In order to better manage our investments, we have to take into account many various trading indicators. The use of trading indicators may be mandatory for some traders (for example, high-frequency algorithmic traders) but completely optional for discretionary traders. Choosing which technical indicator(s) suits us the most is probably the second most important after money management when defining our trading style. Provided that everyone has its favorite flavor, there are, however, certain principles that all technical analysis enthusiasts share:
Technical analysis gives an edge if used properly, but only if you use enough indicators. A technical indicator is not a trading strategy but only a building block for one. Except in rare cases, no indicator can be objective by itself; it all depends on how you use it.
One common mistake beginners make when they start using technical analysis is that they focus on one or two indicators and make trading decisions based on them. However, as we will see further below, indicators are not designed to give buy/sell signals per se! They are simply meant to provide information about what other traders seem to think about the strength of a trend. Only if this information coincides with your judgment should you act upon it. If you decide to act against other traders’ opinions, make sure that there is enough money on the other side of your trade.
The choice of indicators depends greatly on what kind of trader you are: a day trader, a swing trader, or a position trader? How much time do you want to spend on analyzing the markets each day? What is your risk level? etc. Here we will list some popular technical analysis indicators and provide recommendations on what type of traders should use them and how they should be applied to perform well. In addition, as articles often state what type of indicators authors have used for their backtests, we will also list those used during our tests.
Types of technical indicators, there are three main types of technical indicators: oscillators, trend following, and mean reversion. Oscillator type indicators indicate whether the latest price bar closed stronger or weaker than the previous one (i.e., above average for bullish bars or below average for bearish ones). Trend following indicators would indicate as to whether the price is currently in an uptrend or a downtrend. Mean reversion indicators would be those that give information about how far away the current price is from its ultimate value (or “fair” value if you assume all traders are rational). Finally, momentum-type indicators tell us only whether the most recent price move was strong enough without giving any further information on trends or mean reversion.
In conclusion, oscillator-type indicators are best suited for day trading or position trading; mean reversion indicators are usually better for swing trading, while any trader can use trend-following indicators.
