Making Decisions With Indicators
Of the vast array of technical indicators available there a few classic indicators that form the bedrock of many profitable trading strategies and can be used successfully by retail traders to make informed trading decisions.
The key when using technical indicators is to have a proper understanding of what each indicator is telling you about price movement and how it can help you make trading decisions. For example, does the indicator give you a directional bias? Does it inform you about momentum in the market? Is it representative of volatility in the market?
To gain a fuller understanding of the movement of price traders can reference different indicators to get a different view of the market. Using combinations of indicators, that measure a different aspect of price movement, can be a fantastic way to gain a multi-dimensional view of the market and thus identify powerful trading opportunities.
A class indicator combination is to use the MACD in conjunction with the stochastics indicator.
The stochastics indicator is a bound oscillator measuring momentum in the market. The indicator measures the closing price of an instrument against a price range over a specified look back period. Essentially the indicator highlights periods when the price can be considered oversold, and thus vulnerable to a bullish reversal, or overbought, and thus vulnerable to a bearish reversal.
The image above shows the stochastic indicator. You can see the indicator has both an upper and lower threshold. Once the stochastics crosses above the upper threshold momentum is classed as overbought. Similarly, once the stochastics crosses below the lower threshold momentum is classed as oversold.
The Moving Average Convergence Divergence indicator identifies trend direction by looking at the difference between a shorter term and longer term moving average and then also a moving average of that difference. Unlike the stochastics indicator the MACD is not bound and so has no upper or lower threshold.
The image above shows the MACD indicator. The key thing to focus on in this strategy is the histogram which represents the difference between the shorter term (12 period) and longer term (26 period) moving averages. When the histogram is above the center line, trend direction is indicated as bullish. When the histogram is below the center line, trend direction is indicated as bearish.
Stochastics & MACD
With the MACD indicator helping us identify trend direction in the market and the stochastics indicator helping us identify periods of momentum exhaustion, one basic strategy we can employ is:
- Using the MACD to establish directional bias
- Using the stochastics indicator to fade periods of exhausted momentum in the direction of the trend
In the image above you can see that we have both our stochastics and MACD indicators applied to the chart. We first of all look at our MACD indicator to establish our directional bias. Once the MCAD crosses below the zero line, we know that the trend is likely bearish and as such as we look for selling opportunities.
We then look to our stochastics indicator to identify periods of overbought momentum which gives us the opportunity to sell, in line with the dominant bearish trend.
Essentially, we are looking to the stochastics indicator to help identify the potential end to periods of correction within the trend. So once we have established our bearish trend, we then look to sell subsequent bullish corrections, using the stochastics indicator to signal when bullish momentum is exhausted and the trend is likely to resume.
You can see highlighted on the chart that there are four instances when the Stochastics moves into overbought territory, offering us the opportunity to sell in line with the bearish trend as dictated by the MACD indicator.
The beauty of the strategy is that it can be particularly useful in helping us gain entry to trending markets. The two-tiered approach to entry means that this is quite a conservative strategy as we have two sets of criteria which must be satisfied in order to enter a trade. This two-tiered approach is particularly effective at helping us avoid losing trades during range bound periods as during choppy markets it is rare to get a full signal as the price is unable to sustain a directional move long enough to get confluent signals on both indicators.