What Role do Technical Indicators Play in Your Trading or Investing?
Are you a successful swing trader looking for the latest technical analysis indicator to help you solidify your stock market edge?
Or maybe you’re a longer-term investor who’s hoping to improve performance by adding some technical indicators to complement your fundamental analysis?
Either way, this detailed article will explain EVERYTHING you need to know about technical indicators… even if you’ve never uses them before.
Plus, I will share with you what I think the best technical indicators, and how I use them. That way, you can see exactly how I put this information into action. Sound good?
Then let’s get down to business.
One Key Reason Technical Indicators Deserve Your Attention:
I’m not sure how experienced you are using technical indicators in your trading and investing. So I want to summarize why I think these techniques are worth paying attention to. After all…
Dave Larrabee, CFA, quotes a study of portfolio manager showing those who prioritized technical analysis had higher returns. It’s actually a pretty compelling case for considering augmenting your analysis with technicals.
And even if technical indicators don’t immediately boost your returns. There’s still another important reason you should pay attention to this tool. Because when it comes down to it…
“Technical indicators are so valuable because they provide an objective way to measure changes in the stocks you own.”
I know that sounds simple. But the implications are profound.
A lot of the time, individual investors buy a stock based on a tip, gut instinct and some superficial fundamental analysis.
But the big problem with this approach is that it can be hard to tell when you’re wrong. And then how do you know when to buy more shares? Or sell your investment as the facts on the ground change?
Financial Mentor puts it this way: “Numerous studies show that people who are methodical enough to create a written investment plan can expect to outperform their peers, not by just a few percentage points, but by multiples.”
And this is where technical indicators can really help. They provide valuable guideposts to show you whether or not your stock pick is on the right track.
- By keeping an eye on the moving average, you can get a better direction of the trend.
- By watching relative strength, you can see how your stock is performing relative to your benchmark (or even the stock market as a whole).
- By looking for changes in volume patterns and how stocks act at support and resistance (link), you can get a much better idea of whether it’s time to cut your losses or double down.
And when you’re actively managing your own money, aren’t those the kind of things you’d like to know?
In any of the examples above, you can see that technical indicators provide an additional objective input to help you make a plan and then see if your investment analysis is likely to be right or wrong. Easy, right?
Not so fast!
When using technical indicators, don’t lose sight of the forest for the trees
Before we dive into the details of how you can start using these indicators to augment your technical analysis, there’s a couple things you should be aware of. Why?
Because I don’t want you to lose the forest for the trees.
By paying attention to these strategic insights, you can get a lot more mileage out of your favourite technical indicators.
After all, you need a strong foundation if you want to build a lasting house, right?
Now let me show you what I mean…
Two Big Words of Warning About Trading With Technical Indicators:
The name of the book is kind of tongue and cheek. Because the point is, there’s no such thing as holy grails! If you haven’t heard of him, I’d advise you check out his video about what it takes to be a successful trader. Primo stuff!
So that leads us to…
Word of Warning #1 – No technical indicator is perfect!
So many traders and investors (especially beginners) spend hours and hours looking for the perfect technical indicator.
But the honest truth is…
“No indicators will work 100% of the time.”
This is obvious right? Because if an indicator were to be infallible, everyone would use it and everyone would be rich. Of course that’s not the case.
And on the flip side…
If you trade enough, you’ll find that losing trades WILL happen to you. Sorry. It’s a fact of life.
It’s just the price you pay to sit at the table.
So listen to me: You CANNOT avoid losses all the time by trying to jerry rig the perfect combination of moving averages, MACD and stochastics.
I’m sorry… but… it’s not gonna happen!
And please, don’t fool yourself by pulling up old charts and “backtesting” which technical indicators work well. All this will do is keep setting you up for failure and frustration. Seriously.
Because although technical indicators do work well, they don’t work all the time.
That brings us to the second point…
Word of Warning #2 – Technical indicators work best over a series of trades!
This is an incredibly important point to keep in mind. The esteemed author and trading coach Mark Douglas first brought it up on my radar.
And he explains the concept very effectively in this YouTube video.
The point is, even if an indicator works 70% of the time… then by definition… it’s going to be wrong 3 times out of 10.
There’s no way around it. So…
Just by chance, there’s a big possibility your indicators won’t work out on any given trade. Make sense?
Adam Williams from BetFair puts it this way,
“You don’t need to win all the time to be a good trader. What you should worry about is whether you’ll be right enough of the time to generate a profit, which is a completely different way of thinking. You don’t even necessarily need to win more often than you lose!”
It’s all about thinking in probabilities.
If you find yourself scratching your head about this concept, you may want to pick up the book Trading in the Zone.
And here’s something else you can do…
I encourage you to try testing your trading indicators over a series of trades.
Commit to trying out a strategy based on a set of indicators over a batch of 10-20 trades at a time. Why?
