Example of a stock chart with two technical indicators, RSI and Bollinger Bands.
Technical indicators are like math equations you can automatically run on price and volume placed on your charts. These math equations are as simple as an average of prices over time, to much more involved math.
Some of these math equations can help you forecast price direction, identify if a stock is trading too high or low, compare the price movements of two different stocks, or simply help you organize the price action on the chart.
There are thousands of technical indicators out there. Some cost money, and most are free. If you use TradingView for your charts, you’ll notice that the platform provides hundreds of indicators, but there are hundreds of additional community-developed indicators.
With thousands of indicators to choose from and learn about, where do you even start? How does anyone pick the “best” indicator to use?
Luckily for you is that the world of technical indicators is mostly noise. All indicators aim to capitalize on two stock market phenomena: mean reversion and trend following.
Mean reversion indicators help you to identify when something is overbought or oversold. In other words, the price is ‘too high’ or ‘too low.’
Trend following indicators help you spot new trends and when the supply/demand balance is significantly shifting in one direction.
While the developer of an indicator will claim that they have some “proprietary methodology,” remember all indicators capitalize on these simple concepts. Differences between them are incremental and dependent on your ability to interpret and utilize them effectively.
So as long as the concepts behind the indicator are sound, it doesn’t matter which indicator you use, but how you use it.
For that reason, we’ll focus on a few of the most popular indicators and how to use them to your advantage.
RSI: the Relative Strength Index. The RSI indicator is a mean reversion focused indicator, meaning your primary use will be identifying overbought and oversold conditions.
The indicator is insanely simple to use when RSI is low, the stock is ‘oversold’ and is more likely to rally shortly. When RSI is high, the stock is ‘overbought’ and is more likely to drop soon.
The RSI is separate from your candlesticks and shows up on its own pane above or below your chart. This is because the RSI’s calculation is from 0 to 100, meaning it doesn’t have the same scaling as your candlestick chart.
Here’s an example:
How To Use the RSI
When using the RSI period, you have to select one input, the ‘lookback period,’ this is the number of candlesticks the indicator uses to calculate it’s value. In other words, a lookback period of 14 will use the previous 14 candlesticks to calculate the RSI.
A simple trick for selecting the lookback period is to base it on how many candlesticks you want to be in a trade. For example, if you trade using a daily chart and want to be in a trade for, on average, four days, you should use a lookback period of 4.
Basic RSI Mean Reversion Strategy
RSI is best used in conjunction with other chart reading techniques. If you blindly buy any stock with an overbought reading, you’ll continuously buy falling knives. Keep this in mind, and don’t throw out your chart reading skills in favor of relying on a math equation.
The most simple and effective method for trading with RSI is to combine trend following and mean reversion. Use trend following to select the stocks you’re going to trade: stocks in strong trends, and mean reversion to choose your entries: buying pullbacks in the direction of the trend.
Let’s use an example. Suppose we want to be in a trade for about three days and trade on a daily chart. We should use a 3-period RSI. For RSIs with shorter lookback periods, overbought and oversold levels will be 80 and 20, respectively. This is due to their tendency to whipsaw more on shorter lookback periods.
Our entry criteria will be when the RSI is below <=20, and our exit criteria are when RSI crosses above 65.
The green arrow is the buy point, and the red arrow is the sell point.
Here’s an example of how this looks:
MACD stands for Moving Average Convergence Divergence. That’s kind of a confusing name, but it’s mostly jargon. In actuality, the MACD is quite simple.
The MACD indicator has three components:
- Two exponential moving averages (defaults are typically 12 and 26)
- MACD line = shorter-term EMA – longer-term EMA
In the chart below, the two moving averages are represented by lines, while the MACD line is plotted as a histogram.
The MACD is a trend-following and momentum indicator, meaning it’s used to spot situations where supply and demand is significantly shifting in one direction over time.
Ways to Use the MACD Indicator
The MACD is a versatile momentum indicator. Unlike the RSI indicator, which is generally used for one purpose, each trader who uses the MACD applies it differently.
A “crossover” trade is when the entry criteria for your trade is contingent on one line crossing over another. In the case of MACD, you can trade crossovers of the moving averages: go long when the short-term EMA crosses above the long-term EMA, and vice versa. Another option is to go long (or short) when the MACD line crosses above (or below) the zero line.
Higher Highs and Higher Lows
At its simplest, a stock trend is simply a series of higher highs and higher lows for uptrends, and lower lows/lower highs for downtrends.
You can apply the same simple trend analysis to the MACD indicator. The difference here is that you’d be looking at “momentum” highs and lows, as opposed to pure price levels.
Using momentum highs and lows has its advantages. There’s a classic stock market maxim which I’ve heard Linda Raschke repeat several times: “momentum precedes price,” in other words high levels of momentum tend to precede big price moves.
Convergence and Divergence
These two phrases are obviously in the name and are probably the most popular method of MACD analysis.
Let’s get two things straight first.
Convergence is when two things meet, like two rivers converging into one stream. In the context of the MACD indicator, there is convergence when price and MACD ‘agree.’ In other words, if a new high accompanies a new price high in the MACD, that’s convergence.
Traders use convergence as confirmation that their view is sound. For example, if you’re trading a chart pattern, you may check to see if the MACD converges with your price forecast. If it does, that puts the odds further in your favor.
Divergence is when two things move away from each other. An example is when someone’s political opinions go from one party to another. You can say that their opinion has diverged from their political party’s opinion.
In the MACD context, divergence is when you see something on a price chart that looks bullish, but the MACD is telling you that things are looking bearish. Traders use divergence as a signal to avoid a trade opportunity, or as a signal that a trend’s momentum is declining.
Take an example in one of today’s hot stocks: Zoom Video Communications (ZOOM).
As you can see, ZOOM’s in a steady uptrend. The price is making higher highs and lower lows, and the 20-day moving average is trending upwards.
However, the MACD peaked in late March, making lower highs since then. This is a textbook example of MACD divergence. The trend’s momentum is weakening, and divergence traders are probably avoiding getting long this stock.