Think | Plan | Manage | Execute
In order for us to make sense of most things in this world, including market drivers, as humans, we tend to look for visual cues. For markets and in particular price dynamics, there are tools that allow you to see a whole host of different data. These can then be utilised to make decisions based on visualisations.
Whether you’re interested in forex, equities or crypto, you will find it difficult to avoid the plethora of technical analysis that is available. Usually this will be found in the form of a candlestick chart which plots price into a visual tool that allows for further analysis. Not everybody uses this and there are other forms of technical analysis that doesn’t involve plotting price over time – the simplest form of this can be an order book where you can see the volume of bids / asks relative to price.
In this article we will concentrate on candlestick charting and the tools that can be overlaid to support your trading strategy and decision making process – Trading Indicators.
What is a candlestick chart?
Thought to have originated in Japan in the 1700s as a way to visualise the price movements of the native rice market, the candle stick is widely used today to interpret all types of markets. They represent price movements of an asset but they they have since inception, been linked to human emotion and cycles of human behaviour associated to reactions that create demand and supply.
Candlesticks show that emotion by visually representing the size of price moves with different colors. Traders use the candlesticks to make trading decisions based on regularly occurring patterns that help forecast price directions.
As was discussed in Cryptocurrency; Trading Strategies Part #1 – It can be helpful to use technical analysis as part of your strategy – and this includes studying various trading indicators. In addition to the candle stick charts, indicators are mathematical calculations, which, can be plotted on top of the candlestick chart or as additional visuals aligned to the time periods. These can then be used to assess market conditions, price strength and relative momentum.
There are different types of indicators that traders can use to support / influence their decisions including leading and lagging indicators. Leading indicators provide a view of future price directly e.g. the Fibonacci Retracement Tool. Most technical indicators are however Lagging indicators which utilise past trends or historic price points to indicate momentum or where price may go next. There are also trend or momentum indicators (oscilators) that can indicate periods of interest – these are mainly viewed in separate windows to the candlestick chart, above / below depending on your platform config. These can be used to interprest many things, in particular trends but also price extremes for particular periods – over – bought / sold are terms I’m sure you are familiar with.
In this article we will look at some of the most popular indicators used today. I will explain the principals behind them. Using indicators can support mechanical aspects of your trading system which can support a consistent approach but they are not for everyone, some traders don’t use them at all.
What are trading indicators?
I would qualify anything that interprets price and plots data points on-top of a candlestick chart as a trading indicator. In essence, it is anything that is repeatable and derived from calculations based on the data presented.
There is no right or wrong way to trade in my opinion. Everybody buys their own ticket and pays the price for entry into the market – in order to measure success I believe it helps to have a point of control (a repeatable process) of which indicators can be a part but not always.
A few things to consider when using indicators;
- Time frame (TF)
- Market conditions
- Market Trend (and strength of that trend)
Markets change, the environment within which some indicators are more effective over others is constantly shifting. Time frames give a term of reference to this and it is important to know when using certain indicators what noise to remove (which signals to ignore). We should always be mindful of our strategy – e.g. my trading decisions for scalping should not be overly influenced by longer TF structures and tools should be used according to the our plans and not made to fit a certain bias (easier dais than done). That being said – lets jump in.
Ichimoku Kinko Hyo
Ichimoku Kinko Hyo, is a box of tricks with a number of tools all wrapped into a single indicator for traders that require multiple sources of data. The name translates roughly as ‘one-look equilibrium chart’ – it is designed to give a balanced view of both past, present and future price movement. As with other technical indicators it identifies areas of interest (price levels) with its structures that could act as either support or resistance.
It is comprised of 5 key parts;
- The Tenkan-sen, known as the conversion line, is the nine-period high plus the nine-period low, divided by two. This is the midpoint of the 9-day high-low range, which means that the line spans just under two weeks.
- The Kijun-sen, known as the base line, is the 26-period high plus the 26-period low, divided by two. This line is the midpoint of the 26-day high-low range
- The Senkou Span A, known as the leading span A, is the conversion line plus the base line, divided by two.
- The Senkou Span B, known as the leading span B, is the 52-period high plus the 52-period low, divided by two.
- The Chikou Span, known as the lagging span, shows the closing levels plotted 26 days in the past
A unique feature of the the indicator is the Cloud which denotes an area of equilibrium on the chart. It is formed as a result of the space between the forward projected Senkou Spans, the combination of which suggests possible areas of interest for future price.
