Among the multitude of available technical indicators, there are a few that are used far more than others. Here are three to try.
- Bollinger Bands
Bollinger bands are another technical indicator to use moving averages interestingly. This time, by plotting lines two standard deviations away from a market’s MA. They can help you visualise volatility and determine whether a trend is set to continue – or reverse.
Bollinger bands take the form of three lines:
- The middle line is a moving average of the given market
- An upper band, which is two standard deviations above the MA
- A lower band, which is two standard deviations below the MA
A standard deviation is a measure of how close prices are to the average. So, when the two bands are far apart, prices are far from the average and the market is in a period of high volatility. When they are close, it is relatively calm.
Like most technical indicators, you can tweak Bollinger bands to suit your trading style, changing the length of the moving average or number of standard deviations.
Trading with Bollinger bands
There are a few different ways to read Bollinger bands. One of the most common is to look at how close your market’s live price is to either band.
If the price is close to the upper band, then it is considered high relative to the average. If it moves beyond the upper band, it is overbought. This could be a good time to short the market.
If the price is close to the lower band, then it is considered low relative to its average. If it moves beyond the lower band, it may be oversold, which could mean it’s a good time to buy.
If the market is close to the middle line, then its price is fairly close to its average.
It isn’t overbought or oversold, so no signal is generated.
Bollinger bands can be used on trading charts within any timeframe, making them useful to both day traders and longer-term investors. They can be particularly helpful when a market is in a trend and moves beyond the opposite band, signifying a potential reversal.
Relative Strength Index (RSI)
Another way to spot whether a market is overbought or oversold is by using the Relative Strength Index (RSI) indicator. Like MACD, this appears at the bottom of your chart and takes the form of a line that moves above and below zero.
RSI compares the average number of days that an instrument closes up to the average number of days that it closes down. This average is then listed on a scale of 1 to 100.
Typically, RSI is used with a 9, 14, or 25 calendar day (7, 10, or 20 trading day) period. If you add more days to the calculation, the value is usually taken to be less volatile.
Trading with RSI
The typical way to read the Relative Strength Index is that a value of under 20 suggests that a market is oversold, while a value above 80 suggests it is overbought.
As with Bollinger bands, if a market in a strong uptrend sees its RSI move above 80, the trend may soon come in for a reversal. Likewise, a value under 20 may signal the impending end of a bear run.
However, these signals are no guarantee of a move, so caution is advised.
- Log in to your trading account
- Bring up a market chart
- Hit ‘Indicators’ at the top of the chart
- Scroll down to the Relative Strength Index, and select it
- The RSI will now appear at the bottom of your chart
The stochastic oscillator works a little bit like the RSI indicator. But instead of averaging out how often a market has closed up or down, it compares an instrument’s closing price to its average price over a given period.
Like the other indicators listed here, stochastic is mostly used to find overbought and oversold markets – as well as help you identify possible entry and exit points.
The stochastic oscillator is formed of two lines on a sub-chart:
- The %K line compares the market’s close for the day to its trading range over the past 14 days
- The %D line is the signal line. In this case, a five-day SMA of the %K line
To calculate the %K line, you take the market’s lowest point over the past 14 days (not including today) away from today’s close price, and times that by 100. Then you divide that figure by the range of the past 14 days (so its highest point minus its lowest point). This creates a figure between 0-100.
As ever, you don’t have to calculate a 14-day Stochastic – you can use almost any number of periods.
Trading with the stochastic oscillator
Like RSI, a reading above 80 or below 20 on the oscillator is usually taken as either overbought or oversold. However, as with MACD, you can also use stochastic to look for crossovers.
Most traders use both in conjunction, waiting for a crossover when the indicator is already above 80 or below 20 and taking that as a buy or sell signal. For example, when the %K line rises above 80 and then crosses the %D line, you may have a strong sell signal.
RSI compares the average number of days that an instrument closes up to the average number of days that it closes down.