Chart indicators are mathematical calculations that are preformed on a stock’s price and/or volume data and the resulting values are plotted on the stock’s chart. The basis for this analysis is to provide an indication of the probable direction that the stock’s price may trade.
While there are numerous charting indicators, some which are quite complex, most are best suited to short-term trading or for investors timing their entry or exit. However some indicators also work well for locating long-term trends.
The primary purpose of chart indicators is to alert the stock investor or trader to the possibly of a reversal of the stock’s trending direction.
While some indicators are used to determine the strength of a trend, most indicators are used to determine when a trend is likely to reverse direction. They can be used to determine both the start of a trend and the end of a trend.
Some indicators are plotted as a line that overlaps the price data. These indicators are known as price overlay indicators. There are other indicators which are plotted as a line chart in their own separate chart pane in the same way as volume is usually plotted in its own separate chart pane. Most of these indicators are oscillating indicators where the plotted line alternates up and down around a zero neutral line. With an oscillating indicator, a trend change is signaled when the indicator value exceeds a certain value.
Indicators can be classified as either Leading indicators or Lagging indicators. Leading indicators are designed to provide an early indication that a trend is about to reverse before the actual trend reversal occurs. Lagging indicators are designed to follow the trend and are used to confirm a trends direction.
Chart indicators require historical data in order to perform their calculations and this allows the trader to analyze how an indicator performed in the past (this is known as back testing). By back testing an indicator the trader can get a good indication of an indicator’s predictability and reliability.
Generally all modern charting software applications include a vast array of indicators that can be easily selected and plotted on a stock chart and as such they do not require any calculations to be performed manually. However, the indicators can be calculated using a spreadsheet application if so desired.
Modern charting software allow the trader to
easily plot a wide variety of indicators
There is no one single indicator that is perfect and all indicators have advantages and disadvantages. One problem all charting indicators have in common is they provide a certain number of false reversal signals. This means that the indicator signaled that a trend was likely to reverse but the stock continued trading along its existing trend rather than having reversed. Sometimes a Leading indicator misses a trend reversal altogether. Also Lagging indicators can be quite late at confirming a new trend direction.
So why bother even considering using an indicator. While charting indicators do have some disadvantages, when used properly they do a fairly good job of locating trend reversals. Most of the disadvantages revolve around using only one single indicator. As no indicator is perfect, it is best to use several indicators concurrently. It is also generally better to use charting indicators in conjunction with other technical analysis techniques rather than in isolation.
Stock investors can make good use of chart indicators as a timing tool to help them with their buying and selling decisions. For a value investor looking to take a position in a falling stock, chart indicators can provide them with a signal that the downtrend may be reversing. A growth investor who is looking to sell an excessively overvalued stock can use chart indicators to remain with the uptrend until a signal is given that it may have ended.
A few of the simple and most useful indicators for stock investors and beginner stock traders will be covered in the following articles.