Technical indicators represent a component of technical analysis. They are tools which are used either as standalone instruments or in combination either with each other or with other chart information to predict future movements in price in financial markets.
Classification of Technical Indicators
Technical indicators are many and varied in type, function and reliability. There are several ways by which indicators can be classified.
One method is to classify technical indicators according to the speed with which they react to events in the market. This puts indicators into three groups: leading, coincident, and lagging indicators.
Leading indicators are used to predict future market or price events. A leading indicator will usually show a signal that the price will either move up or down before the market actually does so. However, they also have a drawback; they tend to give false signals just like athletes have false starts. They must therefore be used with a system to filter out the true predictive signals from the false ones.
A lagging indicator follows the price action. Lagging indicators are mostly used for confirmation of price action. However, they also have a drawback: the signals they give may end up being too late to be used for any meaningful trade. They therefore must be combined with leading indicators to increase their speed of signal detection.
Coincident indicators are technical indicators which generate signals at the same time that the price action has started to move in the direction shown by the indicator.
This is one system of classification of technical indicators. However, there is another method which classifies technical indicators according to the function that they exert on the charts. With this classification, we have technical indicators that are:
- Trend indicators - Momentum indicators (oscillators) - Volume indicators - Bill Williams indicators - Custom indicators
The trend indicators work by smoothing out price action over a certain period of time. They are therefore good at detecting the future direction of the price action. The technical indicators that make up the trend indicators are Bollinger bands, envelopes, moving averages, Parabolic SAR, ADX, etc.
The momentum indicators (oscillators) measure the speed with which price moves over a period of time, and some of these indicators also fluctuate around a centre line. Examples are the Stochastics oscillator, Relative Strength Index, Relative Vigor Index, Commodity Channel Index, etc.
Volume indicators measure the activity of buyers and sellers in the market. They are used to detect the degree of selling or buying pressure on an asset. The Money Flow Index, On Balance Volume, Accumulation-Distribution indicator and the Volumes indicator make up this class of indicators.
A certain trader known as Bill Williams invented his group of indicators in an attempt to disprove the linearity of price action. Linearity refers to the forecasting of future price events using past price actions. Bill Williams indicators were created as a measure of the five dimensions which Williams himself advocated for price analysis. Indicators listed as Bill Williams indicators include the Alligator, Fractals and Market Facilitation Index.
Custom Indicators refer to a series of indicators created by traders and programmers to analyze the market using their own individual methods which do not fall into the categories discussed above.
Uses of Technical Indicators
The uses of technical indicators in the financial markets can be summed up as a three-fold function of alerting, predicting and confirming price action.
A classic example of a technical indicator functioning as an alert tool is when a momentum indicator or a volume indicator is used in trading the divergence. Usually in a divergence, the indicator line starts to shift in the opposite direction before the price has started to react. Therefore, a divergence of the technical indicator is an alert that price is about to shift.
Technical indicators can be used to predict the future direction of price action. For instance, if price action bounces on a trend line that is pointing upwards, then it can be safe to assume that the price will go up. If the price now turns downwards and breaks below this trend line, then it can be assumed that the price will go down. Therefore in this instance, the technical indicator (the trend line) can be used as a predictive tool.
Technical indicators also find great use in confirming some chart information or even other technical indicators. A cross of the Stochastics oscillator at an oversold area when prices in an uptrend have retraced to a Fibonacci retracement level is a confirmation that the uptrend is about to resume. There are several other instances where technical indicators can be used to confirm moves. These form the basis of trading strategies.