Technical analysis is gaining steam, but there are misconceptions about the best indicators in different market environments. Brush up on trend-following.
I’m a longtime disciple of technical analysis and use it almost exclusively in my trading, which is why I am so glad it’s becoming a more mainstream tool for investors. But despite its growing popularity, there are still some misconceptions about which types of indicators work best in different market environments.
Most technical indicators fall into one of two categories: trend-following or range-based.
Trend-following indicators, as the name indicates, are designed to take advantage of trends in the market or an individual stock. Examples include moving averages, the average directional index (ADX), and on-balance volume (OBV).
Range-based indicators are mostly designed to show overbought and oversold conditions in a price range and include Bollinger Bands, the Commodity Channel Index (CCI), the Relative Strength Index (RSI), and stochastics. Some indicators, like the moving average convergence divergence (MACD), can be used to generate either a trend-following or a range-based trade signal depending on the time periods used in its calculation.
Let’s take a look at how both types of indicators can be effective in different sample market conditions and time frames using the charting tools on the thinkorswim® platform from TD Ameritrade. Take a look at the following figures and their descriptions.
FIGURE 1: TREND TRACKER. Here we see a one-year daily chart with a simple 50-day moving average plotted as a light blue line. The area enclosed by the rectangle shows the price staying above the moving average, which at several points provides support, indicating an uptrend is in place. You might stay long in this trend until the price breaks below the moving average. For illustrative purposes only. Past performance does not guarantee future results.
FIGURE 2: TREND TURNS TO RANGE. By highlighting a different area of the same chart, we see price moving in a range instead of a trend. As a result, the trend-following moving average loses its effectiveness. At this point, a range-based indicator like stochastics would work better. For illustrative purposes only. Past performance does not guarantee future results.
FIGURE 3: SIGNALS EMERGE. By zooming in on the highlighted area shown in figure 2, we can see how stochastics provides a number of clear buy and sell signals, indicated by the respective green and red arrows within this range. For illustrative purposes only. Past performance does not guarantee future results.
Can these indicators sometimes work in combination? You bet. Both trend-following and range-based indicators can work on shorter time frames as well, such as those used for day trading.
FIGURE 4: BETTER ALTERNATIVE? Here we see a five-minute intraday chart where the price breaks out cleanly above a resistance level (red line). The nine-period exponential moving average (light blue line) illustrates the uptrend. In this case, you might stay long until the price closes below that uptrend. During that same time, stochastics would have been ineffective in managing the trade, because the contract remained overbought almost the entire time. For illustrative purposes only. Past performance does not guarantee future results.
FIGURE 5: DIFFERENT VANTAGE POINT. A different intraday chart that’s also using the five-minute time frame offers an example where price stays in a range, whipsawing above and below the moving average. In this case, stochastics provides a number of clear buy and sell signals. For illustrative purposes only. Past performance does not guarantee future results.
There are a wide variety of trend-following and range-based indicators available on the thinkorswim platform. Understanding how they work, and more importantly, when to use them, can help you fine-tune your trading and potentially improve your winning percentage.
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