Technical Analysis: How to use Technical Indicators – part 1

There are dozens of technical indicators, how to choose good stock indicators? Technical indicators are used to know when to enter or exit a trade. If you know how to enter and exit a trade, you can easily make profits. That is why choosing good stock indicators are important.

Some of stock market indicators are more common and useful than others. Also you need a few of them to trade not all off them.

In this article I try to describe three oscillators:

Momentum and Rate of Change (ROC) Moving Average Convergence/Divergence (MACD) Relative Strength Index (RSI)

What are oscillators?

Oscillators are indicators that are usually computed from prices and tend to cycle or “oscillate” within a fixed or limited range.

Momentum and Rate of Change (ROC)

Momentum is an oscillator designed to measure the rate of price change, not the actual price level. This oscillator consists of the net difference between the current closing price and the oldest closing price from predetermined period.

The formula is:

Momentum (M) = CCP – OCP

Where: CCP is Current Closing Price and OCP is Old Closing Price

Momentum is simply the difference, and the ROC is a ratio expressed in percentage. Momentum and Rate of Change (ROC) are simple indicators showing the difference between today's price and the close N days ago. Momentum in general term means strongly movement of prices in a given direction.

Moving Average Convergence/Divergence (MACD)

MACD is computed by subtracting a longer moving average from a shorter moving average. MACD is used with a signal or trigger line, which is a moving average of MACD. If MACD and trigger line cross, then this indicate that a change in the trend is likely. MACD developed by Gerald Appel.

The MACD smoothes data, as does a moving average; but it also removes some of the trend, highlighting cycles and sometimes moving in coincidence with the market .

Relative Strength Index (RSI)

RSI measures the relative changes between up-moves or down-moves and scales its output to a fixed range, 0 to 100. RSI is an oscillator and Welles Wilder devised it.

The formula for calculating RSI is:

RSI = 100 – [100/ (1+RS)]

Where: RS is average of N days up closes, divided by average of N days down closes and N is predetermined number of days that usually chosen 14.

RSI can use as an overbought/oversold indicator. A buy signal is when the RSI moves below a threshold, into oversold territory, and then crosses back above that threshold, usually 30 is taken for oversold threshold. A sell is signaled when the RSI moves above another threshold, into overbought territory, and then crosses below that threshold, usually 70 is taken for overbought threshold.

Conclusion

Oscillators are used as an overbought/oversold indicator. A buy is signaled when the oscillator moves below some threshold, and then crosses back above that threshold. A sell is signaled when the oscillator moves above another threshold, and then crosses below that threshold.

Oscillators have the potential to provide good entry and exit points. So they have the potential to provide a high percentage of wining trade. Also they have some weaknesses; some of them can easily become stuck at one of their extremes, or don't capture some trends.