Technical indicators are the data points that show how an asset’s price has changed over time. They can reflect everything from straightforward information, such as a simple average or highs and lows, to complex market-wide analysis of how investors have traded the asset. Technical indicators are particularly useful for analyzing patterns. Investors can use information about how an asset’s price has changed over time to make predictions about what its price will do in the future. They can then invest accordingly. Here’s how it works.
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Technical Indicators Represent Price and Trading Data
Readers should note that we will discuss stocks and companies in this piece for ease of language, but these concepts apply equally to any financial asset. Technical and fundamental analysis are practiced in all areas of investment.
Investors approach stocks from two main perspectives. The first is called “fundamental analysis.” With this approach an investor reviews the asset behind a given financial product, such as the company underlying a stock. A stock represents one proportional share of ownership in a company, so the investor reviews that company’s business model, leadership, products, profits and much more to determine if they want to own that company.
The second is called “technical analysis.” With this approach, an investor reviews the stock itself. They look at data such as the stock’s price and how it has changed over time, how many shares of this stock other investors have bought and sold, how quickly they’ve done so, how volatile its price movements have been, and much more. Together this data tells them how other investors on the market are trading this asset, which an investor can use to make predictions about how this stock will do in the future.
The data that investors use to conduct technical analysis are called “technical indicators.”
A technical indicator is a piece of specific data that describes a stock’s price, volume, volatility or any other trading data. While some can be very simple, most technical indicators are relatively complex mathematically derived models that describe some aspect of a stock’s trading history. Investors use these indicators to find patterns so they can predict how a stock will move in the future.
For example, one of the most basic technical indicators is called a simple moving average (SMA). With this indicator, an investor calculates the average, or mean, of a stock’s price over a given period of time. A common SMA is 200 days. With this, for any given day you would calculate the stock’s average price over the past 200 days including that one. Then you do it again for the next day and so on. The result is a curve that tracks how the stock’s average price changes over time.
Two Most Common Types of Technical Indicators
There are hundreds of different technical indicators, all based on a different way of analyzing trading data. However, they fall into two general categories.
Overlays. An overly is any technical indicator that you present on the same chart as a stock’s pricing data. This means that the overlay uses the same basic data points on the same scale as the stock itself does, charting a change in prices (the Y axis) over time (the X axis). This lets you plot the indicator alongside the stock’s price information itself.
Two of the most common overlays are moving averages (described above) and Bollinger Bands. Bollinger Bands analyze a stock’s volatility by comparing its daily price against its simple moving average. Investors create a chart with the stock’s price data. Then they overlay its simple moving average. They use the price and the average to calculate the Bollinger Bands, which in turn they overlay on the chart. With the moving average they can see how a stock’s price has been trending over time. With the Bollinger Bands they can predict whether that trend is likely to change in the near future based on recent trading patterns.
Oscillators. An oscillator is a technical indicator that swings between local minimums and maximums. Generally speaking, an oscillator is used to predict momentum, which means that the investor is trying to decide if a stock’s price will keep heading in the same direction or if it’s about to reverse.
This indicator doesn’t follow the same data points as the stock’s pricing information, it measures a different set of data, and as a result, it’s presented on a separate chart. Typically an oscillator is presented below the stock’s price chart.
The most common oscillator for stocks is called the P/E ratio (or price-to-earnings ratio). With a P/E ratio, investors take the stock’s current share price and divide it by the company’s earnings per-share of stock. For example, say a company has 100 shares of stock trading at $2 and it earned $500 last year. It would have earned $5 per share ($500/100 shares), and it would have a price-to-earnings ratio of 0.4 ($2 share price/$5 earnings per share).
Investors use the P/E ratio, which is sometimes thought of as a tool in fundamental analysis, to determine if a stock’s price is too high or too low. A high ratio means that investors are asking a lot of money relative to how much the company has actually earned, while a low one indicates that the stock might be a good bargain relative to the company’s earnings.
While the P/E ratio is based on price information, you don’t represent it in terms of price-per-day. As a result you can’t overlay this on the stock’s price chart. Like all oscillators, it needs its own chart separate from pricing.
How to Use Technical Indicators
There are hundreds of technical indicators, all of which represent a different way of looking at trading data. Investors all have their own approach to this part of investing. Some use technical indicators sparingly. They prefer to rely on fundamental data. These tend to be long-term investors who trade based on the belief that the value of the company will eventually outperform any short-term trading patterns.
Other investors prefer to rely on technical indicators almost, if not entirely, exclusively. These tend to be shorter-term traders who operate on the scale of months or weeks, not years. They are primarily concerned with how other investors will treat their stocks, because that’s how they’ll make their money.
Regardless of the degree to which investors rely on technical indicators, with most you look for patterns in the data. Investors create charts with technical indicators so that they can see how the data has changed over time. The shape of the chart and the pattern it represents can help the investor decide what to do in the future. While the raw numbers can tell you the same thing, most technical indicators are more intuitive when represented in graphical form.
But it’s important to understand that technical indicators sit at the intersection of mathematics and psychology. Ultimately at the other end of every trade is a human being, whether they actually click the button or have instructed an AI to do so.
Investors use their data to look for patterns that they can compare against how other investors have historically traded. They can look at a P/E ratio and determine that a stock in publicly traded company is likely to start selling because once a ratio climbs to a certain point, investors often start to sell. They can look at pair of Bollinger Bands and determine that a stock’s price is likely to start moving because once Bollinger Bands begin to narrow around the SMA, investors often start to trade more heavily.
But these are all predictions around what will happen because it has happened in the past. Ultimately, for all the mathematics involved, investors use technical indicators to predict what other investors, other human beings, are likely to do. That’s their greatest strength, but also their absolute limit.
Technical indicators represent some aspects of an asset’s trading data. They are generally based on mathematic formulas and they can represent anything from a stock’s price changes to its volatility, trading volume and much more.
Investing Tips for Beginners
- A financial advisor could help you create a financial plan for your investment needs and goals. 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.
- Technical and fundamental analysis are two sides of the same coin. With one you look at how your asset has traded. With the other, you look at how its underlying product has done. To be a successful investor you need to understand both.
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