Indikator

Technical analysis includes not only candlestick patterns and chart formations, but also the so-called indicators.

What are indicators?

Indicators are tools that analyse the price using certain formulae and support us in our decision-making through direct visual evaluations on our charts. The indicators usually analyse the characteristics of candlestick opening and closing prices, the size and development of candlesticks and the ratio between the buyer and the seller candlesticks to obtain information regarding current market proceedings and the prevailing strength ratio.

Indicator lagging – are indicators too slow?

Many traders have prejudices against indicators and claim that they are not helpful because they are only based on the price information that is already available and therefore do not contribute anything new to chart analysis. In this context, the keyword lagging is often used by traders to suggest that the information from indicators lags behind the price and gives signals too late since they are based on past data.

I cannot agree with this. The same criticism would then have to be made against candlesticks and chart patterns, since we can recognise a candlestick or a chart pattern only when the price has already moved and we look at past information. However, this does not make technical analysis or the use of indicators any less valuable. If a trader knows how to interpret the information on his/her charts correctly, lagging is often attributed to pure ignorance of inexperienced or poorly trained traders.

In the following section, we will see how indicators can be used correctly and effectively to improve the quality of our own trading significantly.

Indicator groups

There are numerous indicators that can be ultimately divided into three indicator groups:

Momentum indicators

Momentum indicators are often known as oscillators since they oscillate between the defined upper and lower limits. They help us in analysing the ratio of the buyers and sellers to understand which

group of market players have the majority and how strongly the candlesticks are pushing in one direction or whether the price is losing strength.

Trend indicators

Trend indicators analyse a prevailing trend. They are generally not effective when the price enters a sideways phase, but can be important tools in trend markets.

Volatility indicators

The group of indicators checks the degree of volatility and the extent to which the price fluctuates. This information is usually needed to place trades, set stops, define goals and determine the position size.

Indicator selection and redundancy

The most important factor for selecting the indicators is to use only one indicator per group to avoid repeat (redundant) signals. For example, if a trader uses two or more momentum indicators, they will always show him/her the same signals, which may have a significant impact on his/her decision-making. The trader will then give too much importance to individual signals because he/she thinks that suddenly all indicators give the same signal to buy or sell, although they are only redundant signals.

---

Moving averages

Moving averages (MA) are by far the most popular indicators used by numerous traders and are even used in the mainstream financial media.

What is the function of moving averages?

Moving averages (MA) indicate an average price. If an MA is set to 14 periods, it shows the average price over the last 14 periods (or 14 candlesticks). The average price is important because it shows whether the current price is above or below the average and whether it is cheap or expensive compared to the past.

Which MA is the best – EMA or SMA?

There are many types of MA and hence the question arises which is the best one. The EMA (Exponential Moving Average) and the SMA (Simple/Smoothed Moving Average) are compared below.

Differences between the EMA and the SMA

EMA and SMA differ only in the calculation of the average price. The EMA gives more weight to the last candlesticks and therefore moves faster than the SMA. The SMA weights all candlesticks equally over the observation period. The comparison in figure 65 clearly shows that the EMA adapts more quickly to the current price. But is this a good thing or a bad thing?

Advantages and disadvantages – EMA vs. SMA

The answer is neither. The advantages of one MA are the disadvantages of the other and vice versa.

Figure 65 shows that the EMA reacts faster when the price changes direction. However, this also means that the EMA is more susceptible to giving signals too early, and there are more noise signals. On the other hand, the SMA adapts more slowly to current price movements and can thus filter out noise in a better manner. However, traders using the SMA will also notice changes in direction later since the signals are displayed more slowly.

Ultimately, there is no right or wrong here, which is often the case in trading. It primarily depends on the preferences of a trader and how he/she integrates the MA into his/her trading.

Figure 65: The EMA reacts significantly faster than the CMA when prices rise and fall.

What is the best setting for an MA?

