Technical indicators are attractive and appealing, especially to beginners in the markets.
They return a clear signal whether you should buy or sell and can be easily interpreted across different markets.
That said, should you really rely on technical indicators and neglect other types of analysis? And what are the best technical indicators to use when day trading the markets?
Let’s find out…
Why Are Technical Indicators Important?
Technical indicators are based on algorithms that use past price-data in their calculation. As a result, all technical indicators are lagging in their nature, but that doesn’t mean that they can’t return helpful information when day trading the markets.
That being said, a complete trading strategy shouldn’t rely solely on technical indicators. They return the best results as a confirmation tool. Don’t buy simply because the RSI is below 30 or sell because the Stochastics oscillator rises above 80. Instead, create a well-defined trading strategy (based on price-action or fundamentals, for example) and use technical indicators only to confirm a potential setup and fine-tune your entry levels.
Types of Technical Indicators
Depending on the information that technical indicators provide, they can be grouped into three main categories:
- Trend-following indicators
- Momentum indicators
- Volatility indicators
- Trend-following indicators are used to determine trends and to measure the strength of a trending market. While most traders are able to identify a trend simply by looking at the price chart, it’s often difficult to measure its strength or to spot a trend early in its formation. Popular trend-following indicators include moving averages, MACD, and the ADX indicator, to name a few.
- Momentum indicators usually measure the strength of recent price-moves relative to previous periods. They fluctuate between 0 and 100, providing signals of overbought and oversold market conditions. In essence, momentum indicators return a selling signal when prices start to move strongly higher, and a buying signal when prices start to move strongly lower. While this can be profitable in ranging markets, momentum indicators usually return false signals during strong trends. Some examples of momentum indicators include the RSI, Stochastics, and CCI.
- Volatility indicators, as their name suggests, measure the volatility of the underlying instrument. Traders are usually chasing volatility across different markets to find profitable trading opportunities, which makes volatility indicators a powerful tool for day trading. Examples of volatility indicators include Bollinger Bands and the ATR indicator, among others.
#1 Moving Averages
Moving averages are a popular day trading indicator. They’re used both as a trend-following indicator and a counter-trend trading indicator.
Moving averages represent the average of the last n-period closing prices. With each new closing price, a moving average drops the last closing price in its series and adds the newest one. Moving averages are usually plotted on the price chart itself.
Moving averages can be grouped into simple moving averages (SMAs) and exponential moving averages (EMAs). SMAs are the simplest form of moving averages, as they take the arithmetic average of the last n-period closing prices. This means that each closing price has an equal weight in the calculation of an SMA.
EMAs, on the other hand, use the exponential average of the last n-period closing prices, which makes them quicker react to new closing prices than their SMA peers. If you don’t know which type of moving averages to use, I would recommend you to start with EMAs and see how they align with your trading strategy. Moving averages are also often used as dynamic support and resistance lines. Traders often use longer-term MAs, such as the 200-day or 100-day MA, to find areas where the price could retrace and continue in the direction of the underlying trend.
Here’s an example of dynamic support and resistance zone created by moving averages. The following chart shows the daily EUR/USD chart with the 200-day EMA, 100-day EMA, and 50-day EMA applied to it.
The MACD indicator (pronounced mac-dee, short for Moving Average Convergence Divergence) is a powerful technical indicator that combines the best of trend-following indicators and oscillators. The MACD consists of two lines and the MACD histogram. The first MACD line usually represents the difference between two moving averages (one faster and one slower MA), while the second MACD line is a moving average of the first MACD line.
The MACD Histogram represents the difference between the two MACD lines in a graphically appealing way. In essence, when the two lines cross, the MACD histogram returns a value of zero. As the two lines diverge one from another, the MACD histogram starts to rise.
The MACD indicator is often used to confirm the trend in a price-chart. If the latest histogram bar is higher than the previous bar, this shows that an uptrend is starting to form. Similarly, if the latest bar is lower than the previous bar, this signals the start of an upcoming downtrend.
Here’s the MACD indicator applied below the 4-hour EUR/USD chart. The MACD histogram provides an effective way to determine periods of rising or falling prices.
Originally developed by J. Welles Wilder in 1978, the RSI (Relative Strength Index) is still one of the most popular day trading indicators today. The RSI measures the magnitude of recent price-changes and returns a reading of between 0 and 100. The indicator is mostly used to determine overbought and oversold market conditions – A reading above 70 usually signals that the underlying market is overbought, while a reading below 30 signals that the market is oversold.
A common trading strategy based on the RSI is to buy when the RSI falls below 30, bottoms, and then returns to a value above 30. Conversely, a trader could sell when the RSI rises above 70, tops, and then returns to a value below 70.
However, bear in mind that this strategy returns the best results in markets that are not trending, i.e. that are trading in a range. If the market is trending, the value of the RSI can stay overbought or oversold for a long period of time before we see a market correction. That’s why you should use additional filters and combine different types of technical indicators (both trend-following and momentum) in your trading strategy.
The following chart shows the RSI indicator in a sideways-moving EUR/USD daily chart. Notice the overbought and oversold levels and the price reaction.
#4 Bollinger Bands
Another popular day trading indicator, Bollinger Bands are based on a simple moving average and can be used to identify the current market volatility. Bollinger Bands include three lines: The middle line is a simple moving average, and the upper and lower lines are lines that are plotted two standard deviations away from the simple moving average, creating a band.
