Technical indicators are based on mathematical equations that produce values that are plotted on charts. For example, a moving average calculates the historic average price of a share or CFD and plots it on your chart as a line. As your share or CFD chart moves forward, the moving average is revised accordingly. The system then plots new points. As you’ll see, this moving average irons out a lot of the temporary price fluctuations (because it is based on a larger sampling of data) and provides a smooth line that indicates the direction in which the share or CFD is moving (see Figure 1).
We have previously identified some of the key factors in technical analysis and in this lesson we will expand on your knowledge and will cover Technical Indicators and Price Patterns. Technical indicators are the interpreters of the CFD markets. They examine price information and translate it into simple, easy-to-read signals that assist you in determining when to buy and when to sell.
Each technical indicator provides unique information but most traders will have a preference for a particular indicator. It is important to familiarize yourself with all of the technical indicators. The one weakness associated with technical indicators is that it is based on historical price data and there is therefore a lag behind the current market; however, they still provide valuable information.
Technical indicators are divided into the following categories:
- Trending Indicators
- Oscillating Indicators
- Volume Indicators
Trending Indicators – Moving Average
Trending indicators identify and follow the trend of a share or CFD. Traders are most successful when there is a trend on which they can capitalise. It is critical that you therefore know when a share or CFD is on a trend and when it is consolidating. In this section, we will talk about Moving Averages.
Moving averages are the most fundamental trending indicator. They indicate the direction in which a share or CFD is going and where potential levels of support and resistance may be. Moving averages themselves can serve as both support and resistance levels because they will be watched by many traders and will be influential.
Regarding moving averages we shall examine three key topics:
- How moving averages are constructed
- Moving average trading signals
- Strengths of moving averages
How a Moving Average is constructed
Moving averages utilise the average closing prices of a share or CFD, plotting these points on a price chart. The result is a fairly smooth line that follows price movements (see Figure 2).
You can influence the volatility of a moving average by adjusting the time-frame the indicator uses to obtain an average price. Moving averages that examine a shorter time are more volatile (and therefore more erratic). Moving averages that examine a longer time-frame are less volatile (and therefore smoother).
Moving Average Trading Signal
Moving averages provide useful trading signals for shares or CFDs that are following trends.
Entry signal – when a share or CFD is enjoying an upward trend and bounces back up after hitting an upward-trending moving average, or when a downward-trending share or CFD bounces back down after hitting a downward-trending moving average.
Exit signal – when you trade in an upward-trending share or CFD you should set a stop-loss below the moving average. As the moving average rises you can move your stop-loss up along with the moving average or use a trailing stop loss which will automatically adjust your stop loss level. If the share or CFD moves below the moving average by your predetermined value, your stop-loss will prompt you to sell.
When you trade in a downward-trending share or CFD, set a stop-loss above the moving average. As the moving average falls, move your stop-loss down along with the moving average. If the share or CFD breaks far enough above the moving average, your stop-loss will prompt you to sell.
Strengths of a Moving Average
- They identify simple trends
- They are flexible enough to work in both short-term and long-term time frames
Weaknesses of a Moving Average
- They lag behind the market. The data used to calculate a moving average is historic, which doesn’t necessarily influence what will happen in the future.
- They cannot identify trends, or levels of support or resistance, during channelling markets.