Moving Average Convergence Divergence (MACD)
MACD can be used to detect changes in momentum and as such is favoured by trend followers. THe mechanics of the indicated are based around moving averages but specifically the proximity of them. The indicator itself is made up of 3 components that act in harmony to help traders identify opportunities located around support and resistance levels.
There 3 parts that make up the MACD indicator:
- The MACD line, which measures the distance between two moving averages
- The signal line, which identifies changes in price momentum and acts as a trigger for buy and sell signals
- The histogram, which represents the difference between the MACD and the signal line
The indicator uses the positioning of the moving averages in relation to each other to highlight the coming together or moveing apart. These are translated as convergence / divergence.
- Convergence: the 2 moving averages are coming together which occurs as the result of momentum decreasing (and possibly the end of a trend)
- Divergence: the 2 moving averages are moving apart which occurs as the result of momentum increasing (and possibly the start of a trend)
The indicator is a version of an oscillating indicator which require a centerline to move (oscilate) above and below. The MACD transforms the results of its calculations into the visualisation so instead of being overlaid on the chart itself the MACD is provided in its own window. The indicator itself fluctuates above and below zero. The translation of certain events can be interpreted differently depending on its position in relation to zero.
A basic strategy would be to look at which side of zero the MACD lines are and for how long they have been there. If they are above zero for a period of time price is likely to be trending upwards. If they are below zero for a period of time price is likely to be trending downwards.
Traders could look to identify bullish / bearish trends just based on the position around the centerline. A potential buy could be when the MACD moves above the centerline and conversely a sell signal could be interpreted when it moves below.
Moving average (MA)
The MA (aka a simple moving average, SMA) is used to smooth out price movement over a period of time and can be used to identify price direction in the current trend. The indicator itself aggregates a number of price point over a specific time frame into a single line that can be overlaid on the candlestick chart for visual reference.
The data aggregated depends entirely on the user parameters but there are standard averages that are used by many. For investors and long-term trend followers, the 200-day, 100-day, and 50-day are common choices.
The smoothing effect of using the averages removes the noise from price spikes and fluctuations to give a more consistent (flat) feature on the chart which traders can plan around.
Popular examples of using a single MA can be to identify key areas of likely support / resistance and thus drive bullish / bearish trading set-ups.
- MA is flat / horizontal = price is range bound
- MA is moving up = bullish trend – price is increasing or has been
- MA is moving down = bearish trend – price is decreasing or has been
Multiple Moving Averages
Using a combination of MAs gives further options for traders to build plans around. In effect they work the same as a moving average only you will have more than one plotted. Strategies will include similar logic as detailed above for a single MA but the strategy can be more dynamic.
Price being below or above a single line is one way to set a bias. Adding to this a concept of speed, assigned by a faster average period when compared to a slower period. For example plotting a 50 day MA with a 100 day MA, you get a fast and slow moving average. Combining these with a popular strategy of MA Crossovers can give confirmation bias and increased the probability of certain outcomes.
In the crossover scenario a sell signal could be when the fast moving average falls below the slow moving average (50 MA crosses below the 100 MA). Such action would suggest bearish market conditions. For investors this would potentially suggest a good value point for long term investment. As you can see the exact same events can drive opposite behaviors and much of this has to do with yourself as a trader but also the time horizon upon which you have stated your plan for.
These crossovers are difficult to trade alone as price is often more volatile than the average and therefore these events can be prone to false signals. To increase probabilities further additional confirmations can be added, such as price moving back above the MAs or buying / selling them as support resistance structures with bias set by the direction of crossover.
Exponential Moving Average (EMA)
The EMA is the same as the SMA except it weights more recent price action more heavily in its calculations. This can enable traders to take advantage of more near terms events as they will have more bearing on the average line that is plotted. This can help traders respond to more up to date data or a shift in market conditions as they develop.
Relative strength index (RSI)
Another momentum indicator the RSI is mostly used to help traders identify signals for extreme price movements (extreme being relative to the specific config of the indicator). The RSI is similar to the MACD, although it presents different information, it is visulaised in its own window aside from the candlesticks. It also moves within a range of figures and around a centerline of sorts.