Since standard deviation is a measure of volatility, the bands widen when the market volatility increases and contract when the volatility decreases. This phenomenon can be used to create interesting trading strategies, such as the Bollinger Squeeze. The Squeeze forms as a result of very low volatility that leads to very tight Bollinger Bands.
Traders who expect a surge in volatility after a period of very slow trading can enter a long position when the latest bar closes above the upper band and a short position when the latest bar closes below the lower band. Bear in mind that around 95% of all price-action occurs inside the two standard deviations above/below the simple moving average.
Here’s an example of the Bollinger Bands indicator on the GBP/JPY chart. Notice the Bollinger Squeeze on the right-hand side of the chart.
The CCI, or Commodity Channel Index, was developed in 1980 by Donald Lambert. The indicator compares the current price relative to the average price over a specific period of time and fluctuates above or below a zero-line.
Around 75% of all CCI values fall in the range between -100 and +100, with values above that range signaling extremely strong price-changes relative to the average price. Despite its name, the CCI indicator can be successfully used across different types of markets, including the stock market and Forex market.
Day traders usually apply the CCI indicator to short-term charts to get more trading signals. In addition, when applied to shorter timeframes, the CCI returns more trading signals than when applied to longer-term charts. When the CCI rises above +100, this signals a buying opportunity, and when the CCI falls below -100, this signals a selling opportunity.
Although the Fibonacci tool is not a regular technical indicator, it’s still one of the most effective tools that traders can use to day trade the market. The Fibonacci tool is based on the Fibonacci sequence of numbers, which goes like this: 1, 1, 2, 3, 5, 8, 13, 21, 34, 55… In the sequence, each number is the sum of the previous two numbers. If we divide two consecutive numbers, the result is always the same: 0.618, also called the Golden ratio. This ratio is used in the Fibonacci tool to determine possible retracement levels in trending markets. Other major Fibonacci levels include the 38.2% and 50% levels.
When trading Fibonacci retracement levels, don’t focus too much on precise levels. Instead, think about Fibonacci levels as “zones” where the price has a higher probability to retrace and continue in the direction of the underlying trend. For example, the zone between 38.2% and 61.8% can be considered as an important support zone during uptrends and resistance zone during downtrends.
The following picture shows the Fibonacci retracement tool confirming a trade setup based on a horizontal support zone. The price retraced at the 38.2% Fibonacci level.
The Stochastics indicator is an oscillator that compares the actual price of a security to a range of prices over a certain period of time. The interpretation of the Stochastics indicator is quite similar to the RSI indicator: Traders look for overbought and oversold levels in Stochastics to determine whether to buy or sell a security. However, unlike the RSI indicator where overbought and oversold levels appear at an indicator reading of 70 and 30 (in default settings), respectively, when using the Stochastics indicator traders look at the 80 and 20 levels.
Stochastics has similar disadvantages to RSI. While the indicator works great in ranging markets, it starts to return fake signals when markets start to trend. That’s why you’re better off combining different types of indicators, such as oscillators and trend-following indicators for example.
If a trend-following indicator shows that the market is trending, don’t pay attention to signals generated by oscillators, and vice-versa. The following indicator that we’ll cover, ADX, is a trend-following indicator that can be used in that regard.
The Average Directional Movement Index, or ADX, is a trend-following indicator that can be used to determine both the direction and strength of the underlying trend. The ADX indicator consists of three lines: The ADX line, the +DI line, and the –DI line. The +DI and –DI lines determine the direction of the trend. When the +DI line crosses above the –DI line, the market is entering into an uptrend, and when the –DI line crosses above the +DI line, the market is entering into a downtrend.
The ADX line is used to determine the strength of the trend: A reading above 25 usually signals a weak trend, readings between 25 and 50 signal a strong trend, and readings above 50 a very strong trend.
The ADX indicator is best used when day trading the market with a trend-following approach. If the reading reaches 25 or above, you could wait for pullbacks (for example to an important Fibonacci level) to enter into the direction of the underlying trend.
The indicator can also be combined with oscillators to reduce the number of fake signals. For example, if the ADX shows that the market is trending, don’t pay attention to overbought and oversold readings in the RSI or Stochastics indicators.
The Average True Range indicator (ATR) is a technical indicator that measures market volatility by taking the greatest of the following: the current high minus the current low, the absolute value of the current high minus the previous close, and the absolute value of the current low minus the previous close. The ATR indicator takes then the average of those values for a pre-specified period of time and plots them in the form of a moving average on the chart.
As a measure of volatility, the ATR is often used by day traders for calculating their stop-loss levels.
Should You Trade on Technical Indicators?
As noted in the introduction, technical indicators use past price-data in their calculation and are therefore lagging the current price. However, since historical data is the only piece of information that traders have to anticipate future price movements, technical indicators do have an important role in a well-defined trading strategy.
Avoid adding too many indicators to your chart as indicators of the same type usually return similar trading signals. Instead, choose only one indicator out of each group (trend-following, momentum, and volatility) and combine their signals to confirm a setup and trade based on it. An effective combination of indicators could be the moving averages, the RSI indicator, and the ATR indicator, for example.
Don’t base your trading decisions primarily on indicators and their signals. Trend-following indicators will return a buy signal when prices start to move higher, even if the market is trading sideways. Similarly, oscillators and momentum indicators will give you a selling signal when prices start to rise during an uptrend. There is no single best indicator, which is why you should combine different types of indicators and incorporate them into a broader trading strategy.