The next question that arises about the MA is that of the best time setting and period selection. We need to consider a few aspects for this:

Swing trading- vs. day trading

The time horizon and the style of your own trading are decisive for selecting the right MA. Those, who like to hold trades over a longer time period and do not want to be pushed out of the market due to initial smaller correction movements should choose a higher number of periods for their MA. However, those, who tend to react quickly to price fluctuations and want to enter and exit the market immediately, are better off with a shorter number of periods.

A distinction is also made between day traders, who usually trade within time frames of 30 minutes and smaller, and swing traders, who can be found in the 1H, the 4H or the one-day time frames.

Day traders must react quickly to price changes and have many trades per day. For swing traders, long-term and strategic thinking is important since they often hold their trades for days.

The following guidelines apply for selecting the number of periods of an MA:

• 9 or 10 periods: These settings are popular because the MAs react quickly to price changes. This number of periods is particularly suitable for day trading in lower time frames.
• 20/21 periods: This is the range of medium-term MAs that can be used in smaller as well as higher time frames. The 21-period MA is a universal tool.
• 50 periods: The 50-period MA is very popular. It is often used as a support and resistance tool, since it is generally well respected by the price – keyword: self-fulfilling prophecy. The 50-period MA is used as a trend tool by long-term traders, because it analyses a longer time frame.
• 100 and 200 periods: These MAs are regularly used by swing traders in the high time frames. On television and in the financial media, you can often also see that the analysts fall back on the 100- or 200-period MA. These MAs are also repeatedly used as support and resistance as figure 66 shows.

Figure 66: The 100- and 200-period MAs effectively describe trend phases and trend direction.Support and resistance also act as support and resistance as indicated by the Xs.

Self-fulfilling prophecy

I advise sticking to commonly used MAs, because the factor of self- fulfilling prophecy should not be underestimated in this case either. When millions of traders, the financial media and even algorithms (programs that make automatic buy and sell decisions) use the same MAs, they strengthen the impact of these MAs.

How to use MAs – the five signals

If we now look at trading using an MA, we can distinguish between five types of signals:

Trend direction and filter

The legendary trader Marty Schwartz was featured in the book "Market Wizards". He is a staunch supporter of MAs. In his own book, “Pit Bull: Lessons from Wall Street's Champion Day Trader”, he says the following about the use of MAs:

"The 10-day EMA is my favourite indicator to determine the trend. I call it 'red light, green light' because trading requires you to trade on the right side of the MA to maximise the probability of profits. If the price is above the 10-day EMA, you have the green light. The market will be in a positive mood and you should think about buying. On the other hand, a price below the 10-EMA indicates a red light. The market is in a negative mood and you should think about selling.”

Thus, Marty Schwartz uses his MA to determine the trend direction and to distinguish between buy and sell signals. This is a good tip, because you should never buy when the price is in an overall downward trend – and an MA acts as a filter.

The following rule is applicable for such a trading strategy: If the price is above the MA, you should search for buy trades, and search for sell trades

if the price is below the MA. This way traders can go with the higher-level trend which usually results in smoother trading opportunities.

Determining the higher-level trend in a higher time frame using an MA and then planning the entries in this direction in the lower time frame has proven to be particularly effective. Figure 67 shows how the 100 period MA described the long-term trend direction effectively.

Figure 67: The long-term 100-period MA acts as a trend direction filter if the price is in a trend phase. When the price is above the MA, the market is in an upward trend and vice versa. A break of the MA is an important signal.

Golden cross trading strategy

The golden cross is a popular trend following system. A golden cross is formed when the 50-period and 200-period MAs cross. The underlying idea is: if the short-term MA falls below the long-term MA, this indicates an important turnaround since the current prices fall below the long-term average.

As indicated by the golden crosses shown in figure 68, this signal is often suitable for determining the long-term trend and identifying changes in the trend direction. The vertical lines mark the cross-over signals.

It does not necessarily have to be the 50-period and 200-period MAs. Another popular combination is the 12-period and 26-period MAs. It reacts

faster due to the smaller number of periods and is usually better suited for short-term traders.

