In our last lesson we finished up our series on chart patterns with a look at strategies which can be used to trade triangle chart patterns. In this lesson we are going to start a new series on technical indicators with an overview of what technical indicators are, and how traders use them to help pick their entry and exit points.
A technical indicator is a mathematical formula which is derived from the price action of a financial instrument and/or the volume traded. The results of these formulas are commonly displayed in graphical form above or below a financial instruments price chart, and are used to help predict future price movement. When used in combination with other forms of technical analysis, such as the chart patterns we have learned so far, technical indicators can be a powerful compliment which traders can use to assist in their trading decisions.
Technical indicators can be broken down into two main categories which are leading and lagging indicators. As their name suggests, leading indicators are created to try and predict future price movement. Because most leading indicators are trying to gauge price momentum from relatively recent price action, these indicators tend to generate frequent buy and sell signals and are therefore normally used in ranging markets. While some traders like the opportunity to enter more trades, it is important to keep in mind that the potential for false signals with leading indicators is high.
Lagging indicators on the other hand are created to give a picture of where the market has been, and therefore where it is likely to continue to go. As this is the case these indicators are normally used by traders looking to trade with the trend, and offer little value in ranging markets. Secondly because these indicators are designed to catch and stay with the trend for as long as possible, they generate less trading signals than leading indicators. This is often seen as a positive from the standpoint of generating less false trading signals and also a negative as this also means that they normally get you into a move later than a leading indicator.
One of the biggest issues when deciding how and when to use a particular indicator is determining how sensitive to make the indicator to price movements. The more sensitive the indicator the earlier you will catch the move, however the more false signals that will be given. Conversely the less sensitive the indicator the less false signals but the later you will get into the move.