Technical analysis is one of the two main ways that investors consider their position. Technical indicators are the specific data points that make up technical analysis. These are mathematical models that analyze some aspects of an asset’s history, such as price, trading volume, volatility and much more. An investor can work with a financial advisor, who will perform this analysis on their behalf, to make sure they are choosing investments that are likely to work for their financial plan.
What Technical Indicators Are Used For
Investors use technical indicators to look for patterns. Based on how investors have historically behaved, they can look for similar charts and data to predict what an asset will do next. For example, when a stock’s price approaches its support band it often stops declining. Or when a Simple Moving Average begins to level off, you will likely see upcoming volatility.
Investors generate this data mathematically but their conclusions are based on history and psychology. They predict what will happen next because they see a pattern emerging. Based on what other investors in that situation have done in the past, they make predictions based on how that pattern often ends.
There are dozens, if not hundreds, of different technical indicators that investors can choose from, and no clear best choices. However, if you’d like to get started with technical trading, here are five of the best indicators you can start with.
1. The Simple Moving Average
A simple moving average (SMA) is exactly what it sounds like. It calculates the day-to-day average, or mean, of a stock’s price over time. When you calculate an SMA you choose a time frame to apply. The most common is 200-day moving averages, in which you calculate the stock’s average price over the past 200 days, and 50-day moving averages, in which you calculate the stock’s average price over the past 50 days.
Investors use the simple moving average to look at how a stock’s price has trended over time. It lets you look at general price movements without the volatility of day-to-day trading. Looking at a longer time frame you can see more durable trends while considering shorter time frames will let you see how a stock may start trading in the near future.
2. Bollinger Bands
Bollinger bands add an additional layer of analysis to the simple moving average. To calculate a Bollinger Band you determine a stock’s simple moving average. You then apply a standard deviation to each day’s price above and below the SMA, based on that day’s high and low. This creates a price envelope with a band at the top and the bottom of the simple moving average.
Bollinger Bands help you determine a stock’s likely stability or volatility. When the bands widen, it means that a stock may be trending toward stability. When the bands converge, it means that the stock may be trending toward volatility. Note that this doesn’t indicate which direction the stock’s price will go, just that trading will likely begin to pick up and the price will likely change.
3. 52-Week High/Low
This may be the simplest technical indicator you can find.
The 52-Week High measures the highest price that a stock has traded for in the past year. The low measures its lowest point over that same time period.
Investors use this to establish what is known as support and resistance bands. A support band is a low point, where you expect downward trading to slow down or halt. A resistance band is a high point, where you expect upward trading to slow down or halt. While simple, it’s common for investors to avoid trading significantly above a stock’s 52-Week High or below its 52-Week Low. This can give investors a way to predict trading as they approach those points.
4. P/E Ratio
This indicator, which is sometimes thought of as a tool in fundamental analysis, only applies to stocks, but it’s one of the most important for analyzing those.
A price-to-earnings ratio compares the stock’s share price against the underlying company’s earnings-per-share (or EPS). It measures how much you’re paying for every dollar of earnings that the company makes. For example, say a stock has a P/E Ratio of 10. This means that if you buy a share of this stock, you’re paying $10 for every $1 of underlying earnings that share represents.
Investors use the P/E Ratio to determine if a stock is overbought or oversold. When the ratio gets too high, it generally indicates that the stock is getting too expensive relative to the amount of value you’re getting. Investors will probably start to sell fairly soon. By contrast, a low P/E Ratio indicates that investors can get a lot of value for their money. You might expect people to begin buying.
5. Parabolic Stop-And-Reverse
With the Parabolic SAR, you’re trying to determine what’s known as a stock’s “acceleration.” You calculate it based on the stock’s current price, its prior high or low points and an acceleration variable that investors can define as needed.
The result creates a series of parabolic curves that track the price changes of a stock over time. As the stock’s price increases, the curve will track that trend and eventually begin to level out as the curve forms the top of a parabola. If the price declines, the Parabolic SAR will do the same thing in reverse, tracking the trend downward and again leveling out at the bottom of the curve. In each case, the peak or trough of the parabola indicates that the trend is ending and investors should expect a near-term reversal.
The purpose of this indicator is to help investors follow trends. By applying the Parabolic SAR to your trading, you can see when a trading trend has begun to level off. You can sell, for example, once the curve begins to hit its high-point parabola or buy once it levels out on the low end.
That said, this indicator works best with consistent trend lines. If the market is experiencing high volatility, slow trading or general movement within a band (known as sideways market conditions), you aren’t likely to get much value from the Parabolic SAR.
The Bottom Line
Technical indicators are the data points that you use to analyze how an asset has traded based on its price and history. While you can get deep in the weeds on this subject, five of the best places to start are with Bollinger Bands, SMAs, P/E Ratios, Support and Resistance Bands and the Parabolic SAR. A financial advisor often will perform this analysis on an investor’s behalf to make focused investment choices.
Tips for Technical Analysis
- Technical analysis is generally used in shorter-term trading. A financial advisor can provide this analysis and manage your portfolio based on its findings. Finding the right financial advisor who will do this well doesn’t have to be difficult. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Momentum is one of the most important concepts in technical analysis. Investors look for patterns as an asset gets more valuable or cheaper, but they want to know when that pattern will change.
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