Indicators and Broad Types of Indicators

In technical analysis, charts created from historical price data help traders understand previous trends. But what exactly are indicators, and how do they enhance trading decisions? 

Technical indicators are mathematical tools that analyse price and volume data to project potential market movements. These calculations are plotted alongside or below price charts to provide additional insight into trend strength, momentum, and reversals. 

Indicators are instrumental in identifying entry and exit points in the market. With time, traders and analysts have developed a wide range of indicators, many of which are now built into advanced trading platforms You can use these tools individually or in combinations for more precise decision-making. 

Broad Types of Indicators in Technical Analysis 

Technical indicators are generally categorised into overlays and underlays (oscillators). 

Overlay Indicators 

These are plotted directly over price data and move in conjunction with prices. They help identify zones of support and resistance, as well as demand and supply levels. 

Underlay Indicators (Oscillators) 

These are plotted separately, often below the price chart. Oscillators fluctuate between a fixed range (typically 0 to 100), signalling whether a stock is overbought or oversold. 

Oscillators are also effective in identifying divergence, which occurs when price action and the oscillator move in opposite directions (a common precursor to trend reversals.) Most traders use a blend of overlay and underlay indicators along with price patterns for more accurate entries and exits. 

In this chapter, we’ll focus on some widely used overlay indicators, while momentum indicators will be discussed in detail in the next chapter. 

Overlay Indicators 

Moving Averages (SMA & EMA) 

Moving averages are among the most commonly used overlay indicators. There are two types: 

• Simple Moving Average (SMA): An average of past prices over a defined period. 

• Exponential Moving Average (EMA): Averages that give more weight to recent price data, making them more responsive to new information. 

Moving averages help identify trends and support/resistance levels, though they are considered lagging indicators as they rely on past price data. Traders often use combinations of moving averages to generate signals: 

• Short-term MAs (e.g., 9-day EMA): Generate faster signals 

• Long-term MAs (e.g., 50-day or 200-day SMA): Identify trend strength or support zones 

Crossovers: Where a short-term MA crosses a long-term MA, are commonly used as trade triggers. 

Bollinger Bands 

Bollinger Bands consist of three lines: 

• A 20-period simple moving average (middle line) 

• An upper band: 2 standard deviations above the average 

• A lower band: 2 standard deviations below the average 

These bands expand and contract based on market volatility: 

• Widening bands indicate increasing volatility 

• Contracting bands signal a consolidation or low volatility period 

Prices often oscillate within the bands, and sharp moves often follow a squeeze (when bands contract). Traders use Bollinger Bands to anticipate breakouts and to identify overbought or oversold conditions. 

Super Trend Indicator 

The Super Trend indicator is a dynamic overlay that adjusts based on volatility. It uses: 

• The average of the high and low price 

• A volatility component known as the Average True Range (ATR) 

• A multiplier (default setting: 10-period ATR and multiplier of 3) 

Super Trend visually changes colour to show trend direction: 

• Green: Bullish (Buy signal) 

• Red: Bearish (Sell signal) 

This makes it intuitive to follow for both new and experienced traders, as it combines trend direction and trade signals in a single indicator. 

Ichimoku Cloud 

The Ichimoku Cloud is not just an indicator, it's a complete trading system. It provides information about trend direction, momentum, and support/resistance levels. 

Ichimoku is made up of five key components: 

1. Conversion Line (Tenkan-sen): Average of 9-period high and low – fast-moving average (blue line) 

2. Base Line (Kijun-sen): Average of 26-period high and low – slower-moving average (red line) 

3. Leading Span A (Senkou Span A): Average of Conversion and Base Line – one edge of the cloud 

4. Leading Span B (Senkou Span B): Average of 52-period high and low – other edge of the cloud 

5. Lagging Span (Chikou Line): Current price shifted back by 26 periods – shows how today’s price compares to historical prices 

Trade Signals Using Ichimoku: 

• Buy Setup: 

• Conversion Line crosses above the Base Line 

• Price is above the cloud 

• Span A is above Span B 

• Current price is higher than the price 26 periods ago 

• Sell Setup: 

• Conversion Line crosses below the Base Line 

• Price is below the cloud 

• Span A is below Span B 

• Current price is lower than the price 26 periods ago 

Ichimoku provides a holistic view of the market and is especially useful in trending markets. 

Points to Remember 

• All indicators are derived from price or volume data, making them inherently lagging 

• Use overlay indicators in conjunction with oscillators for better accuracy 

• Combining price action with indicators increases the probability of successful trades