Figure 68: The Golden Cross signal can often indicate the start of a new trend phase. In this case, the 50-period and 100-period MAs were used in a 4-hour chart. MAs are universally applicable.

Support and resistance (C&R)

As already mentioned, MAs are so important because they are used by a lot of traders. For this reason, MAs can also be used ideally as an S&R tool. It is important only to stick to the most popular period settings to make use of this effect.

In an upward trend, many traders use the MA to find re-entries in the prevailing trend direction when the price moves back into the MA range during a correction. This is also known as pullback trading. If the price is supported at an MA, this represents a buy signal for many traders.

Especially the long-term MAs like the 50-period, 100-period or 200- period MAs are effective tools in this context, because several traders use them – keyword: self-fulfilling prophecy.

Figure 69 marks each support and resistance contact point at the MAs with an X. As with trend lines, traders often use those contact points to find trend trading opportunities into the overall trend direction.

Figure 69: This chart analysis uses a 200-period MA. The price respects it as support and resistance at almost every contact point. If you now add other concepts such as highs and lows, you can clearly explain the price developments in a proper manner.

Distance from the MA

The distance between the price and the MA indicates the strength of a trend. The farther the price can move away from the MA, the stronger the movement. If the price approaches the MA again or even breaks it, this can be an important trend reversal signal.

If the distance between the price and the MA increases, this may indicate that a trend is no longer sustainable. An explosive leap away from the MA should always be a warning to be extremely careful and wait for trend reversal signals – similar to the bump-and-run formation.

Figure 70 demonstrates that the price moves away from the MA during strong trend phases. When the price then breaks the MA, as indicated by the vertical lines, a shift in trend direction can often be the result.

Figure 70: This chart analysis uses a 50-period MA and shows its effectiveness in a comprehensible manner. During trend phases, the price moves away from its MA. When a trend comes to an end, the price first approaches the MA and then breaches it completely. The horizontal lines mark these breaches and it is always the starting point of a prolonged trend phase.

Momentum

The distance between two MAs provides information about the momentum: The further the two MAs move apart, the stronger the prevailing trend. A short-term and a long-term MA are normally used for this type of price analysis. For example, traders can use the 12-period and 26-period MAs, which are also the basis of the MACD indicator that we will discuss in the next section.

There are two possible signals and applications: The trader waits for the two MAs to cross and separate, indicating the start of a trend. As long as the MAs do not cross or converge, the prevailing trend is still intact. A trend reversal is initiated when both the MAs converge and eventually cross. The vertical lines in figure 71 mark the crosses of the two MAs. A cross often indicates a change in trend direction effectively.

Figure 71: If the two MAs intersect, a new trend is initiated. During the trend phases, the distance between the two MAs indicates the strength of a trend. In the shaded area, the MA has displayed false signals because the price has moved sideways. One 12-period and one 26-period MAs were used.

---

The MACD is a well-known and popular momentum and trend indicator based on moving averages.

Components of the MACD

Figure 87 shows the MACD has three important components: two lines and one histogram.

MACD line: The MACD line is the heart of the MACD. It represents the difference between the 12-period and 26-period EMA (EMA = exponential moving average). The MACD is essentially a complete MA crossover system. Crossover systems are very popular because they can effectively determine the trend direction, trend strength and trend changes through MA analysis.

Signal line: The signal line is the 9-period EMA of the MACD line.

MACD histogram: The histogram in the MACD is the difference between the signal line and the MACD line.

In this section, we focus on the MACD and signal lines, since the two lines can give meaningful signals collectively. The histogram is not a deciding factor for our purposes, because it does not improve the signal strength significantly.

Figure 87: Ctandard display of the MACD indicator with the histogram in the background, which is not required for our analysis purposes. The faster reacting line is the MACD line and the slower progressing line is the signal line. We use the default settings of 12, 26 and 9 periods.

