When a pilot is flying an airplane, and it starts to get so cloudy outside that they can’t see in front of them, how do they navigate? They use their flight instruments. Things like the attitude indicator, the heading indicator, turn coordination, airspeed indicator. They use these tools to keep track of what’s happening to the airplane and to better understand where they’re headed, even though they cannot see.

Using technical indicators is a similar idea for trading. None of us know for certain what a stock will do next, the future is cloudy for all of us. What we can do is use our own indicators to understand what is happening to the stock right now to create a better image of where we’re at and where we might be heading.

Indicators are there to support what we’re doing, with each serving a different purpose and providing us with different information useful to the chart we’re looking at. In this article, we’ll dig into a few different common indicators that are useful for traders to understand. I’ll talk about what they are, how they’re calculated, and how they’re used in trading.

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1. Simple Moving Averages (SMA) and Exponential Moving Averages (EMA)

Definition:

• SMA: The average price over a specific period. The period of time is usually a combination of the chart period you’re looking at, and a certain number of candle sticks. So 20MA on the daily chart, where each trade day is 1 candle, would represent a 20 day moving average. A 30MA on the 1 minute chart would be representing a 30 minute moving average.

• EMA: Similar to a SMA but gives more weight to recent prices, making it more responsive to current market conditions.

Mathematical Difference:

• SMA: Add prices for a given period and divide by the number of periods.

• EMA: Use a multiplier to assign greater weight to recent data.

• Formula: EMA = [Price(t) × (Smoothing Factor)] + EMA(previous candle) × (1 - Smoothing Factor). So on and so on for the look back period chosen.

How to Use These in Trading:

• Spot trends like when an EMA crosses over a SMA and using that as a signal to enter a trade. Technically works for both long and short trades.

• Not only comparing SMA vs EMA but you can also compare the same type of moving average but on different scales. An example would be to compare the 50SMA to the 200SMA to capture a different view of the current trend.

Real Example:

• In the picture below, the purple line is the 9EMA and the yellow line in the 20SMA. Recall that these are moving averages which mean they are always going to lag behind the current price. What we see here is the price finding a bottom with the help of a hammer candle stick and then reversing up. One reason we might assume this trend could continue is once we saw the cross over between the two moving averages. Seeing the cross over acts as a sort of confirmation that the move is likely to go a little further. You’re smart, so I know you’re also thinking, well, there are other spots on the chart when the 9EMA crosses above the 20SMA and those don't lead to bullish breakouts… You’re absolutely right. No indicator is going to be right 100% of the time. This is why it’s so important to have multiple at your disposal at all times to quickly understand if a move is to continue or not. In this example, the bullish move continues for a short bit, but then levels off and eventually the down trend resumes.

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2. Relative Strength Index (RSI)

Definition:

• Momentum oscillator measuring the speed and change of price movements on a scale of 0-100.

How It’s Calculated:

• RSI = 100 − [100 / (1 + RS)], where RS = (Average Gain / Average Loss) over a specified period. The average gain or loss in that calculation is derived from getting a percentage gain over a prespecified look-back period.

• The standard number of periods used to calculate the RSI is usually 14.

How to Use in Trading:

• It’s used to detect oversold (<30) and overbought (>70) conditions within the pricing of a security.

• Divergences between RSI and price indicating potential reversals. If RSI is above 70 and price has been trending up, this could be an indication of a reversal soon to take place.

• When the RSI is staying mostly flat, hovering within the 30-70 range and staying even closer to around the 50 range, it usually means that whatever trend is happening is likely to continue.

Practical Tips:

• Combine with other indicators, like moving averages, for confirmation of an entry or a trend.

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3. Moving Average Convergence Divergence (MACD)

Definition:

• Trend-following indicator showing the relationship between two EMAs (typically 12-day and 26-day).

Components:

• MACD Line: Difference between two EMAs.
• Signal Line: 9-day EMA of the MACD Line that is smoothed out.
• Histogram: Difference between the MACD Line and Signal Line.

How It’s Calculated:

• The MACD is calculated by subtracting the 26EMA from the 12EMA.
• The Signal Line is then a 9EMA of the MACD line.

