IndicatorsThe 4 Major Categories Of Indicators You Must Know
In order to operate profitably within the financial markets we must be familiar with and know how to use indicators. Most indicators are built on prices and they lag behind the market. What this means is that they point out a past situation and condition of prices hence they are not useful for estimating future prices. Once this important principle is acknowledged, our use of indicators can only be used to sustain our analysis. In order to properly use indicators, we must understand their use case scenario. By this we mean "how to use some indicators in particular situations". Indicators can be divided into four large major categories known as; trending indicators, sentiment indicators, volatility indicators and oscillators.
The category of trend indicators mainly includes all kinds of moving averages, with methods such as weighted, exponential and logarithmic. Each moving average is calculated in a different way by giving more or less relevance to recent or past prices. Beginners who want to use this indicator are advised to use simple rather than exponential moving average. They have the main functionality of smoothing out price, making it easy to read the moving trend in a very sharp and intuitive way.
These indicators are very useful in identifying the development of trends. They follow prices and signal trend strength or indicate the end of the price run, but are not appropriate when markets are entering a lateral/ranging phase. In order to obtain trading signals more than one moving average over different time periods are often used. In fact, their cross over point indicate the likely start of a trend (Notice where the red line crosses the blue one).
It must be pointed out that there isn't a universal set of moving averages that works well for all types of markets. Quantitative tests are necessary to figure out the best set of two or three moving averages for the specific currency or security we are trading.
Beginners who want to experiment on the market may consider using a faster moving average set to 5 periods and a slower one set on 20 periods.
Another widely used trend indicator is the Parabolic SAR acronym for stop and reverse.
This indicator is represented as a series of dots positioned above or below candles. When dots are positioned below candles it indicates that the trend is bullish and vice versa. That moment dots go from top to bottom is called SAR i.e. stop and reverse.
SAR at formation, momentarily suggests closing a long position and opening a short one or vice versa. Like any other indicator it suffers from false signals or errors, so it must be correctly optimized for the asset we are going to trade. For those trading for the first time, it is recommended to leave the minimum acceleration factor of this indicator unchanged. The minimum acceleration factor indicates the sensitivity of SAR at price fluctuations.
Another important class of indicators is sentiment indicators. For those who work in the short term, this indicator should not be missing on your chart. Sentiment indicators show the speed of price deviation suggesting the directional trend of the market at a certain moment. These types of indicators are calculated such that they oscillate around a zero point. When the indicator is greater than zero it signals prices going towards an upward direction, however when the indicator is less than zero it signals a downward price direction. Among sentiment indicators, we can certainly mention awesome oscillator and momentum.
Volatility based indicator category lends an understanding of price variations, indicating market’s tendency to make larger price movements in the short term. These indicators are therefore very useful for those financial instruments where profit is proportional to price movement. When a market is volatile it means that it will take a direction rather than randomness and so the probability of a forecast is increased. Among volatility indicators, Bollinger bands are most popular. Bollinger bands are calculated on the standard deviation of price setup on two periods. The broadening or narrowing of the bands, allows us to understand whether the market is volatile or not.
Another widely used indicator is ATR which calculates the amplitude average of prices in a given period and in practice measure the gradual increase of price bars.
The last but not the least group of indicators is the category of oscillators. All indicators in this category fluctuate in a range between 0 and 100, when the values move towards zero we are in an oversold area, vice versa when the values move close to 100 we are in a situation where the price run is in overbought.
There are no overbought and oversold values for all types of markets or currencies, so it is useful to carry out statistical tests to learn what the sensitive values of the currency or security we are trading are. In practice, this class of oscillators should be deployed in the most appropriate way. When prices are in overbought or in oversold it does not mean we need to go short or long on the asset, but the indicator suggests a large buy or sell region that asset.
There are many types of oscillators, however the most famous are: RSI and stochastics. Other types of oscillators have been created based on these two oscillators, taking other information such as volatility into consideration. Last tip is to also read the article "the truth about indicators" in order to have a very clear vision on the subject.
We can say that no group of indicators is better than another, since all of them are useful or necessary depending on the trading techniques that we use. Indicators can also be used as a simple support to our trading activities, because making decision mainly on a single indicator is an extremely risky choice.
the Analyst's answerJean Grossett - Financial analyst
Indicators and oscillators are a valuable aid to trading, but making investment decisions just by observing those values expressed by indicators is a risky strategy. The main rule is not to use them on their own but a helpful tip is to use them in combination with “price action” formations of candles on our charts. A practical example would be to search for simple patterns such as “hammer” reversal pattern, “shooting star”, “morning star” etc. or more complex such as “head and shoulder”, “triple minimum / maximum” etc. Finally bringing oversold / overbought oscillators into the mix. If after an uptrend, we see the formation of one of the patterns before indicated and contextually our oscillator is over 80, or even better above 90, we can expect a reversal and we can open a put / short position after the oscillator cross downward from 80 or 90. To open a call / long position apply the same logic in reverse (with oscillator below 20 or even better below 10).
the Manager's answerRobert Danvil - Investment Manager
I can give some suggestions about them:
According to different volatilities, which as he said above can be measured by the Bollinger bands or by the ATR, we choose the most appropriate indicator. If volatility is high, trending and sentiment indicators are definitely most useful. However if volatility tends to be low, the use of oscillators is essential before starting any trading activity.