Two trading signals of the MACD

When it comes to using the MACD, two trading strategies are particularly effective:

The MACD lines 0-level crossover

The vertical lines in figure 88 mark the points at which the MACD line crosses the 0-level. The 26-period and the 12-period MAs are shown for clarity right on the price chart. A crossing of averages on the charts provides the identical signals to that of the MACD lines, because the MACD uses these two averages as described above.

When two moving averages cross, this signals a change in the trend structure. If a short MA crosses the long-term MA downwards, this means that current prices have fallen below the long-term average. This often indicates a new downward trend. The horizontal lines mark the MA crossovers.

Figure 88: If the two MAs intersect, this is also the sign that the MACD is giving a new signal. This chart analysis clearly shows that the MACD lines can effectively indicate a trend change and confirm the trend direction.

Signal line

In the MACD window, when we see that the two lines separate, it means that the trend is gaining strength because the current prices are rising faster than the past prices. The further the two lines move apart, the stronger the trend is. When the two lines converge, this indicates a slowdown in the trend.

As long as the price is running above the moving averages and the MACD lines are also above 0, we are in an upward trend. This often helps in understanding the price in a better manner.

Figure 89 shows how well the Signal lines can indicate the trend direction. The vertical lines mark the crossovers.

Figure 89: The section at point 1 shows a short upward trend. Both MACD lines quickly cross again. In section 2, we can see a slightly stronger trend; both MACD lines are below the 0 level for a longer time. In section 3, the MACD signals a new upward trend early and both MACD lines remain above the 0 line throughout the trend.

During sideways markets, the MACD and signal lines are very close to each other and fluctuate around the 0-level, which means that there is no momentum and no trend. Just like the MA, the MACD should not be used during sideways phases.

If the price then suddenly breaks out and moves in one direction, both MACD lines will also separate and begin to rise. Many traders also use horizontal support and resistance lines in their MACD to identify such breakouts.

When the MACD and signal lines flatten again and reach the 0-level, the trend is over. Naturally, this does not immediately mean that the price changes the direction completely, but only that the trend is losing strength.

Use of MACD signals

Figure 90 shows a classic example of how the MACD can be used for trading signals. After the price breaks the trend line on the left on MACD

(1), it has started a new upward trend (2). During the trend, the MACD line has always been above 0 and the price has, therefore, also risen steadily above the MAs (2).

During the consolidation phase (3), we can use trend lines to identify a wedge. If the price breaks out of this, the MACD also starts to rise and separate again (4).

At the end of the trend, we can spot a divergence (5). A trend reversal is very likely now, because the divergence signals decreasing buying interest. The subsequent break by the MAs is also accompanied by a fall of the MACD line below the 0-level and initiates the new downward trend (6)

Figure 90: The MACD is ideal for tracking the price developments during trend markets.

MACD divergence

In the chart shown in figure 91, although the price formed new highs during the upward trend, the MACD was able to form lower highs and thus a divergence.

Now a trader has to wait until the price actively breaks through the MAs and, in the most favourable case, also reaches a new low on the charts.

Figure 91: The MACD divergence signals the trend direction reversal in advance.

What is the best indicator?

At the end of this chapter on indicators, let me make it very clear once again: no indicator is better than the other! It always depends on the area of application and the usage by the trader. An indicator is a tool developed for a specific purpose. Most traders make the mistake of using their indicators during inappropriate market conditions.

For example, a hammer is only useful for hitting the nail; it fails if you try to use it for tightening the screws. However, it cannot be generalised that a hammer is not a suitable tool. It is just that it is not useful for all purposes. The same applies to the indicators. First, the market conditions must be clear: Are we in a trend phase or a sideways phase? An appropriate

indicator can then be selected to carry out an effective analysis.

Moreover, an indicator, as the name implies, does not provide independent signals, but only certain indications. It supports the decision- making process, but should not justify it. Indicators should therefore only be used to obtain further confluence signals.