DueDEX: Hello traders, welcome back to DueDEX Connect. It’s great to have you here!
Along with Three Steps, today we are taking a sweeping look at common indicators, how they work, the differences between them, and how to use them for profit.
Thank you very much for joining us Three Steps!
Three Steps: Glad to be here! So today's topic as Michele already said is about the various types of indicators, how they work and how we can use them to trade.
We will just discuss a few indicators per 'type' because there are so many out there!
But first, what are the different categories indicators fall into?
- Trend indicators tell you which direction the market is moving in, assuming there is a trend at all. They are sometimes called oscillators, because they tend to move between high and low values like a wave. Of these, we will discuss the Simple/Exponential/Weighted Moving averages and the Parabolic SAR.
- Momentum indicators reveal how strong the trend is and can also show if a reversal is going to occur. They can be useful for picking out price tops and bottoms. Among them we find the Relative Strength Index (RSI), Stochastic, and the Average Directional Index (ADX).
- Volume indicators show how volume changes over time, basically how many units of bitcoin are being bought and sold. This is useful because when the price changes, the volume gives an indication of how strong the move is. Bullish moves on high volume are more likely to be maintained than those on low volume. This category includes the On-Balance Volume (OBV) and the Money Flow Index (MFI).
- Volatility indicators tell you how much the price is changing in a given period. Although they do not provide information about direction, the higher the volatility is, the faster a price is changing. The Bollinger Bands are a typical example of a volatility indicator.
Let us begin our review with moving averages. There are three ways in which traders use them:
-To determine the direction of the trend
-To determine support and resistance levels
-Using multiple moving averages for long- and short-term market trends
The Simple Moving Average (SMA) is the most straightforward to calculate. It is the average price over a chosen time period. Its main selling point is that it offers a smoothed line, less prone to whipsawing up and down in response to slight, temporary price swings. Therefore, it provides a relatively stable level indicating support or resistance.
On the other hand, the SMA’s weakness is that it is slower to respond to the kind of rapid price changes that often occur at market reversal points.
For these reasons, the SMA is often favored by traders and analysts operating on longer time frames, such as daily or weekly charts.
The advantage of the Exponential Moving Average (EMA) is that by being weighted to the most recent prices, it responds more quickly to changes than the SMA does. This is particularly helpful to traders attempting to trade intraday swing highs and lows, since the EMA signals trend change more rapidly than the SMA does.
The concurrent disadvantage of the greater sensitivity of the EMA is that it is more vulnerable to false signals.
The EMA is commonly used by intraday traders who are trading on shorter time frame charts, such as the 15-minute or hourly charts.
A trader using a Weighted Moving Average (WMA) is less likely to pick a trend change early on but is also less likely to mistake a minor correction for a trend change. The advantage of using WMAs is that they pick up trends more quickly than simple moving averages - this is why some traders prefer to use WMAs for shorter time periods - but at the same time, they produce more false signals than simple moving averages.
This is why some investors prefer simple moving averages over long time periods to identify long-term trend changes.
So, which one should you choose? This question is left to the risk profile of the trader and her familiarity with moving averages.
Some prefer plain simple moving averages while others try to dig deeper by using combinations of exponential and smoothed moving averages. It all depends on what you are looking for.
My advice? Consider longer-term moving averages.
The other trend indicator we are going to look at is the Parabolic SAR indicator, developed by J. Welles Wilder Jr., which is used to determine trend direction and potential reversals in price.
This technical indicator uses a trailing stop and reverse method called "SAR," - stop and reverse - to identify suitable exit and entry points.
The parabolic SAR indicator appears on a chart as a series of dots, either above or below an asset's price, depending on the direction the price is moving in.
A dot is placed below the price when it is trending upward, and above the price when it is trending downward.
The parabolic SAR is used to gauge a stock's direction and for placing stop-loss orders. The indicator tends to produce good results in a trending environment, but it produces plenty of false signals - which may result in losing trades - when the price is moving sideways.
To help filter out some of these poor trade signals, a good starting point is to only trade in the direction of the dominant trend. Combining the Parabolic SAR with other technical tools, such as the moving average, can also be of help.
Probably the most famous momentum indicator is the Relative Strength Index (RSI), a momentum oscillator developed in 1978. The RSI is used in technical analysis to measure the magnitude of recent price changes and evaluate overbought or oversold conditions in the price of a stock or other asset. The RSI is displayed as an oscillator - a line graph that moves between two extremes - and can have a reading from 0 to 100.
The RSI provides technical traders signals about bullish and bearish price momentum, and it is often plotted beneath the graph of an asset's price.
An asset is usually considered overbought when the RSI is above 70% and oversold when it is below 30%.
The next indicator in this category is the Average Directional Index (ADX). Originally designed by Welles Wilder for commodity daily charts, it can be used in other markets and on other timeframes, too, to determine the strength of a trend.
The trend can be either up or down, and this is shown by two accompanying indicators, the Negative Directional Indicator (-DI) and the Positive Directional Indicator (+DI). The price is moving up when +DI is above -DI, and the price is moving down when -DI is above +DI. Crosses between +DI and -DI are potential trading signals as bears or bulls gain the upper hand.
The trend has strength when ADX is above 25 and is weak - or the price is trendless - when ADX is below 20, according to Wilder.
(Note that all the indicators discussed here are available on DueDEX under the indicator tab!)