Well, if you refer to Price Action Lab you’ll see they say that trading based on small sample sizes isn’t just naive, it’s downright dangerous! Remember, when indicators can be wrong 30-40% of the time, you need a big sample size todistinguish signal from noise.
When you do that, you can start to smooth out the effects of chance.
By looking at groupings of trades you get a bigger and more robust sample size from which to decide what indicators work best for you. And look…
I know you’re probably dying to learn what indicators and oscillators I personally use for my technical analysis.
But don’t worry, we’ll get there.
There’s just one more thing you need to know before we dive into the details of using technical indicators for your trading.
One of The Biggest Mistake With Technical Indicators:
Do you know what the biggest mistake technical traders make while trying to use indicators? I hinted at it earlier. Did you catch it?
Let me give you another clue. Have you ever seen a chart like this:
“One of the biggest mistake new traders make is using too many indicators at once.”
I mean honestly, how can you even make sense of a chart like that?
And more importantly…
How can you make consistent trading decisions based on it?
Personally, I don’t think you can. And sure, maybe this is a bit extreme, but I want to illustrate the point: Simple is better!!
And I’m not the only one who thinks this way.
His articles do a great job explaining why you should declutter your charts and only focus on the most important indicators for your analysis.
After all, what’s the point of a chart if you can’t even see the underlying price action? Wouldn’t you rather get a clear look at the naked goods?
For me, this over-reliance on technical indicators is a big red flag.
Michael Batnick, director of research at Ritholtz Wealth Management also echoed this sentiment perfectly in a recent blog post. I especially liked his focus on the investor psychology behind using trading signals:
“We’re addicted to signals because they provide us with a scapegoat. They give us something to blame other than chance when we experience an adverse outcome. Heaven forbid we look in the mirror and accept that we made a bad decision or just experienced bad luck.”
And he’s right! Plus when you have too many signals providing conflicting inputs, you will never get a clear trading signal. Not only is this unproductive, but it’s also confusing and costly.
Without a clearly defined trading signal, you can start making discretionary trading errors based on your gut feel.
And that inconsistent approach (with no reliable trading or investing system) can be very detrimental to your net worth.
Any by the way… I don’t want you to forget…
All technical indicators are derived using price and volume (also known as price action).
Why do I mention that?
Because it has a few very important implications, such as:
- A lot of indicators have similar output (sometimes they say the same things in different ways)…
- They’re all based on the underlying trading activity (especially how urgently people are buying and selling)…
- Most well-known technical indicators don’t provide much unique insight.
So while technical trading indicators can help you get pointed in the right direction, they aren’t the be-all and end-all of stock picking.
That’s why my advice to you is to keep it simple. Trade semi-naked with a couple key indicators and you’ll find your investing decision making process becomes much clearer. Make sense?
Glad to hear it.
Let’s get to the part of this article that you’ve been waiting for:
What Are The Best Technical Indicators to Help You Improve Your Trading?
In my experience, indicators and oscillators work slightly differently depending on the type of trader you are.
On the other hand, mean reversion traders can improve their technical analysis with indicators and oscillators that help them buy the dip.
Both applications of trading indicators are important. But let’s look at this second approach first…
The Best Free Technical Indicators for Mean Reversion Trading:
Do you like to buy the dip?
Do you prefer to sell a stock when it hits resistance?
If so, you will be happy to learn that there are a variety of technical tools and indicators that can help you make better and more accurate trading decisions.
Using indicators like this can help you try to pick a bottom, catch a reversal, and even lock-in profit.
Plus, these indicators work with stocks, futures and other asset classes like currencies and commodities. What’s not to love about that?
So here are some of my favourite mean reversion trading strategies using technical indicators:
Volume by Price is one of the best technical indicators for mean reversion traders. That’s because this chart overlay helps you understand the role of volume in support and resistance.
And when you learn where the big pockets of volume are located, it provides A LOT more context around support and resistance levels.
For example, if you are buying at a support level, wouldn’t you like to know how many other people are doing the same?
And as a counter-point…
Wouldn’t you want to know the amount of selling you could encounter if you’re holding a stock as it charges toward resistance? TradingSetupReviews also makes the point that support and resistance work better at high-volume levels. So let me show you a quick example of what this looks like in practice. After all, a picture is worth a thousand words, right?
So can you see how this unique indicator can help you figure out the relative strengths of tops and bottoms? Personally, I don’t do a ton of mean reversion trading. But when I do, I almost always use this price by volume overlay to inform my approach.
Force Index: I first learned about this technical indicator while reading “Trading for a Living” by Dr. Alexander Elder. And actually, this is a proprietary indicator first created by Dr. Elder himself to try and judge the strength of a move in a stock. I have had some good fortune in the past when using this indicator to help me buy the dip.
Stochastics and Williams %R are similar indicators that can be good for determining when a stock is overbought or oversold. These measures can help tell you when the pendulum has swung too far to one side and is poised to revert back to the mean. Combined with volume-by-price analysis you can really start to improve your odds of mean reversion success. Make sense?
