There’s one question I get asked all the time…
What’s the “best” indicator I can use to attack the market?
To be honest with you, there is no be-all and end-all indicator out there.
I believe it’s important to understand price action first, and then utilize a handful of tools that work for you.
Listen, with the market the way it’s acting, it’s important to have a few weapons in your toolkit to generate trade ideas…
Whether they be bullish or bearish.
That’s why I want to show you some of the most widely used tools by professional traders and reveal how they can help you attack the market.
Let me explain to you what technical indicators are, first.
They’re a set of chart tools that in some shape or form are used by the masses. While there’s no bullet-proof indicator, when you combine a few indicators… they can help with trading decisions.
Today, I’ll go over three indicators that many traders find helpful… and how you can use them to your advantage.
Moving Average (MA)
Moving Averages is a general name of a popular family of technical indicators. While the concept is nothing new, to this day various MAs remain a popular tool among active traders of all styles.
The basic idea behind the indicator is to average out extreme stock fluctuations and plot a relatively smooth price line, allowing us to visualize bigger picture trends and identify support/resistance areas.
(AAPL hourly chart with 13, 30 and 200 days SMAs. The blue 30-day MA is a major support area)
The price of a stock is averaged over any period of trader’s choosing – from minutes to days and even weeks. Some of the more popular MAs are 10, 15, 30, 50, 100, and 200-day moving averages. The shorter the period – the more sensitive the price is to momentary fluctuations.
There are 2 MAs most traders look at to make trading decisions:
- Simple Moving Average(SMA)
Calculated as a simple mean of stock prices in a given period. SMAs are slower to react to price changes and help see bigger picture trends and higher time frame support/resistance areas.
- Exponential Moving Average(EMA)
EMA is SMA with a “smoothing factor”, that gives more weight to more recent values. Thus, EMA is quicker to respond to recent price changes.
In practical everyday terms, MAs can be useful reference points when looking for entry points and stop-loss levels.
Going back to the AAPL chart from above, it’s not hard to notice that each time the price touched 30 days SMA it steadily bounced right off shortly thereafter, providing an obvious trade opportunity.
TSLA chart above is a good example of using MA’s to spot trend reversals.
First, notice the same steady support/resistance areas(highlighted in yellow) as we’ve seen with AAPL.
However, this time also note the first blue arrow – a gap up above prior MAs(resistance areas) led to a powerful trend reversal and a steady up move followed, while prior resistance turned into support.
Then, just yesterday, on the second blue arrow, TSLA aggressively broke below 13- and 30-day MAs. Could this be another trend reversal, and the start of a long-overdue TSLA pullback?
VWAP (Volume Weighted Moving Average)
This indicator has been widely popular among intraday traders. The name is pretty self-explanatory: VWAP is a function of price and volume.
It is generally used on intraday charts and has several purposes:
- Identifying the direction of momentum
- Improving timing of entries
- Generating trading ideas
Let me explain how VWAP can be helpful to your trading in more detail:
1. Identifying the direction of momentum:
Often, traders will have a trading idea before the market opens. Whether it is getting long a strong stock or shorting a parabolic high-flyer, VWAP will provide an idea about which side the momentum is on.
Consider the chart above: on 8/31/2020 some traders were looking to short “overbought” TSLA after the stock split. However, after 10:00 am the stock never traded below VWAP. If you were looking to short TSLA in the morning of that day, VWAP would have shown you that the momentum is still to the upside. Some traders even have hard rules like not buying (shorting) stocks that are above (below) VWAP after 11:00 am.
2. Improving the timing of entries and exits:
Generally, stocks do not go up or down in a straight line. They will generate pullbacks along the way which allow for a safer entry with defined risk. Sometimes, VWAP serves as an area of support for strong stocks which are holding above and an area of resistance for stocks holding below. Next time when you watch a stock pull back, see how it acts around VWAP. It might help you find safe entries with the primary trend. Again, on the chart above we can see how TSLA held VWAP on 8/31/2020 which could be an excellent entry point for a long trade.
3. Generating trading ideas:
Since we know that VWAP indicates average positioning of participants in a stock, you can generate trading ideas around it. For example, on 9/1/2010 we could see that TSLA was having a hard time holding above. When the blue trendline broke down and price was below VWAP, you could have used these pieces of information to put on a short trade.
RSI (Relative Strength Index)
Last, but not least, The Relative Strength Index is a momentum oscillator that indicates strength or weakness of the stock.
It averages % changes in price for a period and identifies times when the stock is overly extended to either side.
When RSI gets to extreme values like below 20 or above 80, stock might be considered oversold or overbought, respectively. This indicator is usually used to time entries and exits.
Consider this scenario: on 9/2/2020 you are short TSLA off the open and start looking to book some profits. RSI would have given you an indication that the stock is getting oversold and likely to bounce. Blue arrows on the chart above point to RSI at 17 and those spots would be places to take off some risk.
It is generally considered best practice not to buy stocks that are overbought and not to short stocks that are oversold. However, this can largely vary on a specific strategy and the type of market we are in.
Practice shows that a lot of value can be found in using technical indicators. However, it’s important to remember that none of them should be solely relied upon.
Find ones that work for your style, use them with caution, and keep your risk in check when things don’t go your way.