Notice that “non-trending” does not necessarily mean the price is not moving. It may not be, but the price could also be making a trend change or is too volatile for a clear direction to be present.
Some of you might know it already, since besides regular volume bars this is probably the most used indicator in this category. I am referring to the On-balance Volume (OBV) indicator, which uses volume flow to predict changes in the price of a stock.
The OBV shows crowd sentiment and can predict a bullish or bearish outcome. In this sense, you may argue that while this is primarily a volume indicator, it also covers momentum as a subtype, so to speak.
Comparing relative action between price bars and OBV generates more actionable signals than the green or red volume histograms commonly found at the bottom of price charts.
Then another volume indicator is the the Money Flow Index (MFI), which uses volume in combination with recent price movements to determine whether momentum is up or down.
The OBV and MFI on one chart.
Many traders view this indicator as a volume-weighted relative strength index (RSI), which is calculated using average price gains and losses over a period of time (usually 14 days). However, when using the money flow index, buy and sell signals are generated when the index moves beyond the 20 or 80 levels. Similarly to the RSI, those represent oversold and overbought levels, respectively.
And finally the last indicator we will discuss today, the Bollinger Bands! There are three lines that compose Bollinger Bands: a simple moving average (middle band) and an upper and lower band. The upper and lower bands are typically 2 standard deviations +/- from a 20-day simple moving average. They can, however, be adjusted to a user’s preferences.
Bollinger Bands are a highly popular tool. Many traders believe the closer the prices move to the upper band, the more overbought the market will be, and the closer the prices move to the lower band, the more oversold.
When the bands come close together, constricting the moving average, we have what is referred to as a squeeze. A squeeze signals a period of low volatility and is considered by traders to be a potential sign of future increased volatility and possible trading opportunities.
Approximately 90% of price action occurs between the two bands. Any breakout above or below the bands is a major event.
Q: Thank you so much for the exhaustive explanation! With so many indicators it is easy for traders to get confused. To help our audience, we were wondering if you could tell us which ones you like best and why?
A: Simplicity is key for me, avoid getting confused by overloading yourself with too many indicators. Use one of each type so you are not displaying the same data twice unless you really value it. I am a big fan of the RSI, the ADX, and the Bollinger bands.
Q: Over the top of your head, what is the number one suggestion you would give the audience about using multiple indicators at the same time?
A: Try to understand when indicators are showing different signals and what this could mean. Most times these signals hint that the market is losing its trend.
It's really about carefully watching the indicators to understand whether they are in sync or start to show mixed signals.
That's when you need to take a step back and start to plan what you will do with the next move, depending on whether it goes down or up.
(And this is probably where the SAR comes in perfectly, by the way!)
Q: What about the main mistake traders tend to make when choosing technical indicators?
A: Putting too many on their screens and not understanding what they actually mean. They drown in information and are unable to make critical decisions on whether to close or open a trade.
Try to simplify how much effort you have to do, especially in intraday trading sessions.
Q: Indeed, clarity really is an advantage. There is also a common issue, however, with traders using the same type of indicator and ending up seeing only one kind of information while believing they have a fair understanding of the market. How would you tackle this problem?
A: As stated earlier by doing some research about the indicator and understanding in which circumstances it is good and when it is best to avoid using it. Traders should learn a lot about the instruments they use, and their pros and cons.
Ideally, you want to have different types of tools that can complement each other in your analysis.
DueDEX: No way around doing some homework it seems…
ThreeSteps: Don't drive a bike down a hill without knowing how to steer!
Q: Looking specifically at the RSI, one thing many new traders wonder is whether they should have it calculated on 6, 12, or 24 days. What is your suggestion in this regard?
A: I personally find that using a smaller RSI period when you use time frames above 3D can be helpful because it tends to move very slowly. In general on a daily time frame and on anything intraday 9-12 seems to work fine.
Here you can see a 1-week chart. Notice the difference between the RSI 14 and 3. (I would not go any lower than that as a general rule.)
You can get more volatile peaks but it is still a good way to see the relative strength with these very big timeframes. A higher period will result in a more smoothed average and might prevent 'fake-outs' but you could also use one small period and one normal one with time frames from 3-days up.
Q: If you look at the indicators we have spoken about, how do you use them in conjunction when trading?
A: I would try out each and everyone and check out trading strategies, see which one you like and master it.
The main thing you want to look for are convergences, divergences, and the like. There is a lot of information about how these work and what kind of effects they have on the market.
In this sense, the RSI and the OBV are great tools when used together. RSI divergences tell us information about price whereas the OBV provides additional information on volume.
And you could add a SAR to figure out where to set your stop-loss when you enter a trend based on an increasing ADX.
One thing I would like to add is that volume can vary from place to place, so a combined volume indicator from many markets would give a better representation of the OBV and the MFI.
Q: Thank you very much. Our time is running out, but we still have one question we would like to ask. How do you advise traders to act if two indicators show diverging signals? For instance, if one is bullish but another is neutral?
A: Be cautious since this means that the trend is showing mixed signals. Also understand which indicator is the faster moving one - the slower moving indicator might still have to catch up and cross down or vice versa.
Thank you once again @ThreeSteps. We appreciate you giving DueDEX users an opportunity to learn more about indicators. We would also like to thank everyone who joined.
Stay tuned for the next #DueDEXConnect!