What is a “technical indicator”, anyway?
Technical indicators are mathematical equations that make predictions based on a stock’s data, including its opening price, closing price, price highs and price lows (OHLC). On most trading platforms, such indicators are displayed either on top of the price, known as overlays, or beneath the candlestick chart, in which case they are called underlays.
The reason for technical indicators is to present what the price action is showing in a visually different way and better inform the trader. When you know how to read them, they give additional insights on things such asvolatility, trends, overbought and oversold conditions. At times, technical indicators by themselves can constitute buy or sell signals.
Types of technical indicators
You have quite a lot of different analysis tools to choose from. This can easily become overwhelming, at least until you get used to them and understand the meaning and limitations of each.
So, let’s focus on three basic types of technical indicators, where each performs a separate function from the others. This means there is no conflicting information to puzzle out and each technical indicator complements the others.
These 3 functions are: trend following, momentum, and volatility.
Your basic toolkit: 3 best technical indicators
The following list of what we consider the best technical indicators for day trading is not exhaustive, but does include some of the most widely-used mathematical gimmicks for short timeframes. As you gain experience in using them, you might choose to change their parameters, use customised combinations, or even create your own bespoke technical indicator.
For now, though, we’ll focus on these:
- Moving Average (SMA or EMA) for trend following
- Relative Strength Index (RSI) for momentum
- Average True Range (ATR) for volatility
Moving Average
Anybody who has glanced at a price chart will know that prices fluctuate wildly. This, in fact, is a characteristic the average day trader thrives on. Still, it’s important to know what midpoint the price is actually wobbling around.
The idea behind a moving average is to reduce the apparent chaos of price action by calculating the average price over a rolling past period. The result is a smooth line that tracks behind the candlesticks or price bars and is overlaid on your chart.
How moving averages are used: The smoothed line makes it easier to determine the overall trend in the market. If the line is sloping up, the price is tending upwards, while if the line is sloping down, the opposite is true. Moving averages can also provide trade signals, such as when the price crosses the moving average, or when a shorter-term moving average crosses a longer-term moving average.
Why a moving average is useful for short-term trading: Moving averages are primarily designed for trend following. SMAs and EMAs are lagging indicators, which means the price moves first and the indicator plays catch-up, reacting to that change. The benefit is that they smooth out the market “noise”, in a sense providing a summary measure. However, the downside of this is that they can be slow to display that trends have just passed turning points.
While popular settings for long-term traders include the 50-day moving average and 200-day moving average, these indicators can be adjusted according to the timeframe you’re trading in. For example, on a daily chart, using a setting of 20 periods means averaging prices over 20 days. Instead, using a one-hour chart, the 20-period moving average will translate to 20 hours. This means traders can apply short-term trend-following strategies and trend-reversal strategies by looking closely at short-term moving averages.
Relative Strength Index
The RSI is an oscillating indicator and is usually displayed beneath the chart. Its value can lie between zero and one hundred. Mathematically speaking, it is a comparison between the size of upward price moves against downward moves. In principle, we can therefore say it measures the relative strength of the bulls versus the bears.
How the RSI indicator is used: When speaking of day trading, it is most useful for finding overbought and oversold conditions in the market. It tells you when the price may have moved too far and too quickly, and could be about to reverse. Divergence between swings in the RSI indicator and swings in the price itself also provides useful signals, often pointing to an imminent change in direction
Why short-term traders depend on it: Over short timeframes, prices can change direction quickly. Momentum indicators like RSI are a leading indicator, which means the RSI will often give advance warning of price shifts. This can give traders early warning to exit a trade before the price drops or enter one where profit is possible. The drawback is that RSI is not infallible and can display false signals, suggesting a trend will change when it doesn’t.
The default setting for RSI is to use 14-days, but dropping down to lower timeframes, like a one-hour chart will produce an RSI constructed using 14 hours of price data instead.
Average True Range (ATR)
The Average True Range can either be written as a single number or presented on the price chart as an underlay, visually tracking how the figure has changed over time. It shows the average number of points a market is moving over a certain time period. The typical setting is 14, meaning it measures over 14 periods.
Applying the ATR indicator: Realised volatility, or how much a market fluctuates over a certain period of time, is a crucial metric. This is something day traders want to know when, for example, trying to decide where to place stop-loss and take-profit orders. If a position is expected to be held for several hours, the stop-loss would typically need to be at least one multiple of the 1-hour ATR(14).
Why it is useful in short-term trading: Day traders are often tempted to get drawn into longer-term trades. The ATR can serve as a benchmark for how high profit targets should reasonably be set and what kinds of losses you can expect if things go south.
As with the above indicators, the default timeframe settings should be adjusted short-term trading. Day traders can use a 14-hour ATR instead of a 14-day ATR for more accurate information on short term volatility.
Technical indicators and your trading strategy
The following chart shows each technical indicator performing its function:
- The moving averages show trends and trend reversals.
- The RSI shows the momentum of price movements and when the momentum slows.
- The ATR shows how volatility goes up and down, confirming other signals when volatility is low and about to pick up.
How technical indicators can be applied in practice
Traders, no matter their investing philosophy, have so many tools and so many sources of information at their disposal, they’re at risk of contracting “analysis paralysis”. While technical indicators are certainly indispensable, they’re not the only way of picking promising stocks and other assets.
In addition, precisely because technical indicators are so accurate and easy to interpret, they are used by almost everybody. Following the herd is usually a good way to avoid catastrophic losses, but doesn’t exactly leave open the possibility of exceptional gains.
Good advice for most people is to learn to weave technical indicators into an existing trading strategy. Importantly, you can then back-test this new approach against historical market data – a demo account on your favourite trading app or website makes this easy.
