A technical indicator is a measure based on price, market sentiment or funds flow which can be used to predict changes in price.

Price-based indicators

Price-based indicators are based on history of market prices. These range from simple (moving average) to complex oscillators.

Moving average

The moving average is the average of closing prices over a specified period. They smooth out short-term fluctuations and provide a clearer indication of market trends.

In a simple moving average, all price points have the same weight, but in an exponential smoothing, exponentially lower weight is assigned to older values. The number of data points included may vary, but 20 points (corresponding to a month of daily data) and 60 (corresponding to a quarter) are common.

Both whether the price line is above or below the moving average line and the distance are important. If a security’s price is above its moving average, it shows that the security is trending up, and vice versa. If the price line moves up towards the moving average line, it acts as a resistance level because investors sell as soon as price approaches the moving average.

Often more than one moving averages are used together. When the short-term moving average crosses the long-term average from beneath, it is called the golden cross (which is bullish), and the opposite (bearish) movement is called the death cross.

Moving averages are simple to construct and use in trading. They are often optimized using computers to determine the best duration of the moving average. However, such an optimization must be performed separately for each security.

Bollinger bands

Bollinger bands represent an indicator created using a moving average coupled with an upper band equal to the moving average plus specified standard deviation, and a lower band equal to the moving average minus specific standard deviation. When Bollinger bands widen, it represents higher volatility.

Bollinger bands can be used to develop a contrarian strategy. If an investor believes a security’s price to stay within the bands, he can develop a strategy to sell when the price touches the upper band and vice versa. Even though such a strategy can result in a large number of trades, it can result in a reduction of risk. A long-term investor, however, may see a breach of a band as a breakout from a trend.

Momentum oscillators

Momentum oscillators are constructed from price data such that they oscillate around a number, say 0 or 100. This allows analysts to see extreme lows and highs more clearly and determine whether a market is overbought or oversold. It is because when the price and the oscillator move in the same direction, it signals convergence, else it shows a divergence.

They help us see the strength of a trend, the point of a trend reversal (when the oscillator changes direction) and may guide short-term trading decisions in the market with no apparent trend.

The momentum or rate of change oscillator value is calculated by multiplying any excess of the most recent price over the last price with 100. When the oscillator crosses zero in the direction of the trend, it shows convergence, i.e. when it is positive in an uptrend, it is a buy signal. Another method through which oscillator is calculated involves taking the ratio of recent price by the previous price multiplied by 100 oscillates around 100 (instead of 0.)

Relative strength index

Relative strength index is calculated over the rolling basis as 100 – 100/(1 + RS) where RS is the ratio of the sum of all positive moves to the sum of absolute values of negative moves. A value above 70 means that the market is overbought, a value below 30 shows that the asset is oversold.

Stochastic oscillator

A stochastic oscillator is composed of two lines, a long-term slower-moving signal line created by %D, and a short-term line %K, such that K = 100 × {(C – L14)/(H14 – L14)}, where C is the latest closing price, and H14 and L14 are the 14-day highs and lows. %D is the moving average of three %K values.

The default buy-sell readings are 20-80 relative to the signal line. The crossover the lines are interpreted just like the crossover of short-term vs long-term moving averages.

Moving-average convergence/divergence (MACD) oscillator

MACD represents the difference between short-term and long-term moving average price of a security. It consists of the MACD line and the signal line, which is the exponentially-smoothed average of the MACD.

The indicator oscillates around zero and has no lower or upper limit. MACD can be used in three ways: look for crossovers, identify times when MACD is outside range, and draw trend lines on the MACD. When MACD is moving in the same direction as the price, it is labeled as convergence, else it is called divergence.

Sentiment indicators

Sentiment indicators attempt to measure the level of bullishness and bearishness.

Opinion polls

Opinion polls provide insight by surveying individual and institutional investors about their sentiments about the securities market.

Calculated statistical indexes

These are calculated from market data. Common examples include put/call ratio, volatility index, margin debt, short interest, etc.

Put/call ratio

Put/call ratio is the ratio of the volume of put options to the volume of call options on a particular security. It is considered a contrarian indicator: lower values are bullish, and vice versa. Since buyers of put options are bearish, hence, if put options are greater than call option, the ratio will be greater than 1 but it would show bearish sentiment. One drawback of this measure is that each security has its own put/call characteristics. Hence, the ratio may be useful in extreme highs or lows.

CBOE volatility index

The CBOE volatility index (VIX) is an indicator of short-term volatility. It rises when the market participants are fearful of a market decline. However, when other indicators show that the market is oversold and VIX is at extreme high, it shows a bullish trend.

Margin debt

Margin debt is the debt that investors obtain to finance their purchase of securities. When margin debt is increasing it means that investor sentiment is high. However, as soon as the margin debt is so high that investors cannot obtain more debt, prices start declining prompting margin calls that drive prices further down.

Short interest

Short interest represents the number of shares of a security sold short. Short interest ratio is worked out by dividing shares sold short by average daily volume. It may be interpreted as an indication of bearishness and impending price decline, or it may be interpreted as potential positive support when short-sellers buy shares to close out their positions.

Flow of funds indicators

Flow of funds indicators look at the potential demand and supply. Demand comes from the buying power of the major participants in a securities market. For example, it looks at cash balances available with mutual funds and other large investors. Supply comes from new or secondary issues of securities.

Arms index

A common indicator is the arms index, also called the short-term trading index (TRIN). It is calculated by dividing the ratio of the number of advancing issues to the number of declining issues divided by the ratio of the volume or advancing issues to the volume of declining issues. An index of 1.0 shows a balance, a value above 1.0 shows more volume in declining stocks, and a value of less than 1.0 shows more volume in advancing stocks.

Margin debt

Margin debt can also be used as a flow of funds indicator.

Mutual fund cash position

Since mutual funds are one of the largest segment of market participants, the percentage of mutual fund assets held in cash is an important indicator of market sentiment. When the market is trending lower, a fund manager may choose to hold cash in excess of its routine requirements. However, some technicians may interpret it exactly oppositely. For example, they look at the extra cash as a future potential demand which would drive prices up. Some technicians also adjust these balances for available interest rates on cash deposits.

New equity issuances

Since a company’s owners attempt to get the highest price possible for their shares, they offer their shares when demand is highest. As premium prices occur near market tops, an increase in the number of IPOs may indicate a reversal of the uptrend. Further, since IPOs increase the number of shares available thereby increasing supply, it may be viewed as a bearish sign.

Secondary issuances

While secondary offerings do not increase the supply of the total number of shares issued, they may increase the number of shares available for trading which in turn increases supply and may put downward pressure on prices.

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