The RSI introduces a couple of new concepts focusing on market extremes;
In simple terms the RSI is expressed as a figure but one that which is continuously updated relative tot he chart time frame. Its readings will be between 0 and 100 and once plotted will create a continuous line which helps visualise previous periods of extremes and the current price level in relation to them.
The terms above are horizons on the indicator where it is commonly observed price to be in extremes, these are defined as a reading of 70 being the extreme measure of buying (overbought) and 30 being the extreme measure of selling activity (oversold).
An oversold signal suggests that declines are reaching extreme levels in comparison to historic price points and so a retracement / reversal could be about to happen and similarly for overbought signals.
It is unlikely that traders will use these signals alone to determine market conditions. Additional information or exploration of ideas would be needed to support confirmation of any bias or directional planning.
Some simple tools could be trendlines or moving averages to support clear identification of the current trend, example below;
On the above chart I have marked the extreme levels (overbought = green and oversold = red) so that you can easily scan up to see what price was doing. I have also highlighted the centerline and the interaction you can observe around it. Additional to the extremes you can also get a sense of the fair market value or expressed differently, the equilibrium between buyers and sellers. This can also be used to support your trading plan.
The RSI can come unstuck as a reliable source alone to determine exit / entry plans when markets are in strong trends. This is because market exuberance (irrationality) can last for long periods and therefore overbought / oversold levels can remain in play without signalling for immediate reversals. It would therefore not be recommended to take trades directly from these levels just because they represent extremes of the range, additional information / indicators could help in these situations.
In addition to the RSI (and indeed the MACD) observations can be made not only of extremes or reversal events, but also of price levels in comparison to the structures of the oscillators. These can be used to identify opportunities.
When conflicting information can be identified on a chart in combination to an oscillator they are called Divergences. These are simply areas where information seems to conflict across the 2. Below I have high highlighted a regular Bullish Divergence based on the selling extremes identified on the RSI when plotted against those same points and the result on price information. We can see that the lowest price point did not actually produce the most extreme RSI reading.
In combination these events can be powerful tools to layer additional information to support your logic and incorporate into your trading plan.
An indicator developed in the 1980’s and still widely used to day is a Bollinger band. It is an indicator that wraps price within a range that is typically traded. In essence the bands are made up of a moving average with a standard deviation applied above and below.
- An N-period moving average(MA)
- An upper band at K times an N-period standard deviation above the moving average (MA + Kσ)
- A lower band at K times an N-period standard deviation below the moving average (MA − Kσ)
The bandwidth is set by calculating the volatility and as such it helps to have a consistent centerpoint so SMAs are preferred over EMAs here. The visualised indicator will show as a narrow band when price is less volatile and wider when price action heats up.
They are useful in identifying when assets are trading outside of the usual levels or for when trying to time the market where contraction of the bands (narrowing) could precede expansion (widening) – note direction is not mentioned! Thus additional bias for trend should be sort either from inclination of the band itself or additional indicators.
Similar concepts from the RSI remain true for the bands, price positions towards the lower level can be deemed as over sold and conversely price positioning towards the upper level could be consider overbought.
I have included Fibonacci and specifically the retracement tool that is available on most charting software these days. It is less of an indicator and more of the charting tool as its placement and use is subjective. Traders will identify areas of interest on the chart and utilise the built-in tool to highlight possible retracement levels. As it name suggests it is used to build theories around the degree to which price will move against a current trend.
Retracement refers to the direction of movement the market takes, if price is going up a retracement would be a downward movement of price also known as a dip / pullback. If price is going down, a retracement would be an upward movement of price. Essentially it is used to describe price moving back to a previous level.
The tool can be used to support price action traders, range traders as well as trend followers looking to identify key levels in ‘what if’ scenario modelling. Traders can map out where price might retrace back to if the current trend is broken and thus plan trades at these key areas ahead of those events happening.
The above indicators are just a select few that are generally available on most charting software. There are however plenty more, too many to go through in any sort of detail.
Whether you use indicators or not, my hope is that the above has a the very least given you a good starting point in understanding the few that have been discussed and provoked a few thoughts of your own.
From my own experience I would say that whilst indicators certainly wont give you an edge they can support more mechanical trading strategies with the key takeaway being consistency of approach and repetition for measuring success or otherwise.
Coming up next we will step into the world of Algorithmic Trading