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Making the Most of Stock Trading Technical Indicators

Posted on July 21, 2010 by StockTrading.net | No Comments

Though buy and hold investors tend to worry about technical analysis less, those looking to take advantage of the market’s short-term stock trading opportunities often rely on one or several technical indicators to find and manage trading ideas. Unfortunately, just because an indicator is included in a charting software package – or just because it’s a highly-accepted one – does not mean it’s consistently profitable. In fact, most indicators are net losers when back-tested as buy/sell signals.

With that in mind, here’s what you need to know about the majority of these tools, how to get the most out of them in your stock trading, and how to largely avoid the downside of each.

Types of Technical Indicators

There are three basic categories of chart trading tools. Though it may seem elementary to break them down into their categories, it’s an exercise worth undertaking, as there’s a bigger point to be made below about the pros and cons of each type.

• Momentum indicators – Tools intended to spot trade-worthy trends already in motion. Popular momentum tools include MACD, moving averages, rate of change (ROC), ADX/DMI, and even the indicators called ‘momentum’.
• Oscillators – Tools intended to spot likely reversals of a trend, allowing a trader to sell at a peak price, or buy at a major low point. Examples include stochastic, RSI, PercentR, and parabolic (SAR) just to name a few.
• Volume-based indicators – Indicators that combine volume trends with price momentum trends in order to grade the quality of said price trend. The idea is that volume should increase as a trend is established if that trend is to have any longevity. Popular volume tools include accumulation-distribution lines, the Chaikin line, and On-Balance volume (or OBV).

Simple enough? It’s about to get complicated.

Pros and Cons of Stock Trading Indicators

Being able to plot – or even a keen understanding of – the various trading tools you have at your disposal is far from a guarantee of success, for one simple reason…. every indicator has an upside as well as a downside. In fact, each category of indicator offers at least one pro and one con.

That’s not a reason to abandon your chart-based trading technique though; you just have to fully understand the good and bad of each type of tool, so you can minimize the liabilities as much as possible.

In the same order as above, here are the main risks posed by each stock trading indicator:

• Momentum indicators are lagging indicators, meaning the trend in question is already underway by the time you see a trade signal. To combat that lag, you could shorten the timeframe of the indicator, but doing so makes that tool more prone to false or errant signals.
• Oscillators are leading indicators, in that they are designed to spot tops and bottoms on a chart by finding periods when a stock is overbought or oversold. The challenge is, charts can stay oversold and overbought for long periods of time, and defy oscillator signals indefinitely.
• Volume-based indicators more akin to momentum indicators than oscillators, and as such, tend to be lagging indicators. However, given that volume trends tend to shift slightly before price trends do, lag time is usually minimal (and dismissible) with volume tools. On the flipside, market volatility can wreak havoc with volume, so volume growth does not always accompany a budding trend (and vice versa).

Tips for Getting the Most Out of Your Trading Tools

Knowing the limitations of each tool is the bulk of the battle…. knowing what each tool does well, and does not do well, for your style of trading. For instance, if you’re a short-term swing trader with a typical holding period of 20 days, and you’re using a 20-day moving average line as a momentum indicator, you’re probably entering trades closer to the end of a useful trend rather than the beginning of it. Adjust your strategy accordingly.

Top traders tend to use elements of two – if not all three – types of technical indicators. For instance, a stochastic oscillator may find an overbought or oversold stock, while a MACD crossover may indicate the point in time when that overbought or oversold condition is being corrected by a new trade-worthy trend in the other direction.

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