-DM) to determine the best course of action. It fluctuates from 0 to 100, with readings below 20 indicating a weak trend and readings above 50 signaling a strong trend. The proper way of using ADX is to wait for breakouts first before jumping to go long or short. It can be used as confirmation whether the pair could possibly continue in its current trend or not. Or you can combine ADX to another indicator.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer


Emerging Growth

Investview Inc

Investview Inc is an investor technology and education company. It provides products that allow the individual investor to find, analyze, track, and manage their portfolio.