Should you use a combination of technical indicators?
Using a combination of indicators can help you confirm signals and avoid false moves.
In this post, we go through the best indicators and how to combine them in your trading.
NOTE: You can get your free combination of technical indicators PDF Guide below.
What are Technical Indicators
Technical indicators are mathematical calculations based on a security’s price, volume, or open interest. Traders and analysts use them to interpret market trends, identify trading opportunities, and make informed decisions. Here are the critical aspects of technical indicators:
Types of Technical Indicators:
- Trend Indicators: Help identify the direction of the market trend.
- Examples: Moving Averages (Simple Moving Average, Exponential Moving Average), Moving Average Convergence Divergence (MACD), and Average Directional Index (ADX).
- Momentum Indicators: Measure the speed and magnitude of price movements.
- Examples: Relative Strength Index (RSI), Stochastic Oscillator, Commodity Channel Index (CCI).
- Volume Indicators: Analyze the trading volume to confirm trends and the strength of price movements.
- Examples: On-Balance Volume (OBV), Volume Weighted Average Price (VWAP), Chaikin Money Flow (CMF).
- Volatility Indicators: Measure the rate of price change regardless of direction.
- Examples: Bollinger Bands, Average True Range (ATR), Volatility Index (VIX).
- Market Strength Indicators: Assess the overall market conditions or breadth.
- Examples: Advance-Decline Line, McClellan Oscillator, TRIN (Arms Index).
How Technical Indicators are Used:
- Identifying Trends: Indicators like moving averages help traders identify and follow the prevailing trend, making it easier to decide when to enter or exit trades.
- Overbought and Oversold Conditions: Momentum indicators like RSI and Stochastic Oscillator signal when an asset might be overbought or oversold, indicating potential reversal points.
- Entry and Exit Points: Technical indicators can provide specific signals to enter or exit trades. For example, a MACD crossover might indicate a buy or sell signal.
- Confirming Patterns: Volume indicators can prove the strength of price patterns, such as breakouts or breakdowns.
- Risk Management: Volatility indicators like ATR help traders set appropriate stop-loss levels and position sizes.
Combining Indicators:
Traders often use a combination of technical indicators to reduce false signals and improve the accuracy of their trading decisions. For example, combining a trend indicator with a momentum indicator can help confirm the direction and strength of a trend.
Example:
- Moving Average: A 50-day moving average can help identify the overall trend. If the price is above the moving average, it suggests an uptrend; if it is below, it is a downtrend.
- RSI: An RSI above 70 may indicate an overbought asset, suggesting a potential sell signal. An RSI below 30 may indicate that the asset is oversold, suggesting a possible buy signal.
- Bollinger Bands: Bollinger Bands can indicate volatility. Prices that touch the upper band might signal an overbought condition, while prices touching the lower band might signal an oversold condition.
Should I use a Combination of Technical Indicators?
Using a combination of technical indicators can be beneficial in trading as it helps to confirm signals and reduce the likelihood of false positives.
Here are some key points to consider:
- Diverse Indicators: Combine indicators that measure different aspects of the market. For example, pairing a trend-following indicator like Moving Averages with an oscillator like the Relative Strength Index (RSI) can provide a more comprehensive view.
- Confirmation: Using multiple indicators can help confirm signals. For instance, if the MACD (Moving Average Convergence Divergence) and RSI indicate a bullish trend, it might be more robust than relying on just one indicator.
- Avoid Redundancy: Ensure the indicators you choose are not redundant. Using two indicators that provide the same information (e.g., two momentum indicators) might not add value and can create confusion.
- Backtesting: Test your combination of indicators on historical data to see how well they perform together. This can help you understand their strengths and limitations in different market conditions.
- Customization: Tailor the combination to your trading style and your specific market. Some combinations might work better for short-term trading, while others might be more suitable for long-term strategies.
- Risk Management: Risk management is crucial even with a combination of indicators. Use stop-loss orders and position sizing to protect your capital.
What is the Best Combination of Technical Indicators
MACD
The Moving Average Convergence Divergence (MACD) is a widely used technical indicator in stock trading that helps identify potential buy and sell signals.
