Technical Indicators: Appropriate Uses for New Traders and Investors

July 13, 2011, 4:49 am

When investors and traders first start playing with all the features of modern stock chart software, many of which is free on financial websites, therell be excitement discovering the many chart tools and technical indicators. This actually is a trap most people fall into when theyre new to using charts and indicators, so be careful. Most people Ive seen, including myself, could not be a profitable trader using charts until they were able to see through the bells and whistles of modern stock charts. Moreover, you have to learn the basic foundations of how each chart feature youre looking at truly works. There are people whove tried trading for years and still cannot make money consistently. One of the main complaints is that indicators dont work, or that they work some times but not all the time. The problem is usually misunderstanding of how the indicators or chart features actually work, therefore misusing the indicator like misusing a hammer on a screw when you needed a screwdriver.

We talked last time about the three types of stock charts (line charts, bar charts, and candlestick charts) and what they say about a stock. How you show the stock price with one of these three stock charts is the foundation for most other features on a chart. Great investors and traders can look at just a candlestick or bar chart, which shows the stocks price action (how the price is changing), and trade purely from this information. Most indicators are calculations based on the stocks price, so without having a decent understanding of reading stock price, it is hard to have a good grasp on how indicators work!

But we are here to talk about correctly using indicators, so we want to start with the most basic and common indicators. RSI (Relative Strength Indicator), Stochastics, and CCI (Commodity Channel Indicators) are oscillating indicators meaning they move in waves going up and down then up again and down again. You may have seen this indicators with areas marked as overbought and oversold with the first thought being the stock has to come down if it is overbought And the stock has to go up if the indicator is in the oversold region. Not always true! This is why a lot of people hate indicators.

First, there are thresholds set to mark overbought and oversold regions. When a stock has been going up a lot and the indicator has been in the overbought region for a while, you have to wait for the indicator to roll over and come down from the overbought region. Stocks can go up or go down a lot more than anyone would think possible, and thus staying overbought and oversold a lot longer than people expect. Even if a stock is overbought, it can keep being overbought and if you thought it would come down right away and made a decision based on that assumption, youd often feel regret because the stock continued higher and continued being overbought.

This takes us to the second key of using indicators correctly. These oscillating indicators such as RSI, CCI, and Stochastics work best with the trend. The trend we were just talking about is if a stock is going up a lot, and stays in the overbought region a long while, the stocks trend is up. You can easily see if a stock is trending up or down just by looking at the chart, but you can also add moving average indicators as a guide. Most common settings for moving average indicators are the 20 period moving average (for short term), 50 period moving average (for intermediate term), and 200 period moving average (for long term). If a stock is above the reference moving average, the stock is still in an up trend. In an up trend, the best results for oscillating indicators is to only use the buy signals when the indicator turns up from the overbought region. If a stock is below the reference moving average, whatever you choose that to be, youd look at the stock as in a down trend. Thus, in a down trend, the best results for basic oscillating indicators is to only use the sell signals when the indicator turns down from the overbought regions.

When you get a chance, try these simple settings. Use a moving average to help you identify the trend. Then add one of these oscillating indicators, taking note only when there is a buy or sell signal with the trend. There maybe hundreds or more indicators people have developed, but what youll find is a few basic ones is more than enough to help you make money if used correctly! Once youre comfortable with using basic indicators well, you can tweak these indicators, which you already know, or slowly branch out to other indicators with the same approach. The important thing is finding something basic that you can do well with, build confidence, then move on. If the new approach or advanced techniques you try doesnt work, you know you can always come back to a basic method of making money with indicators.

Jeffrey lin is an individual futures, options, and stocks trader. His stock market experience helped him launch MarketHEIST.com, an magazine covering investment services and stock trading tools so consumers know what may work for their individual situations. Through MarketHEIST, Jeffrey also produces various stock market video series

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