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Chartologist’s Cocktail: Right Mix of Technical Indicators

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February 13, 2014
Chartologist’s Cocktail: Right Mix of Technical Indicators

Chart-reading might seem overwhelming to the new trader, given the myriad systems and signals you can plaster all over a typical chart. How many indicators are too many or too few? Finding just the right recipe can help you accomplish three key things.

Diving into technical analysis could be likened to a trip to your local big-box home improvement retailer. So many tools to choose from. Decisions, decisions…

Although technicals can be an exciting and rewarding part of a trading strategy, there’s also the risk of going “indicator crazy,” what with the dizzying array of options that can muck up your charts and create confusion rather than clarity. Using too many indicators can generate mixed signals and cause you to miss opportunities to enter or exit trades. On the flip side, if you just zero in on one indicator without anything else to provide context, you run the risk of false signals. You might get in too soon or too late, only to see the market reverse course.

What’s the right number? To answer that question, you may need to ask three more, and then start by applying at least one indicator to answer each question.

1. What is the trend?
2. Where in the trend are we?
3. When do I get in?

Take a look at figure 1. Let’s attempt to answer these questions with as few indicators as possible.

INDICATOR SOUP NO MORE.

FIGURE 1: INDICATOR SOUP NO MORE. Instead of suffering from inaction or jumping the gun, ask a series of questions that an indicator each might answer. For illustrative purposes only.

1. WHAT IS THE TREND?

Simply stated, technical analysis is about slicing and dicing past price and trading volume activity to discern patterns and trends—that is, to identify what the market has been doing and where it may be heading.

Markets move up, down, or sideways. Over the long term, trends may be easier to spot, but ideally, your technical indicators can help identify a trend early enough for you to consider trading. This is where “confirmation,” a basic tenet of technical analysis, comes in.

Let’s say you use four tried-and-true indicators, three of which confirm an opportunity to enter or exit a trade. You may have the odds on your side. However, if only one indicator registers a “buy” or “sell” signal, look out— you might want to wait on the sidelines.

One indicator used to determine trend is a longer-term simple moving average (see figure 1). As long as the price action is holding above a rising moving average, then you typically have an uptrend.

2. WHERE IN THE TREND ARE WE?

Markets don’t move in straight lines up or down, of course. They pause for periods of correction and consolidation before resuming the prior trend— or not. Does a market “in motion” tend to stay in motion? This is where momentum comes into play.

Possible momentum indicators include the Relative Strength Index (RSI) and volume. These indicators hint that a trend is intact and strong—or at a possible “exhaustion” point. For example, healthy volume, coupled with a rising RSI line (lower indicators in figure 1) could indicate the trend continues to be strong.

3. WHEN DO I GET IN?

Suppose you’ve confirmed a strong, bullish uptrend in your stock. When do you get in? If you buy at a high, will it go higher? If you buy at a discount after it drops, will you be “catching a falling knife”?

Believe it or not, perhaps the best indicator is the chart itself. Look for a recognizable pattern that might repeat. There are a lot of patterns you may have heard of—double tops, cup-and-handle, bullish flags, and so on. But one of the simplest is to just wait for a dip in the stock price followed by a breakout to new highs.

Refer to the chart in figure 1 again. Notice that the price action did not go up in a straight line. It ebbs and flows, like most things in life. And along the way, you can see there were opportunities to enter the uptrend with each new “breakout” to new highs (where it crosses each red dashed line in the chart). Alongside your trend and momentum predictions, chart patterns make for a nice accompaniment to chart-reading mojo.

Now, chart patterns can take time to develop—perhaps days or even weeks—and they aren’t ironclad. Still, an attentive trader should keep an eye out for these and other signals that indicate it may be time to take a profit on a long-standing position or to help define a new trade idea. Such chart formations can offer clearly defined “entry” points for traders, and are often combined with a future price target at which to close out a trade.

Keep It Simple

In conclusion, it’s important to remember that there’s a time and a place for different indicators. As with your latest home improvement project, you’ve got a lot of tools to choose from—it comes down to finding the right ones for each particular job. The same goes with chart indicators.

How to Answer "When?"

Numbers aside, spotting support and resistance in the charts is relatively simple, yet crucial. Watch a video on dissecting the psychology of the market using support and resistance.

Presented by Investools®, a separate but affiliated company. TD Ameritrade, Inc. is not responsible for the content of this video.

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