What Is The Best Technical Indicator And How To Use It?

Technical Indicators are simple mathematical formulas derived from price and volume. But a novice trader never looks at them like that. For a beginner, they hold the promise of great riches. A few simple tweaks and the indicators are bound to give them the financial freedom they desired. But we all know how it pans out in the end...

It's not how an indicator is calculated that holds the value, but how a trader uses and interprets it that will decide the ultimate success... But the topic of technical indicators always makes for an interesting read, read my view on them...

Disclaimer: I have spent the better part of my trading career running after these indicators, tweaking parameters, jumping from one indicator to another, basically, searching for the holy grail of trading, luckily I discovered nothing...

What are the technical indicators?

As stated earlier, they are mathematical formulas applied to the two basic elements of markets, viz, price and volume. The objective is to extract some hidden property of price and volume movements which can give us deeper insights into their behaviour. Once these behaviours and patterns are extracted, it is just a matter of monitoring these indicators and take the profitable trades...

The reality is slightly different. The mathematical formula part of the equation is correct but you cannot make money by designing the best indicator, but by using the indicator in the best possible way...

But if you think doing what Indian Jones is doing in the following image is going to help you, then be ready for the aftermath...

Holy Grail GIF from Indianajones GIFs

Rock Indiana Jones GIF from Rock GIFs

There are no holy grails in the markets, period, even if you are the Indiana Jones himself... - Dean

What are the different types of indicators a trader can use?

Here is a list of technical indicators that I have used in the past. There are hundreds of them, but basically, tell one and the same thing depending on which category they fall into... They can either be plotted as overlays on the price or volume chart or they can be plotted below the price chart and then we call them oscillators... Let's dive into these different types of indicators...

Superimposed Indicators (plotted on the price chart)

1. Moving Averages
2. Moving Average Bands
3. Trend Lines and Channels

Oscillators (plotted below the price chart)

1. Advance-Decline Line
2. Average Directional Index
3. Average True Range
4. MACD
5. MACD Histogram
6. On Balance Volume
7. Stochastics
8. Relative Strength Indicator

The list can go on and on, but we will discuss only the above indicators. Also, most of the indicators are minor variations to one of the above, they emanate the same information at the end of the day...

Let's start to go through them one by one...

Superimposed Indicators

These are plotted along with the price on the same chart as price. These indicators are tied to price and move along with it. The main objective is to monitor the behaviour of price and take action when the price either moves way out of line or is about to make a big move. Let's discuss each one of them...

1. Moving Averages

These are calculated in a number of different ways, mathematically it is just an average of the price over a few days or time periods. The difference lies in the way these averages are calculated. Some traders prefer a simple average while others may use a slightly complicated method, by weighting the recent price higher than the older one.

The key is to calculate a running record of these averages. That is for a 10-day moving average we calculate the average of the closing prices of say last 10 days. On the 11th day, we include the latest reading and exclude the reading on the first day. That is the reason why it is called a moving average.

So based on this averaging method we have the following moving average methods, that are commonly used...

• Simple Moving Average (SMA) - This type calculates simple arithmetic average of last 10 days or time periods.
• Exponential Moving Average (EMA) - This is the more popular one, here the formula weighs the latest price more than the old one. So the price on day 10 will have the highest weight and price on day 1 will have the least. The logic is recent price reflects the market in the best possible way.

2. Moving Average Bands

Now the actual price moves around the average. Actually, the price moves first and the average is always trying to catch up to the price. So by drawing bands above and below the moving average, we can get an idea about the historical tendency of the price to move away from the average for that particular instrument.

The most common method is to use the standard deviation of the price and plot it around the moving average. The most common setting is 2 Std Dev on either side of the moving average. This indicator is also called as Bollinger Bands after the trader who invented them.

When I was using them in my early days my favourite setting was to use a 20 EMA and plot 2 Std Dev bands around it.

3. Trend Lines and Channels

Trend lines and channels provide an option to contain and organise the seemingly non-random moves on the charts. A trendline or a channel in itself does not do anything, other than giving you some visual references to mark the price development against.

But sometimes their usefulness is uncanny when price turns on the dime on a trendline or follows a channel perfectly. But as with all other technical analysis tools, these are not set in stone. If you use them as guiding posts along with an improved market understanding, they will definitely help.

Oscillators

These are plotted below the price chart. These are slightly more complex calculations done on price in most of the cased, but some indicators also use volume as input. These indicators are supposed to tell us the internal strength or weakness in a price move. 