How To Use in Trading

• Crossovers - MACD Line crossing Signal Line in either direction. Direction is relative to the trend
• Divergence between MACD and price trends. If MACD is staying pretty close to the signal line, it’s usually a sign that things are steady and calm.
• Works better in a trading zone rather than on a broader scale to track momentum.
• Use histogram to gauge momentum shifts and quickly determine if the trend is positive or negative.

Practical Tips

• Combine MACD with volume indicators for stronger signals.
• In the picture below, which is the same as the above but now with the MACD addition on bottom, we can see a very clear cross over at the same point we’ve been talking about. This is why it’s important to use multiple indicators at the same time. If they all are telling the same story, it becomes that much more likely that the story is true. In the picture, the blue line is the MACD line and the orange is the Signal Line. We see the sort of abrupt change in direction from the MACD and watch it cross above with conviction.

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4. Bollinger Bands

Definition:

• A volatility indicator consisting of a moving average and two standard deviation bands (upper and lower).

How It's Calculated

• Middle Band: 20-day SMA. This is straight forward - you know what a 20SMA is.
• Upper/Lower Bands: SMA ± (Standard Deviation × Factor, typically 2).

How To Use in Trading

• When the price touches or breaks the bands, it suggests overbought or oversold conditions.
• A "squeeze" indicates low volatility and potential breakout. A squeeze is when the bands become noticeably tighter or closer together than they’ve been historically.

Practical Example

• See below, same graph we’ve been looking at but now it includes the Bollinger Bands. See how the band starts to squeeze a bit right before the dip? It’s noticeably tighter than what it’s perceived normal width. As we know, this can lead to potential breakouts. We see that shortly after the tightening, it takes a huge downward dive, really pushing that bottom band the whole way down. While that’s happening, the band starts to get noticeably larger, indicating higher volatility and those are the scenarios when prices can move dramatically.
• One thing to point out here is to observe the similarities between the Bollinger Bands and the RSI. Both are used to track these overbought / oversold conditions, having them both on the graph helps visualize the differences between the two in how they can be interpreted compared to what the stock is actually doing. Food for thought.

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5. Volume Indicators

Definition:

• Measure of the number of shares/contracts traded during a specific period.This is different from Open Interest that shows up in some places, but that is usually only on derivative products.

Key Indicators

• Volume: tracks the buying and selling volume that takes place over a given period of time.
• Volume Oscillator: Shows the difference between two moving averages of volume.

How To Use in Trading

• Confirm breakouts (ex: rising volume during directional price movement).
• Understand the movement and if buyers or sellers are in control.

Practical Example

• Below, we can see the volume for each candle stick. This is how much the underlying was traded during that specific candle stick. Earlier on in the initial descent after the Bollinger Bands tightened, there were some big volume spikes showing sell activity. Normally that would mean the downtrend is likely to continue but may see a short reversal once the buyers fight back. In this case, that mostly holds true. The decline continues, with another big red volume stick and then immediately after is when we see the reversal start. In a perfect world, we would’ve seen some big green volume sticks of increasing size follow, but instead we got 3 medium strength green volume sticks of similar size. Here is where each trader is different, I would’ve seen that and been a bit turned off. When volume is decreasing from a recent high, that means that whatever trend is happening is likely to discontinue. In that case, that would be the bullish reversal, I would’ve counted volume as a -1 to take the trade whereas the SMA/EMA cross over, the RSI, and the MACD were all +1’s. People interpret things differently, Play around with how you want to interpet these signals.

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Conclusion

Now look, there are hundreds of different technical indicators and thousands of different combinations of them. The ones we’ve talked about today are sort of the entry level ones that are commonly used for trading. As you advance in your trading career, you’ll likely end up using these less and less until you’re not using them at all. You might end up developing your own indicator tailored specific to your strategy that gives you an edge and makes you profitable.

Nobody learns these overnight; sure, you can learn of them, and you can add them to your chart to look at them, but the best way to fully understand them is through constant exposure. Really test yourself to understand the underlying nuances with a set of indicators, how they work with each other, how they work against each other, and everything in between. Attempt trading with them on a paper account until they feel almost intuitive to look at. Just remember, it does not happen overnight - learning these takes time and dedication, something all good traders require.

Happy Trading,
B