How does a technical indicator work ?

How does a technical indicator work?

Technical indicators are derived from technical charts – which are graphical or pictorial representations of the market activity in terms of upward or downward movements in stock prices over a period of time. Mathematically, a technical chart is a plot of a set of price data (on the vertical axis) as a function of time (on the horizontal axis). The price data can include a stock’s opening price, closing price, day’s high or low price, average price, or a combination of these. The plotted data points on the chart can show as individual points or as small bars.

When all the data points on the chart are joined, a wave-like pattern is obtained. This pattern is then subjected to technical analysis by experts, who apply standard mathematical formulae to these price movements in order to arrive at technical indicators, from which they can predict the future market price of a stock or its market trend (upward/downward movement).

Types of signals- Crossovers and Divergence

The indicators show the signals in one of the two ways- through ‘crossovers’ or ‘divergence’. ‘Crossover’ indicators are constructed with an upper limit and a lower limit. When the limits set are breached, it signals that the trend in the indicator is shifting and that this trend shift will lead to a certain movement in the price of the underlying security.

Divergence means the direction of the price trend and the direction of the indicator trend moves in the opposite direction. This signals that the direction of the price trend may be weakening as the underlying momentum is changing. Divergence is a key concept.  Divergences can serve as a warning that the trend is about to change.

There are two types of divergences: positive and negative. In its most basic form, a positive divergence occurs when the indicator advances and the underlying security declines. A negative divergence occurs when an indicator declines and the underlying security advances.

The concepts of ‘crossovers’ and ‘Divergence’ would become clear to you once you learn more about indicators and oscillators.

How do technical indicators help the investor/trader?

If you have watched the stock market action on a computer screen, you would have noticed that stock prices keep fluctuating almost every second and it is impossible to make head or tail of the pattern if all the price movements are planted on a chart. So, to smooth out the data, technical analysts plot any one of the high/low/open/close/average prices on the charts. This also helps in understanding the movements of an extremely volatile stock and then predicting its future price movement. Technical indicators also help an investor in the following.

  1. They determine support and resistance levels. Even an amateur technical chartist can determine important technical levels, which when breached will take a stock’s price lower (support levels) or higher (resistance levels).
  2. Some indicators can help determine the future price of a share.
  3. Technical indicators help in establishing trends (upward or downward), which are critical for both traders and investors.
  4. Technical indicators always alert a technical analyst of any major price action/volatility is about to occur in a stock’s price. Even you will be able to interpret the alerts once you are through all the articles featured in this topic.

Next we need to look at something called ‘oscillators’. more about that in our next lesson.

You may like these posts:

  1. Introduction to technical indicators
  2. Technical Analysis
  3. A study of chart patterns

2 Responses to “How does a technical indicator work ?”

lakskarly

July 26, 2011 at 9:20 am

waiting for next post

Kaiden

November 3, 2011 at 7:32 pm

Thanks for sharing. What a pleausre to read!

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