In the stock market, technical indicators aim to predict future performance using historical data. But can we accurately predict the future using past information? Shall investors solely rely on them?
Technical indicators are only reliable if used in conjunction with other analysis techniques. Otherwise, you may miss critical information. Try to blend them with other information from fundamental analysis to get a good sense of investors’ attitude toward a stock and make better investment decisions.
Read on for a comprehensive description of technical indicators, why they’re popular, and why you should combine them with other techniques for optimal results.
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Table of Contents
What Are Technical Indicators?
Technical indicators are a subset of technical analysis, the method of evaluating securities and stock prices based on historical prices and trade volumes. Simply put, they’re pattern-based signals obtained from mathematical calculations of past data.
Technical indicators are typically plotted on the price chart and are used to predict market trends. Notably, certain technical indicators such as RSI and MACD are excessively used by technical traders to determine whether a security is “overbought” or “oversold” at a given moment.
Why Are Technical Indicators So Popular?
Technical indicators are popular among individual and institutional investors alike. According to a study published in the Journal of Banking and Finance, up to 86% of fund managers employ technical analysis when making investment decisions. But why has this technique gained such a strong following?
Here are some of the reasons behind the huge popularity of technical indicators, according to an experienced analyst on various discussion forums:
- Objectivity: The data used in charting is objective. The only variables are the trade volume and the opening, highest, lowest, and closing stock prices.
- Malleability: You can adjust or refine the cumulative data each season, and use different formulas to calculate various indicators.
- Consistency: Technical indicators use the same type of data, regardless of the company or index under consideration. Unlike fundamental analysis, it doesn’t rely on data from companies and agencies, which may have been prepared to fit different accounting standards.
Do Technical Indicators Work?
Having discussed the ins and outs of technical indicators, let me address the pertinent issue that brought you to this page: Are technical indicators effective? The following empirical findings and opinions show they may work, but only as long as you know how to use or mix them with other methods.
What Does Academic Literature Say?
This topic is controversial in academic circles. One group of scholars argue technical indicators don’t translate to profitable trading. They believe investors who use technical analysis are poor decision-makers and tend to make massive losses (The study based on a Chinese index, and a survey of 5500 investors are two examples of this group – links in the article sources below).
The second group, though, reports technical analysis is profitable and can generate successful trading strategies (Such as the study based on the Karachi Stock Exchange (KSE100), and another based on the Oslo Benchmark Index – links in article sources below).
Since the answer is inconclusive at this point, let’s see what seasoned investors have to say.
What Do Investors Say?
Like scholars, investors are split on the practicality of technical indicators in generating profits. On the one hand, Warren Buffet considers them worthless and says they’re only good for predicting the past; it doesn’t matter whether you look at them upright or turn them upside down!
On the other hand, Rory Gillen, co-founder of Merrion Capital and GillenMarkets, maintains that technical indicators provide critical information on market psychology, making them valuable tools. Anthony Bolton touted as Britain’s answer to Warren Buffet also supports the use of technical indicators.
But it’s good to know that all of these investors combine this method with other analyses.
Examples of Technical Indicators
Now that you have a brief overview of what technical indicators are and why they’re so popular, here are some of the common ones you’ll come across in analysts’ reports:
Simple Moving Average (SMA)
The SMA is the average price of a stock or financial security over a given period, such as 1 hour, 1 week, 1 month, and so on. With SMA, each of the periods is assumed to be equally important in the calculations. For example, assuming a security price is $1.00 on the first day, $0.98 on the second day, and $1.02 on the third day, then the 3-Day SMA is $1.00 (the average of the previous three prices).
However, suppose the price increases to $1.20 on the fourth day. In that case, the 3-Day SMA becomes the average of the 3 most recent prices, that is:
(0.98 + 1.02 + 1.20) / 3 = 1.067
In a nutshell, each time you hear an analyst talk of an n-day or n-month moving average, it means the average value over the past n-days or n-months, respectively.
