Technical Indicators Tutorial : Trend Indicators
Trend lines are the basic indicator of trend, but they are quite subjective, depending on the eye of the beholder. So analysts have refined technical indicators such as moving averages or the directional movement index to quantify the data and smooth out day-to-day fluctuations to present an overall view of price direction and the trendiness of the market.
Moving Averages – Perhaps the simplest to understand and most widely used technical indicator is a moving average, which smoothes past data to illustrate existing trends or situations where a trend may be ready to begin or is about to reverse. A moving average helps you spot market direction over time rather than being caught up in short-term erratic market fluctuations. There are three main types of moving averages:
- Simple. Each price point over the specified period of the moving average is given an equal weight. You just add the prices and divide by the number of prices to get an average. As each new price becomes available, the oldest price is dropped from the calculation.
- Weighted. More weight is given to the latest price, which is regarded as more important than older prices. If you used a three-day weighted moving average, for example, the latest price might be multiplied by 3, yesterday’s price by 2 and the oldest price three days ago by 1. The sum of these figures is divided by the sum of the weighting factors – 6 in this example. This makes the moving average more responsive to current price changes.
- Exponential. An exponential moving average (EMA) is another form of a weighted moving average that gives more importance to the most recent prices. Instead of dropping off the oldest prices in the calculation, however, all past prices are factored into the current average. The current EMA is calculated by subtracting yesterday’s EMA from today’s price and then adding this result to yesterday’s EMA to get today’s EMA. An EMA generally produces a smoother line than other forms of moving averages, which can be an important factor in choppy market conditions.
Closing prices for a period are usually used to calculate a moving average, but you can also use the open, high or low or some combination of all of them. Moving averages are often used in crossover trading systems. A buy signal occurs when the shortor intermediate-term averages cross from below to above the longer-term average. Conversely, a sell signal is issued when the short- and intermediate-term averages cross from above to below the longer-term average.
Another trading approach is to use the “current price” method. If the current price is above the moving average, you buy. Liquidate that position when the current price crosses below your selected moving average. For a short position, sell when the current price falls below the moving average. Liquidate that position when the current price rises above the average.
Because the moving average changes constantly as the latest market data arrive, many traders test different “specified” time frames before they come up with a series of moving averages that are optimal for a particular market.
Some use combinations such as 5-day, 10-day and 20-day moving averages, taking crossovers of the shorter moving average over the longer moving average as a trading signal. Still others use longer-term moving average lines as another point of support or resistance.
In short, moving averages have a number of applications and are easy to understand, making them a clear indicator choice for many traders.
Moving Average Convergence Divergence (MACD) – MACD is a more detailed method of using moving averages to find trading signals from price charts. MACD plots the difference between a longer-term exponential moving average and a shorter exponential moving average (the chart below uses 21 days and 9 days). Then a 9-day moving average of this difference is generally used as a trigger line.
The MACD indicator is used in three ways:
- Crossover signals. When the MACD line crosses below the trigger line, it is a bearish signal; when it crosses above it, it’s a bullish signal. Another crossover signal occurs when MACD crosses above or below the zero line.
- Overbought-oversold. If the shorter moving average pulls away from the longer moving average dramatically, it indicates the market may be coming over-extended and is due for a correction to bring the averages back together.
- Divergence. As with other studies, traders look at MACD to provide early signals or divergences between market prices and a technical indicator. If the MACD turns positive and makes higher lows while prices are still tanking, this could be a strong buy signal. Conversely, if the MACD makes lower highs while prices are making new highs, this could be a strong bearish divergence and a sell signal.
With its moving average base, MACD is a lagging indicator and requires rather strong price movement to generate a signal. Therefore, it works best in markets that make broad moves but does perform well in choppy, congested trading conditions.
Directional Movement Index – The Directional Movement Indicator (DMI), also called the Directional Movement System, is used to determine the strength of a market trend. The Average Directional Movement index, or ADX, is part of the DMI and gauges the trendiness of the market. When used with the up and down Directional Indicator (DI) values – Plus DI and Minus DI – you could have a trading system.
The basic rules for a DMI system include establishing a long position whenever the Plus DI crosses above the Minus DI. Reverse that position – liquidate the long position and establish a short position – when the Minus DI crosses below the Plus DI.
The ADX line (green on the chart below) is perhaps the focal point of the DMI for most traders. If the ADX line is trading above 30, then the market is in a strong trend, either up or down. ADX does not indicate the direction of the trend. If the ADX line is below 30, it means the trend is not a strong one. If the market is in a solid trend and scoring new highs and the ADX line shows divergence and turns down, that is a warning signal that the market trend is losing power and a market top or bottom may be close at hand.