With so many technical indicators to choose from, it can be tough to choose the ones to use in your stock trading. Consider a top-down approach to help you decide whether to use stock momentum indicators, trend indicators, or consolidating indicators.
When applying technical indicators, first start by looking at the overall market
Next, look for stocks that are moving in sync with the overall market
Come up with a set of indicators to use for trending markets, consolidating markets, and breakouts
With hundreds of technical indicators available, it can be difficult to select the mix of indicators to apply to your trading. If you try to use too many technical indicators, you may suffer from “analysis paralysis.” If too few, you’ll stare at the screen without any conviction. How do you find that sweet spot? Consider using a top-down approach.
First, figure out if the broader indices are trending or consolidating. To do that, bring up a chart of an index such as the S&P 500 on the TD Ameritrade thinkorswim® trading platform. Select the Charts tab and enter SPX in the symbol box. Is SPX trending or consolidating? Sometimes it’s easy to see, but not always, which is why it’s helpful to apply trend indicators to identify market conditions.
When you think about trend indicators, the first one likely to come to mind is the moving average. But should you use simple, exponential, or weighted? It’s a matter of personal preference, so try out different ones to see which works best for you.
Let’s start with a simple moving average (SMA). Going back to the chart, select Studies > Add Study > Moving Averages > SimpleMovingAvg. This places a moving average overlay on the price chart (see figure 1). The default parameter is nine, but that can be changed. Select the indicator, then Edit Study SimpleMovingAvg (CLOSE, 9, 0, no) to change the inputs and display. Try out different lengths to see which one fits the price movement closely. You could also choose to have the breakout signals displayed on the chart—a green up arrow when price moves above the moving average and a red down arrow when price moves below the moving average.
You can use more than one moving average on a price chart. For example, you could add the 25-day and 50-day moving averages. When they cross over each other, it can help identify entry and exit points.
There’s no way to tell how long a trend will last. A trend that’s just starting could fizzle out soon, and a trend that’s been around for 10 years could continue to trend for many more years. But if you’re going to trade in a market that’s trending, traders typically trade stocks that trend in the same direction as the broader market.
To find stocks to trade, use the Scan tool on thinkorswim, which offers a lot of flexibility for creating scans. Once you’ve come up with a manageable list of stocks, you can go down the list and apply a moving average to the charts to figure out which way the stocks are trending.
Traders often worry that once they place a trade, the market will reverse and they’ll end up losing money. Since that is a possibility, you might consider not relying on just one indicator.
Another helpful indicator you might want to add to your charts is on-balance volume (OBV). This indicator displays on the lower subchart (see figure 2). To place OBV on a chart, select Studies > Add Study > Lower Studies (Popular) > OnBalanceVolume. If OBV is trending up, it’s likely prices will also trend up. If prices aren’t trending up but OBV is, that’s an indication prices could start trending up. If OBV starts flattening or reverses, prices may start trending lower.
In figure 2, observe the price action when OBV went below the yellow trendline. The 20-period moving average was still sloping upward, and if you didn’t have OBV as a guide, you might have thought the trend would continue up. It wasn’t until about a week later that price fell below the moving average. But the OBV signal came earlier.
At the extreme right of the chart, the moving average is trending down slightly, but OBV looks like it’s trending up. It could mean price will start trending up—something to keep an eye on.
You may find stocks on your scan list that’re moving within a trading range. Do you reject them because they aren’t trending in the direction of the overall market? Not necessarily. You can still find potential trading opportunities.
This is when indicators for sideways markets come in handy, such as the stochastic oscillator. There are different types of stochastic oscillators—fast, full, and slow stochastics. Try using them all to learn the subtle differences between them.
Figure 3 shows how to apply the full stochastic. The 10-period weighted moving average is overlaid on the price chart as a confirmation indicator.
FIGURE 3: PRICE OSCILLATIONS. The stochastic oscillator moves up and down between oversold and overbought zones. When the %k line (yellow line) moves above the %d (purple line) after moving above the oversold line, it could indicate upward price movement. Conversely, if the %k line crosses below the %d after moving below the overbought line, it could indicate downward price movement. Chart source: the thinkorswim platform from TD Ameritrade. For illustrative purposes only. Past performance does not guarantee future results.
The stochastic indicator displays two lines—%k (yellow line) and %d (purple line)—and mostly moves between its overbought (top horizontal line) and oversold (bottom horizontal line) levels. But sometimes it moves outside these levels, and that’s when you might want to pay attention. When the %k crosses above the oversold level and the %d line, it could indicate prices are moving up. If that coincides with price moving above the moving average, it’s additional confirmation. Similarly, when the %k crosses below the overbought level and the %d line, it could indicate prices are moving down. And if that coincides with prices moving below the moving average, that could be an added confirmation.
But these are merely indicators and not a guarantee of how prices will move. This is why many traders have exit conditions in place, just in case things don’t go as planned.
Prices typically don’t stay within a range forever. At some point they’re likely to break out to the upside or downside. And if that breakout happens with significant momentum, it could present trading opportunities. A momentum indicator to consider for identifying breakouts is the Relative Strength Index (RSI), which shows the strength of the price move. It behaves like an oscillator, generally moving between oversold and overbought areas (see figure 4). The RSI can give you an idea of the potential strength of the trend as it breaks out of a range.
In figure 4, price was moving within a trading range. When it broke out above the upper range, even though RSI was trending up, it didn’t break out above the overbought level. It’s interesting to note that RSI remained within the overbought and oversold levels while it was consolidating. It wasn’t until RSI started approaching the overbought level (indicated by the cyan line changing to red) that it indicated a possible increase in momentum. But it didn’t stay there long. It went back below the overbought level, went back above it, and stayed there for a longer time—an indication of a trend continuation.
Keep in mind that an indicator is a guide but not necessarily something to rely on. It’s a good idea to have your stop levels in place when you make trades.
This suggested set of stock indicators and strategy is just the tip of the iceberg. There are more than 300 indicators you can consider trying out on the thinkorswim platform. You can categorize them into trending, trading range, and momentum indicators and create a technical indicator list including tools from each category. But make sure the indicators you choose aren’t redundant. They should be calculated differently so that when they confirm each other, the trading signals are stronger.
Jayanthi Gopalakrishnan is not a representative of TD Ameritrade, Inc. The material, views, and opinions expressed in this article are solely those of the author and may not be reflective of those held by TD Ameritrade, Inc.
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