Of course, this is just the tip of the iceberg.
But I hope it gives you an idea of how mean reversion traders can profit from technical indicators.
The key idea is that you buy the bounce after a steep sell-off and sell into resistance after a steep run-up in price.
The right technical indicators can just help you screen for the best opportunities.
Just be sure to manage risk carefully and be aware of when to sell.
I know it might seem complex.
But don’t worry, with a little practice these indicators can become powerful tools that will help you peel back the layers of the stock market onion, and allow you to make better informed trading and investing decisions.
But you might also be wondering, what are the best technical indicators for trend following investors?
Well, It’s a good question. And I’m excited to share my answer with you. That said…
If you’ve spent any time browsing the charts in my trend following trade ideas, you probably have a pretty good indication of what indicators I use on my price charts.
In case you are new here, I’ve provided an example below.
They usually look like this…
Pretty simple, right? Well, let me show you a little more about the thinking behind this semi-naked trend following approach.
I think you’ll like what you see….
The Best Free Trend Following Trading Technical Indicators:
So let’s cut to the chase, shall we? This is where I’ll show you exactly what technical indicators I personally use in my trend following trading.
Moving averages: these are probably the most popular indicators of all. It’s almost impossible to pull up a stock chart without seeing a couple of these lines. And the reason for this popularity is because moving averages are easy to use and very helpful.
Personally I don’t recommend getting too cute with moving average crossovers or obsessing over the perfect look-back window.
Instead, focus on how moving averages smooth out the noise of the market and help you see the direction of the dominant major trend.
Since I trade primarily from weekly charts I like to use. 25, 50 and 200 week moving average to see the shorter, intermediate and longer-term trends.
Do you see how the slope of the lines shows the trend more clearly? Now I’m just scratching the surface here. So if you want to, I encourage you to learn more about trend following with moving averages.
Average True Range (ATR): this is an indicator based on the average volatility of a security. I like to look at ATR to get an idea of how far a new stock could potentially move against me. Then, I can place a stop loss that extend beyond what’s likely based on regular volatility.
If you want more information on this powerful strategy, Carolyn Boroden from SimpleTrading.com has a great article on ATR trailing stops.
And while those are my favourite indicators, we don’t have to stop there…
So below are some of the most trusted resources on the web. For further reading, you may want to check out what they say when it come to trend following trading indicators.
Because as you saw, I keep it pretty simple but if you want to add MACD, RSI or another indicator of your choice the resources below should be of value.
In no particular order…
- The Four Most Commonly Used Indicators in Trend Following. Investopedia is always a reliable resources when it comes to trading news. So if you just have a passing interest in trend following, you probably don’t need to look any further than this. It’s a great introduction.
- Indicator Bullshit takes an entirely different take on trend following indicators. It proclaims that predictive indicators are almost entirely worthless, and you should instead turn more of your focus to price. Turtle Trader is a great resource that deserves an in-depth read by any serious trend follower.
- Four Highly Effective Trading Indicators Every Trader Should Know is another great article from DailyFX. This article does a great job covering some of the trend following indicators mentioned earlier, plus a few others Don’t miss these indicators!
At the end of the day, there are a ton of different ways you can use technical indicators.
And what you end up using (as well as how you use it) will depend on your own personal trading style and risk tolerance. You might even prefer to rely on fundamental indicators to improve your trading.
So given that indicators can be used in so many different ways, let’s wrap this up with one final word of warning…
One Final Word of Warning for Traders Using Technical Indicators:
Technical indicators are designed to help you separate the signal from the noise. But if you aren’t careful, these oscillators and indicators can make your life more complicated than when you started.
So how do you avoid this unfortunate indicator uncertainty?
In my personal experience, the key is to pick your indicators ahead of time… and then… STICK TO YOUR PLAN!
I know that sounds simplistic, but traders get into trouble when they use indicators without really planning for it. They buy because they heard someone mention a MACD divergence; but then, don’t have a plan to sell if the divergence fails.
In a recent article for Money Morning, Matt Hibbard explains why you simply must create a trading plan ahead of time, and stick to it. Plus…
And finally… as I mentioned before… please remember:
No matter what indicators you use, no trend following or mean reversion trading system will be perfect. You’re going to have some losers and that’s inevitable. So how can you still succeed?
Well, a lot of it also comes down to proper risk management and trading psychology. You’ll need to be patient, disciplined and persistent to be a successful technical trader.
So if at first you don’t succeed, keep managing your risk and try again.
Of course, if you need a little more active help in improving your trading and investing, I encourage you to learn more about my intelligent trend following mini course. It’s available free, and might be able to help you put these educational concepts into action.
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My approach here at Intelligent Trend Follower is helping personal traders and investors conquer the stock market with actionable stock picks and educational content. I share solutions to the most common problems holding back individual stock traders and investors. If you are struggling with this I urge you to fill out the form below or contact me firstname.lastname@example.org to learn more.