The most common property tracked is the momentum of a price move. Most of the oscillators are designed to show us the waxing and waning momentum of the price movements. A deteriorating momentum with price moving higher indicates that the price move is not a healthy one and is liable to turn down soon...

I used some or all of these indicators and one point or another in my trading career, let's have a look at them...

1. Advance-Decline Line (AD)

This indicator is based on just the number of stocks advancing or declining in the markets. Especially useful when trading an index and to gauge the overall health of a trend of the markets in general. Say you are looking at Nifty 50 and AD line will tell you how many stocks are moving up vs down on any particular day...

If the market is moving up over a certain period of time at the same time the AD line is moving against it, we can conclude that the health of the market is deteriorating and it is liable for a correction soon.

2. Average Directional Index (ADX)

This indicator is designed to tell you when the strength of a directional move is strong. A reading of above 35-40 indicates the strong trending tendency of the price, whereas a reading below that number indicates weak trending tendency, i.e. likelihood of sideways movement.

Many traders use it in conjunction with another indicator, more as a filter to delineate between trending and sideways markets. Most common parameter setting for this indicator is 14 days.

3. Average True Range (ATR)

ATR is an indicator which shows what is the average daily range over the past few days, depending on the parameter. For instance ATR(14) will show us the average daily range over the past 14 days.

The wider the range higher the volatility and higher the ATR. Very high ATR readings are synonymous with climactic actions and are an indication that the move may not be sustainable anymore.

4. MACD

The full name of this indicator is Moving Average Convergence Divergence. This indicator is calculated using the moving averages we just saw earlier. It is calculated using a combination of 2 moving averages one of shorter duration and one of longer duration. The logic being a shorter period average follows prices more closely but also gives a lot of whipsaws, whereas r period moving average gives fewer whipsaws but is less responsive.

We calculate by taking the difference between the two moving averages. The most common setting for this indicator is (26,12)

5. MACD Histogram

This is a further refinement of the MACD indicator. The histogram makes it easier to track the indicator. The MACD helps in identifying strengthening and weakening trends in price, whereas the histogram helps in finding the strength and weakness of the trend in MACD indicator.

When I put it like that it seems to be an overkill, but sometimes this indicator can be really useful...

6. On Balance Volume (OBV)

The EOD volume number does not tell us whether the buyers were aggressive or sellers were aggressive. Because for every buyer there is a seller and vice versa. The reason why the markets move directionally is the aggression with which these buyers and sellers act in the markets differ.

OBV uses the net direction of the price movement up or down to assign a positive or negative sign to the volume for that day. So, on an up day the volume will be positive and on a down day, the volume will be negative. This is a bit of an oversimplification of things, but still, it fits the bill.

We then take the cumulative total of these positive and negative volume numbers over a certain number of days to get the OBV indicator.

7. Stochastics (STS)

This indicator tells us whether the prices are in overbought or oversold territory. This indicator oscillates between 0 - 100. A reading near 100 tells us that the prices are in overbought territory and reading near 0 indicates the prices are in oversold territory. 

When in overbought territory it is not advisable to buy as the trend has moved too far too quickly, whereas in oversold territory the sellers are at a disadvantage.

8. Relative Strength Index (RSI)

This is another type of oscillator which shows the overbought and oversold regions. This indicator too moves in a range of 0 - 100. A reading above 70 indicates prices are in overbought territory and a reading below 30 tells us it is in oversold territory.

This indicator is special in the sense that you can spot regular price patterns on this indicator too. Like you can draw trendlines on this indicator and are often times broken before the price trend lines are broken.

What are best the most reliable trading indicators?

These are some of the best and most reliable trading indicators for day trading, swing trading stocks, futures and options, the only caveat is you must know what you are doing with the indicators.

A novice often gets trapped in the rabbit holes of tweaking parameters, testing and back-testing indicators, using combinations of these indicators, etc. They can very easily miss the point that all these indicators are derived from price only and will always lag the price.

But an experienced trader will be able to find the subtle nuances of these indicators and then use them with the price action to arrive at prudent trading decisions. So the key lies in understanding why the market does what it does, the indicators are mere reflections of what the markets are doing.

Conclusion

A good trading system can be developed using these indicators, I know many traders who are doing a great job and making a lot of successful trading decisions using these trading indicators. You can do it too, but you need to focus on overall market understanding before jumping head over heels into this.

Focusing only on the indicators and continuously tweaking the parameters will not be a very fruitful strategy. I hope you found this post useful and inspiring. So go ahead and use these indicators in your trading. If you run across any difficulty don't hesitate to write me up on this.

It would be really nice if you can share this post with your friends and colleagues. I am sure they will find it useful to, because...

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