Contents
Stock Trading vs. Stock Investing
Should You Trade Stocks?
A Trader’s Guide to Stock Markets
How to Get Started Trading Stocks
How to Make Stock Trades
How Stock Charts Work
How to Analyze Trends, Support, and Resistance in Stock Charts
How to Use Technical Analysis Indicators to Analyze Stock Charts
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How to Use Technical Analysis Indicators to Analyze Stock Charts
Technical analysis indicators are statistics that traders use to analyze stock charts. Traders use software to plot one more indicators on a stock’s price chart, usually in real time. Indicators help traders identify points at which to buy or sell stocks, known as entry points and exit points, respectively. Indicators are classified as lagging, time-current, or leading, to indicate whether they reflect a stock’s price movement in the past, present, or future. Traders use dozens of indicators. The most popular indicators break down into two main groups:
- Moving average indicators
- Momentum indicators
Moving Average Indicators
A moving average (MA) is a lagging indicator that shows the average share price of a stock during a given time period. Traders use a stock’s MA to identify trends and to track when the stock might break through a support or resistance level. For instance, a stock trading consistently above its MA might be at the beginning of a new uptrend. A stock trading steadily below its MA might be poised to break through its support level. Four of the most popular MA indicators that traders use are the simple moving average, exponential moving average, moving average convergence/divergence, and Bollinger bands.
Simple Moving Average (SMA)
The simple moving average (SMA) is the average (arithmetic mean) of the share prices at which a stock traded during a specific time period. For instance, a 15-day SMA plots the average price of a stock during the previous 15 trading days. Traders usually plot two or more SMAs on the same chart, each of which plots a different number of days—the 15-day, 30-day, 50-day, and 200-day SMAs are the most popular. Traders then look for crossovers, points at which the shorter (more recent) SMA crosses over the longer SMA.
- Points at which the more recent SMA surpasses the longer SMA tend to indicate a new uptrend in share price, so traders would tend to buy the stock.
- Points at which the more recent SMA falls below the longer SMA tend to indicate a possible downtrend, so traders would tend to sell the stock.
Exponential Moving Average (EMA)
The exponential moving average (EMA) weights the recent share prices more heavily than older share prices. Some traders think of the EMA as a more time-current version of the SMA, but in reality the EMA often differs only slightly from the SMA and is used in much the same way for trading purposes.
Moving Average Convergence/Divergence (MACD)
The moving average convergence/divergence (MACD) shows the difference between two MAs of different time periods. For instance, a trader might use the MACD indicator to track a stock’s 15-day and 30-day MAs (the stock’s average share prices during the past 15 and 30 days). The MACD plots the average of those two MAs and compares it to another, more recent SMA or EMA—called the signal line or trigger line—such as the 5-day EMA. Traders then examine points of divergence at which the signal and the MACD differ. The extent of the divergence is usually plotted as a histogram in which longer lines indicate a greater divergence between the MACD and the signal. Here are few of the main ways traders react based on how the signal relates to the MACD:
- If the MACD falls below the signal, traders sell.
- If the MACD moves above the signal, traders buy.
- If the MACD rises significantly, traders sell.
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If the MACD falls significantly, traders buy.
Bollinger Bands
Bollinger bands are lines drawn at set standard deviations above and below a stock’s MA during a given timeframe. By default, Bollinger bands use a 20-day MA and plot lines two standard deviations above and below that MA. Traders use Bollinger bands to get a sense of a stock’s trading range, the range of prices between its support level and its resistance level. Traders often use Bollinger bands with other indicators, such as the SMA, to try to identify opportune exit and entry points. For instance, on a chart that plots a stock’s 30-day SMA and its Bollinger bands, a trader would look for points at which the SMA moved either above the top band or below the bottom band.
- When the SMA approaches the upper band, traders would tend to interpret that move as a sign of a breakout and a possible new uptrend. They would buy the stock.
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When the SMA approaches the bottom band, traders would tend to interpret that move as a sign of a possible new downtrend. They would sell the stock.
Momentum Indicators
Momentum indicators are the largest and most diverse group of indicators. Traders use most momentum indicators to detect stocks that might be overbought or oversold.
- Overbought stocks: These tend to have risen rapidly in price and volume. Traders often expect overbought stocks to show a trend reversal and begin downtrending.
- Oversold stocks: These tend to have plunged rapidly in price and volume. Traders often expect oversold stocks to show a trend reversal and begin uptrending.
Momentum traders aim to buy stocks at the bottom of an oversold trend, hold the stock as it rises in share price, and sell at the top of an overbought trend.
Relative Strength Index (RSI)
One of the most popular momentum indicators is the relative strength index (RSI) indicator. Traders use the RSI indicator to assess the price performance of a stock based on its average recent closing prices. RSI is measured on a scale of 1–100, in which:
- An RSI of 75 or higher indicates that the stock is overbought and will likely experience an imminent reversal and begin downtrending.
- An RSI of 25 or lower indicates that the stock is oversold and will likely experience an imminent reversal and begin uptrending.
Traders use a stock’s RSI to identify trends in which the stock’s RSI fails to move up in tandem with the stock price. This type of divergence may signal an impending reversal, as shown in the example below.
Volume Indicators
Traders use volume indicators to assess a stock’s price movement relative to its share volume (the number of shares traded in a given trading day). In general, traders believe that the higher the volume of shares that accompany a price change, the stronger the move. For instance, a stock moving lower on high volume is believed to be a stronger signal of an imminent downtrend than a stock trading lower on light volume. Perhaps the most popular volume indicator is the on-balance volume indicator, explained below.
On-Balance Volume (OBV)
The on-balance volume indicator compares share price to share volume—it shows traders whether a stock’s price movements are accompanied by an increase or a decrease in volume. Traders use this indicator to evaluate the strength of a recent move in a stock’s share price. The OBV indicator plots volume on a scale in which 0 is the average volume.
- Price changes accompanied by positive volume readings indicate a strong uptrend or downtrend.
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Price changes accompanied by negative or average volume readings indicate a weak uptrend or downtrend.
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