This means any value recorded more than n-days or months ago isn’t included in the calculation.
In other words, you’ll keep dropping older prices and including newer prices when using this method.
When to use the SMA: Since the SMA gives equal weight to the prices used in the calculation, I prefer using it for long-term trading.
Exponential Moving Average (EMA)
Contrary to the SMA, which considers all periods equally important, the EMA gives more weight to recent prices in its calculation.
Even though calculating an EMA is more complicated than determining a stock’s SMA, the key takeaway here is that the weight you assign to older prices decays with time. This means that with EMA the multiplier for the most recent price will be the highest while that of the earliest price will be the least.
When to use the EMA: Since the EMA gives more weight to current prices, it gives a more refined overview of the current market conditions, making it ideal for short-term trading.
Moving Average Convergence & Divergence (MACD)
The MACD is more complex than the two former versions. This indicator is based on EMAs: It combines a longer period EMA with a shorter period EMA and a signal line (usually an EMA).
When the MACD exceeds the signal line, analysts usually say the market is strengthening, signaling investors to buy the security. Conversely, when the MACD is below the signal line, investors are generally advised to sell (or short) the security.
When to Use the MACD: If you want to identify when the bullish or bearish momentum is at its peak, then it’s best to use the MACD.
Relative Strength Index (RSI)
Developed by Welles Wilder Jr., the RSI indicates a stock’s momentum, that is, whether it’s rising or falling steadily. This trend indicator usually lies in the 0-100 range.
As a rule of thumb, a value greater than or equal to 70 implies the financial instrument has been overbought, meaning the price has risen more than expected. Therefore, it’s appropriate to sell it to avoid making a loss as it adjusts downward in the future.
However, if the RSI is 30 or lower, the security in question is considered oversold; hence, it’s advisable to purchase it.
When to use the RSI: The RSI comes in handy if you want to identify if a downtrend or uptrend is forming. If you expect a security’s price will fall or rise, you can use the RSI to gain more insights.
For more information on technical indicators, I recommend that you watch this video:
Caveat: Although each of the indicators I’ve mentioned gives you an overview of the market direction, it’s best to combine them to get more comprehensive information.
Verdict: Reasons To Use a Blended Method
In my opinion, technical analysis works if used correctly. By that, I mean you shouldn’t base investment decisions solely on it. Instead, you need to mix it with other methods, such as fundamental and quantitative analysis.
Here are some points to justify my stand:
- You get enriched information by combining different data. Technical indicators tell you what investors think about a financial instrument. You can use that information to decide whether it’s the appropriate time to buy it or not.
- While the fundamental analysis may give you the long-term potential, chances are you may need a favorable buy-in to spend less. Conversely, you may need a favorable selling price to liquidate your position. Technical indicators would come in handy at such moments.
- You get insights into how investors react to the news. By analyzing past data, you can determine how investors react to new market conditions, such as increased interest rates. You can compare their short-term reactions with how they tend to behave in the long-term and decide whether to buy, sell, or hold a security.
I suggest that you read John Palicka’s Fusion Analysis from Amazon.com for detailed information on how to blend these methods. The book teaches how to balance quantitative, fundamental, and technical analysis for successful trading.
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Conclusion
In a nutshell, I think those who consider technical indicators unreliable tend to look at them from a narrower perspective. They disregard it since it doesn’t provide all the information you’d need to make informed investment decisions.
Although technical analysis focuses on the past, most analysts agree that history tends to repeat itself, and that’s why you need technical indicators as part of your investment arsenal. However, to make the most out of them, it would be better to blend them with other techniques, notably fundamental and quantitative analysis.
BEFORE YOU GO: Don’t forget to check out my latest article – ‘Exploring Social Trading: Community, Profit, and Collaboration’. I surveyed 1500+ traders to identify the impact social trading can have on your trading performance, and shared all my findings in this article. No matter where you are in your trading journey today, I am confident that you will find this article helpful!
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