Technical Analysis Indicators

MACD – Moving Average Convergence/Divergence

The MACD is an indicator which usually sits underneath a chart and shows the relationship between two moving averages. It is a trend-following momentum indicator with a usual default setting of 12, 26 and 9. This means that the MACD Line is calculated by subtracting the 26-day exponential moving average (EMA) from the 12-day EMA.Then the Signal Line is calculated and this is the 9-day EMA of the MACD Line. Finally, the histogram is calculated by subtracting the Signal Line from the MACD Line.

The two lines in the MACD converge and diverge.

Convergence is when the moving averages move towards each other while divergence happens when the moving averages move away from each other.

The shorter moving average (Signal Line) is faster than the longer moving average (MACD Line) and traders look for the Signal Line to cross over the MACD Line.

A crossover from below can be a sign that prices are set to head higher while a crossover from below can signal that prices may trend lower.

The MACD also fluctuates above and below the zero (centre) line as the moving averages converge, cross and diverge. A positive MACD histogram indicates that upside momentum is increasing.

A negative MACD histogram indicates that downside momentum is increasing. But traders should never enter or exit a position on the basis of a single indicator alone.

Traders should try to find confirmation of a change in trend using other complementary technical indices, drawing tools and chart patterns.

RSI – Relative Strength Index

The RSI is another popular technical indicator that usually sits underneath the chart. It is a momentum oscillator which ranges between 0 and 100 and helps to indicate when a market is overbought or oversold.

A market is overbought when a rally is extended to such an extent that buying interest becomes exhausted. Effectively, there is no one left prepared to buy at increasingly higher prices leaving the financial instrument vulnerable to a sell-off.

A downside correction may then accelerate as holders of long positions rush to book profits or cut losses. An oversold market is exactly the opposite. This is where a market sell-off becomes over-extended to such a degree that selling pressure is exhausted.

Traders are then at risk of getting caught out by a sharp reversal which sees prices rally as short-sellers rush to cover their positions and fresh buying comes in as upside momentum builds.

Most commonly, a market is considered overbought when the RSI is above 70 and oversold when it is below 30, although some traders prefer 80 and 20 as their crossover levels. If a market is overbought then this suggests that investors may be about to cash out their long positions taking the market lower. If a market is oversold then the opposite may be true – investors will look to take profits on their short positions and thereby push the market higher.

However, markets can remain oversold and overbought for extended periods. Consequently, it’s important not to open or close a position simply on the basis of an RSI reading above 70 or below 30.

Some traders extend the parameters of the RSI to 80 and 20. In addition, most technical analysts will want to see the RSI dip back below the upper end, or push back above the lower end before considering making a trade. Traders should also look for confirmation using other complementary technical indices, drawing tools and chart patterns.

Stochastic Oscillator

The stochastic oscillator is a momentum indicator which compares the closing price of a financial instrument to the range of its prices over a certain period of time, usually 14 bars.

According to its creator, George C Lane, the oscillator follows the speed or momentum of price. Typically the speed or momentum or speed of the price of a financial instrument changes before the actual price changes. This means that it should act as a predictive rather than a lagging indicator able to highlight price reversals when the indicator shows up bullish or bearish divergences.

The stochastic oscillator ranges between 0 to 100 and can help identify when a particular financial instrument is overbought or oversold. When the oscillator is above 80 it indicates that a financial instrument maybe overbought as it trades near the top of its high-low range. When the oscillator falls below 20 it indicates that a financial instrument could be oversold as it trades near the bottom of its high-low range. But it is important to note that a market can remain overbought or oversold for long periods of time.

Consequently, traders should not open or exit a position simply because the Stochastic Oscillator is above 80 or below 20. As with all technical indicators, it is important to look for confirmation by employing other complementary technical indices, applying certain drawing tools to look for areas of support and resistance and studying chart patterns.

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