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posted on 06 January 2017

What Do Technical Indicators Indicate?

by Brandon Wendell, Online Trading Academy

Online Trading Academy Article of the Week

Online Trading Academy graduates know that their trading decisions should be based on price action and volume in the same manner that professional traders do.

Technical indicators are very popular in the trading community and can be helpful in reading price action, but they should only ever be used as an odds enhancer. It is important to remember that an odds enhancer is part of a scoring system that is used to increase the probability of a trade working out, not to signal the entrance to a trade itself.

Trades should be executed based on price analysis and supply and demand levels. Whenever I start to discuss technical indicators, everyone always asks me what my favorite one is. I never get bored from watching the disappointment on their faces when I answer, “Price!"

You need to understand that technical indicators are built on past price and sometimes volume in relationship to that price. If you realize the mechanics of the indicator, then you know what it reports in relation to price movement and when the indicator will give signals by simply reading price on a chart. When you can do this, then you can predict the signals of an indicator before they actually occur. This will place you ahead of those who are relying on that indicator to render a buy or sell signal prior to acting.

Stochastic Indicators

Stochastic indicators, for instance, only tell you where the current price close for a period is in relation to a range of price movements for a defined period in the past. Online Trading Academy graduates who learn how to read price properly are able to see certain colors and shapes of the candles on their charts and know what the indicator would read before the signal is given. Remember, the most recent candle must close before a signal is generated on an indicator. Anticipation of the signal based on actual price movement allows you to take action before the novices.

Indicators can be helpful when used properly. Since the buy or sell signals usually appear late, we must observe the behavior of the indicator and take our signals from changes in that behavior.

Divergence

Enter divergence. Divergence is when the indicator is not exhibiting the same characteristics as the price of the security. When prices rise in an uptrend, you should be seeing higher highs and higher lows for the uptrend in price. You should also be seeing higher highs being made in the indicators. The upward movement in some indicators measures momentum. In an uptrend, the momentum should be increasing for the trend to continue.

The opposite is true when in a downtrend. In a downtrend there should be lower lows both in price and the indicator to show bearish momentum continuing the trend

When the trend is moving with less momentum, it is likely coming to an end. Think of a car. If you keep your foot on the accelerator, you keep moving and will go faster. Once you let up from the pedal, your momentum slows and you will eventually come to a stop. This is the same as divergence. Your car’s movement is price and the pressure on the pedal is the indicator, without the pressure, the car cannot continue to move.

There are two types of divergence: positive and negative.

Positive divergence typically signals the pause or end of a downtrend. In positive divergence, the price of the security makes lower lows and lower highs, a downtrend. However, the indicator makes the same lows or possibly higher lows.

What is divergence?

The divergence of the indicator shows that even though prices are continuing in the trend, they are doing so with less momentum and are unlikely to continue without a pause, correction or even a reversal. This is shown in the following chart with positive divergence in the Stochastics.

Explanation of positive divergence shown on a price chart.

Negative divergence typically signals the end, pause or correction of an uptrend. It occurs when prices are making higher highs and higher lows (an uptrend), but the indicator makes similar or lower highs. This lack of momentum being demonstrated by price and reflected in the indicator is a signal of weakness of the trend. Be watchful for reversal signals in this environment.

Explanation of negative divergence shown on a price chart.

A trader can use technical indicators, but you want to be sure to use them properly. You need to know when divergence is signaling a reversal or a pause in price.

There are other factors that must be included to make the correct decision. Relying solely on indicators to signal your entry or exit to trades could lead to disaster. Looking for divergence to confirm your trade that was based on price action is the best way.


Author's note: Learn how to read price correctly by visiting your local Online Trading Academy Center and enrolling in our Free Half-Day class.


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