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Master technical indicators



Master technical indicators

What are technical indicators?

A technical indicator is a series of data points that are derived by applying a formula to the price data of a security, whether it is a forex pair, a stock, bond or any other derivative.
Technical indicators have three main functions:

 1- confirm other technical analysis tools.              
 2- alert to study price action a little more closely. 3- predict the direction of future price movements.

Generally technical indicators are classified as either leading or lagging indicators. Many of those indicators are oscillators.
It is important for traders to understand those types of indicators, and in which classification each indicator falls.
This answers the question of which indicator you should use and in what circumstances.
Here is brief explanation of each type and when you use it.  

Leading indicators:

    many leading indicators come in the form of momentum oscillators, and are   designed to lead price movements.  (example: CCI, MOMENTUM, RSI, STOCHASTIC, WILLIAMS %R, ROC …)
   they catch turning points in flat markets, but give premature and dangerous signals when markets begin to trend.
   leading indicators are best used in trading ranges.
   they can also be used in trending markets, but usually with the major trend, not against it.
   in a market that is trending up, the best use is to help identify oversold conditions for buying opportunities. in a market that is trending down, the best use is to help identify overbought conditions for selling opportunities.

Benefits

-         early signaling for entry and exit.
-          generate more signals and allow more opportunities to trade.
-          forewarn against potential strength or weakness

Drawbacks

-          more signals and earlier signals mean that chances of false signals and whipsaws increase.
-          false signals will increase the potential for losses, and whipsaws can generate commissions that may eat away profits

Lagging indicators:

they follow price action and are commonly referred to as trend-following indicators. They work best when markets develop strong trends.
Most known lagging indicators are Moving Averages, MACD and ADX.

Benefits

-         They are designed to get traders in and keep them in as long as the trend is intact.
-         the longer the trend, the fewer the signals and less trading involved.

Drawbacks

-         these indicators are not effective in trading ranges or sideways markets, and may lead to many false signals and whipsaws.
-         trading signals tend to be late. and late entry and exit points can skew the Risk/ Reward ratio.                              

oscillators

an oscillator is an indicator that fluctuates above and below a centerline or between set levels, as its value changes over time. oscillators identify the emotional extremes of market crowds.

  Centered oscillators (ex: MACD, ROC …)

they fluctuate above and below a center line, and are best suited for analyzing the direction of price momentum and its strength or weakness. Momentum is bullish when a centered oscillator is trading above its center line, and bearish when it is below.

  Banded oscillators (ex: RSI, STOCHASTIC …)

They fluctuate between overbought and oversold extremes, and are best suited for identifying overbought and oversold levels. most banded oscillators rely on divergences and overbought / oversold levels to generate signals.

  Oscillator signals

1-    Divergences:

A divergence is a clear difference between the price trend and the trend of the indicator, it can be caused via a deceleration of prices or a matter time, which decreases the angle of each lower low in the downtrend, or higher high in the uptrend compared to the previous one. Also, what can cause a divergence is that the price movement has the same strength compared to the previous one in the same direction, but the previous correction is greater.
A divergence signals a waning of momentum. It does not necessarily signify new momentum in the opposite direction.
divergences are best thought of first and foremost as warnings to exit, and second as opportunities for a reversal.

2-    Overbought and oversold extremes:

Overbought and oversold extremes are a price level that a security reaches, and that analysts believe it is well above or below its intrinsic or average value. Markets usually expect a stock or security price to correct toward its average value after trading at an extreme.

3-    Centerline crossovers:

Centerline crossover signals apply mainly to centered oscillators that fluctuate above and below a centerline. Traders have been also known to use centerline crosses with RSI in order to validate a divergence or signal generated from an overbought or oversold reading.
the middle ground is a bit of a no man’s land for banded oscillators and is probably best left to centered oscillators.
Movements above and below the centerline indicate that momentum has changed from either positive to negative or negative to positive.

Conclusion:

Before using any technical indicator or rely on its signals to enter trades, it is very important to understand what type it is, in which conditions it is used, and what signals it gives.


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