Investing in stocks can greatly enhance long-term wealth if you buy high-quality companies and hold their shares over time. Millions of Americans do this when they fund retirement accounts, save for children’s college costs, or simply wish to leave something valuable to their heirs when they are gone. But not everyone has a timeline that can be measured in decades or years.
If you’re looking to profit off short-term moves in stocks, then earnings projections and cash flow statements likely don’t have much impact on your trading style. When attempting to make money day trading or swing trading, technical indicators are used to make guesses about the next move a volatile stock could make.
Technical analysis doesn’t predict movements with 100% accuracy and many veteran investors and money managers like Burt Malkiel think it’s little more than financial astrology. But the best technical traders understand the limitations of their own tools and use them to make educated predictions, not offer stone-cold locks.
What are Technical Indicators?
In technical analysis, certain indicators serve almost as alarms for buy and sell signals. Technical analysis doesn’t care who the company is, what it does, or even how much money it makes. Instead, technical indicators use historical pricing information in order to predict where the price will be in the future.
Price data on stock charts might seem like random gyrations, but technical analysts view the past as something to view to get a read on the future. According to traders utilizing these strategies, patterns repeat themselves and technical indicators are a way to tell when price might be beginning to shift.
Take one of the most common concepts of technical analysis: support and resistance. When a stock bumps into a certain price level before retreating, that’s known as resistance. When a stock drops but finds buyers at a specific level, that’s support. Support and resistance are good barometers of the price range you could expect in a particular stock. In this scenario, traders buy shares when the support level is reached and sell when the price moves back up to the resistance level.
Common Technical Indicators
Support and resistance is one of the main chapters in the book of technical analysis, but it’s far from the only indicator utilized by day and swing traders. Hundreds of technical trading signals have been developed by all kinds of investors, with new ones popping up even to this day.
- Moving Average – Stock prices tend to have jerky movements, so moving averages are used to calm the spasticity. A moving average uses stock prices over a specific time frame (ie. 50 days or 200 days) in order to create a smoother trend line for the shares. Exponential moving averages (EMA) add more weight to the most recent price data.
- RSI Indicators – The Relative Strength Index is an indicator used to gauge whether a stock is overbought or oversold. RSI uses a 14-day time frame to measure the momentum of a stock’s current trend. The scale goes from 0 to 100 with 70 and over indicating an overbought stock and 30 and under indicating an oversold stock.
- MACD Indicator – The acronym stands for Moving Average Convergence Divergence, but this indicator is usually stylized as the MACD (pronounced Mack Dee, like the first names of the characters from It’s Always Sunny In Philadelphia).
- Bollinger Bands – Used in tandem with moving averages, Bollinger Bands show share prices one standard deviation above and below a moving average, usually the 20-day simple moving average. A stock hugging the lower band could be showing a good entry point; a stock at the higher band might be indicating an exit point.
- On-Balance-Volume (OBV) – Volume begets volatility and OBV measures share volume in terms of momentum. When volume comes flowing into a stock at a higher rate without an accompanying price movement, OBV indicates a good buying situation.
- Volume-Weighted Average Price (VWAP) – Used in day trading, the VWAP is the average price of the shares over the course of the day with volume factored in. Large institutions use indicators like VWAP in order to enter positions without causing large disruptions in the normal price trend.
Tips for Using Technical Indicators
Technical indicators aren’t treasure maps to unlimited stock profits. Each indicator has its own strengths and weaknesses and no single signal should be used to initiate a position. Here are a few tips for using technical signals effectively.
- Decide what type of trader you want to be and use indicators that assist toward that goal. If you want to be a momentum trader, use momentum indicators like RSI and OBV. If you want to be a scalp trader, moving averages are more important.
- Understand WHY you’re using the specific set of indicators you chose. Don’t just trade using VWAP or Bollinger Bands because you see other traders doing it. Understand how each indicator works in conjunction with your trading strategy in order to get the best possible results.
- Understand the limitations of your technical indicators too. No single indicator has a perfect record and you’ll need to use them along with a little intuition and common sense. Fakeouts and false signals are common, so don’t swear off an indicator just because it didn’t work the first time.
- Backtest your theories, write down your ideas, and record your results. Keeping a trading journal might seem tedious, but you often forget certain aspects of a trade when the heat of the moment fades. Keep track of your trades and the mindset you had when entering the position. This will help improve your results over time.
Technical analysis can be a complex subject, but thankfully you don’t need to memorize dozens of indicators and trading signals in order to be successful with stocks. However, you will need to find your niche and comfort zone as a trader. Not all technical indicators will be useful to every trader since not every trader has the same goals and style. You might need to use a little trial and error before getting comfortable with a particular set of indicators, so don’t be afraid to test your trade ideas dispassionately on a demo account with paper money. A little practice never hurts, especially when money is at stake.