In this article we will look at three key indicators used to identify and trade trends: moving averages, stochastics (and RSI) and On Balance Volume (OBV).
Moving Averages
Moving averages are important indicators used to analyze price movement and trend direction.
Moving averages are simply the average of the closing price of a trading security over a given period of time. They are used to understand price action during a specific period of time, in order to identify overall trends.
Because they are based on past price action, moving averages are considered lagging indicators.
There are two types of moving averages that are generally used by traders and investors:
- Simple Moving Averages (SMA)
- Exponential Moving Averages (EMA)
SMA is calculated by adding the closing price of a trading security during a specific period of time and then dividing by the number of days of that trading period.
For example, when we look at the 21 SMA, we look at the average price of stock during a 21-day period. We add the closing prices and we divide that number by 21. The result of that produces the value of the SMA.
As new price data becomes available and is added to the moving average, the value of the SMA shifts forward every day. SMA always uses the last available data for that specific period of time. SMA gives the same weighting to all price data values, regardless of whether that price occurred two days ago or 20 years ago.
EMA is also calculated by adding the closing price of a trading security during a specific period of time and then dividing the number of days by that the trading period. However, while SMA gives equal weighting to all price data values, the EMA assigns higher weighting on more recent price data values.
Because EMA considers recent data more relevant compared to the historical data calculated by SMA, EMA gives faster and clearer buy and sell signals than SMA. However, because of the heavily weighting on more recent data, EMA are also more susceptible to giving false buy and sell signals. For this reason, we recommend using SMAs in combinations with EMAs.
Watch this video to learn how to use moving averages.
Stochastics and RSI (Relative Strength Index)
Stochastics and RSI are trend oscillators used to identify overbought and oversold conditions.
Overbought simply means that the stock price has reached a temporary top and buyer are most likely ready to come in and buy shares.
Oversold is the opposite. Stock price has reached a temporary bottom and sellers are most likely ready to come in start closing positions or go short.
When the lines of the oscillator cross above 80 and higher the stock is overbought. Get ready to sell and close positions.
When the lines of the oscillator cross below 20 and lower the stock is overbought. Get ready to buy.
On Balance Volume (OBV)
In addition to volume, the On Balance Volume (OBV), is a very important indicator that give us a one-line easy visualization of whether volume is increasing or decreasing during a specific timeframe.
The OBV indicator measures cumulative buying and selling pressure, which is calculated by adding volume on gaining days and subtracting volume on losing days.
OBV is used to confirm the trend.
If price is gradually increasing, we should expect the OBV to also be increasing. This indicates that price is in an uptrend.
On the other hand, if price is decreasing, and we should also see a drop in OBV. This indicates that price is in a downtrend.
OBV Divergence
Another aspect to consider when looking at OBV, is whether or not we are in the presence of a divergence.
As long as the OBV makes higher low, the possibility of price to be making higher highs (uptrend) is greater.
But when the OBV shows divergence, meaning price continues to move up while OBV begins to move down, then we might be in the presence of a reversal.
Conclusion
Keep in mind that is you need more than just one or two indicators to confirm your trading entry and/or exit strategies.
In your analysis you need to see where support and resistance is and how price behaves around these areas. Also pay attention to candlestick formations that indicate reversals as well as technical patterns such as consolidations and breakouts.
Good Trading!
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