Trading software programs have almost reached the point where there is an overload of capability. Most packages now come with 100–120 different indicators, tests and overlays. Many people who buy software programs will never get to use all of the stuff that the program contains – which means narrowing down the array of indicators to the ones that give you most bang for your buck.
Gary Stone, managing director of ShareFinder Investment Services, says the three main groups of indicators are momentum indicators, volume indicators and volatility indicators.
"Momentum indicators are easily the most popular. They’re typically oscillators or rate-of-change indicators – they’re effectively mathematical formulas derived from the price."
Stone says the most popular momentum indicators are the moving average convergence/divergence (MACD), the rate-of-change (ROC) indicator – sometimes called the momentum indicator – the relative strength index (RSI), and stochastics.
"By a country mile, these four are the most popular. I would say that 90 per cent of technical traders would use them," says Stone. "That doesn’t mean they’re the best, in fact they’re probably not. They’re very difficult to trade consistently with."
To that group of four, Andrew Doig, senior analyst at charting and technical analysis education firm SpiWatch, adds the standard deviation and the Parabolic stop-and-reversal (SARs), which he says are "good timer indicators."
The Parabolic SAR uses a trailing stop-and-reversal method to determine good exit and entry points. Basically, if the stock is trading below the parabolic SAR you should sell; if the stock price is above the SAR then you should buy (or stay long).
Doig also likes the Bollinger Bands, upper and lower price bands that are a certain standard deviation level away from a central moving average; and the Williams Percentage Range (%R), a momentum indicator that helps to highlight overbought and oversold areas in a non-trending market.
Volume studies such as the negative volume index (NVI) and on-balance volume (OBV), which measures increasing volume relative to price, are also widely used, he says, although they are charting studies, and not as popular as momentum indicators.
"All of those would be the ones that most people would look to first. There are some other more esoteric things where you have to divide by the size of the moon and so on, but if people ran with those, they would cover 90 per cent of what they need to look at," says Doig.
Violetta Todorova, head of technical analysis at Tolhurst, says most technical analysts would use the RSI, moving averages, the MACD, stochastics and Bollinger bands, which she describes as "very powerful."
"It usually shows the standard deviations, and if we see the price going outside two standard deviations, it is a very powerful signal that we will see a reversal to the median. You can use this on both the long and short side," says Todorova.
She says traders should learn to combine the leading indicators – the momentum indicators like RSI and stochastics – with the lagging indicators, such as moving averages and parabolic systems. "The lagging indicators are good for confirmation of trend changes – many traders use moving averages as signals, when two lines cross over. But depending on the timeframe, the signals can come really late with them.
"The more astute traders analysts would use the leading indicators to give them an indication of direction before it is seen in the price. They tend to mimic the price but they give a signal a few days before the price, so they’re very valuable in that sense. But we should never act on what indicators are telling us before we see confirmation from the price."
Another "very powerful" concept with these indicators, she says, is divergence. "That can also tell us, before we see it in the price, what is the most likely future direction of the price. I follow the divergences very closely – especially the divergence between the price and the stochastics. RSI/price gives quite powerful divergences, too," says Todorova.
One of the main problems with the ‘big four’ momentum indicators, says Stone, is that the ROC indicator and RSI and the stochastics are all very ‘noisy’, in that they’re very sensitive to price action movements.
"Trying to work out what are buy signals and sell signals using these indicators is a bit more difficult. Also, they give a lot of false signals. If you’re trying to use the RSI and the stochastics on a mechanical basis, you get a lot of mechanical sell signals using a stochastic or an RSI, and the stock turns around and goes up and you shouldn’t have sold it."
Stone says an indicator that overcomes this ‘noise’ effect is the Know Sure Thing (KST) indicator. "There is a short-term KST, a medium-term KST and a long-term KST. It’s not as well-known as the ‘big four’ indicators, but from a research perspective it probably does better than those, because it works against the ‘noise’ causing you to do trades that shouldn’t be done."
Another rate-of-change indicator that works in a similar way is the smoothed index rate of change (SIROC) indicator. "The SIROC also overcomes the issue that RSI and stochastics have of being too noisy. It’s a bit like the MACD, but the problem with a MACD is that it oscillates about a zero line: it goes positive, then negative, then positive and so on. Whereas the SIROC is indexed between zero and 100," says Stone.
The problem with using an indicator that oscillates between positive and negative numbers, he says, is that you can’t determine when the indicator represents an over-bought or over-sold zone, in an unambiguous manner. "If the stock price is going up, the positive number can keep going up and up and there’s no ‘feeling’ on it. When it comes down, it can go below zero and keep going down and down, and you don’t know where the bottom is – it could be minus one, or minus ten, or minus 15. You don’t know where the bottom is."
But when the indicator is indexed between zero and 100, says Stone, you know the bottom is zero and the top is 100. "You can’t go any lower or higher than those points, so you can start putting together over-bought and over-sold zones. The SIROC helps with that."
While both the RSI and the stochastic are indexed between zero and 100, Stone says the problem with them is that they’re "not smooth enough", and too noise-sensitive. And while the MACD is "nice and smooth," it’s not indexed.
But the SIROC is both smoothed and indexed. "It takes the best of what the RSI and the MACD and the stochastics do – and the KST is a little bit like that, too," says Stone.