by Joe Duffy
When you look at a chart, it may not always be clear what is happening. Some trends are obvious, of course, but in some cases the market may be undergoing some changes that are not so visible. For that reason, some traders have refined their technical analysis to include indicators that measure the market’s momentum, underlying weaknesses and other factors that give them early clues about what the market might do before everyone else can see it.
Many analytical software packages now include a variety of indicators, so you don’t have to worry about doing all the calculations they involve – you just have to apply them to a chart. However, no matter how sophisticated or expensive the program, several introductory points need to be made about indicators in general:
- No single indicator is the Holy Grail for traders. If you are looking for magic in a box, you won’t find it in any indicator.
- No indicator works alone. Indicators provide early alerts, but you must use an indicator in conjunction with other indicators or other types of analysis before you make a trading decision.
- Many indicators look only at price, so multiple indicators aren’t necessarily the answer if they are all looking at the same thing in a similar manner.
- Be wary of “curve-fitting” – that is, applying an indicator to historical data and then trying and trying until you find parameters that work the best. The parameters that provide the best performance in the hypothetical testing may be the ones you want but often they do not do as well in real trading.
- No matter how simple and easy an indicator is supposed to be, a beginning user will find it a real challenge to understand and interpret what the indicator is indicating. Until you have gained some experience with an indicator, you would probably be well-advised to tap the wisdom of analysts who have worked with the indicators before. Not only can they explain to you what an indicator does, but they also can relate the indicator’s status to the current market situation and what it suggests about taking a position.
Indicators: Moving averages
Perhaps the indicator that is most widely used – and most easily understood – is the moving average. One reason is they give a mechanical trading system a precise price at which to take action without calling for subjective decision-making.
An average is simply the sum of the prices for N periods divided by N, the number of periods in the average. A moving average just involves doing this calculation for each period as the new price becomes available.
However, there are so many types of moving averages and so many ways to apply them that you could spend all of your analysis time on moving averages alone. Here are some things you have to consider if you want to use moving averages:
Which price should you use in a moving average? The close is the likely candidate, but you could also use the open, the low, the high or some composite of them all. Some programs even use averages of averages.
How many periods should you use in your average? You can make the average sensitive by using only a few periods or make it produce only a few trades by using a large number of periods. You will have to adapt the moving average to your trading style.
What type of moving average should you use?
- Simple – every price during the period you select has an equal weight in the average.
- Weighted – recent prices get more weight than earlier prices during the period you select.
- Exponential – all prices remain part of the average, rather than have an old price drop out of the window as with the other two averages, but a smoothing constant makes the exponential moving average more sensitive to recent prices than to older prices.
How will you use this moving average in your analysis? There are some standard ways to apply moving averages, but not everyone uses them the same way.
Is one moving average enough or will you use several averages? Many trading systems use several moving averages, deriving trading signals from the way these averages relate to each other.
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