It comprises three main components: the MACD Line, which is the difference between the 12-period and 26-period Exponential Moving Averages (EMA); the Signal Line, a 9-period EMA of the MACD Line that smooths out fluctuations and provides more reliable signals; and the Histogram, which represents the difference between the MACD Line and the Signal Line and visually indicates momentum.
Interpreting the MACD involves analyzing crossovers. A bullish crossover occurs when the MACD Line crosses above the Signal Line, suggesting a buy signal and a bearish crossover occurs when it crosses below, indicating a sell signal.
Additionally, divergence between the MACD and price action can signal potential reversals, with bullish divergence indicating weakening selling momentum and bearish divergence indicating weakening buying momentum.
The histogram’s bars further illustrate momentum strength, with increasing positive bars signaling stronger bullish momentum and increasing negative bars signaling stronger bearish momentum.
For instance, if the MACD Line crosses above the Signal Line with increasing positive histogram bars and no significant divergence, it suggests a buy signal. However, it’s prudent to confirm with other indicators or analyses.
Best Combination of Technical Indicators for Swing Trading
Stochastic
The Stochastic Oscillator, developed by George Lane in the late 1950s, is a widely used technical analysis tool that helps identify a stock’s momentum by comparing its closing price to a range of prices over a specific period.
It comprises the %K line, the primary line calculated based on the current close, lowest low, and highest high over the lookback period, and the %D line, a 3-period moving average of the %K line that smooths fluctuations.
The oscillator ranges from 0 to 100, with readings above 80 indicating overbought conditions and below 20 indicating oversold conditions.
Traders interpret the Stochastic Oscillator through crossovers, where a bullish signal is generated when the %K line crosses above the %D line and a bearish signal when it crosses below.
Additionally, the divergence between the oscillator and price action can indicate potential reversals, with bullish divergence suggesting a possible upside reversal and bearish divergence suggesting a downside reversal.
For example, if the %K line crosses above the %D line in oversold territory and the price makes a new low while the oscillator does not, it signals a potential buy.
Confirming such signals with other indicators or fundamental analysis is essential for a comprehensive trading decision.
Best Combination of Technical Indicators for Day Trading
ADX
The Average Directional Index (ADX), developed by J. Welles Wilder, is a technical indicator used to quantify the strength of a trend in a financial market, regardless of its direction.
The ADX is part of the Directional Movement System and is often used alongside the Positive Directional Indicator (+DI) and the Negative Directional Indicator (-DI). The +DI measures the strength of upward movement, while the -DI measures the strength of downward movement.
The ADX represents the average absolute difference between the +DI and -DI over a specific period, typically 14 periods, and smooths out fluctuations to provide a clearer picture of trend strength.
To calculate the ADX, the +DI and -DI are first determined, followed by the DX (Directional Movement Index), and finally, the ADX, which is a smoothed average of the DX values.
Interpreting the ADX involves looking at its value to gauge trend strength: values above 25 indicate a strong trend, values below 20 indicate a weak or non-existent trend, and values between 20 and 25 suggest a trend gaining or losing strength. The ADX measures trend strength without indicating direction, so traders use the +DI and -DI lines for directional cues.
When the +DI crosses above the -DI, it suggests a bullish trend; when the -DI crosses above the +DI, it indicates a bearish trend.
For example, if the ADX is above 25 and the +DI is above the -DI, it signals a solid bullish trend, indicating a potential buying opportunity.
Conversely, if the ADX is above 25 and the -DI is above the +DI, it signals a solid bearish trend, indicating a potential selling opportunity. Confirming ADX signals with other technical indicators or analysis methods ensures comprehensive decision-making.
Lastly
Technical indicators are essential tools in technical analysis. They provide valuable insights into market behavior and help traders make more informed decisions.
By understanding and effectively using these indicators, traders can enhance their ability to predict price movements and manage risk.
NOTE: You can get your free combination of technical indicators PDF Guide below.
Stock Markets Guides content team.