Indicators Explained: What Are Trading Indicators?
When entering the volatile world of CFD trading, making the use of different trading analytical tools is crucial in order to help form an understanding of critical underlying market dynamics that can be applied to your personal trading strategy. One key category of tools is that of indicators. Below, we will delve into what indicators are, their diverse subtypes, and how they may be integrated into your trading style.
What Are Indicators in Trading?
At their core, trading indicators are mathematical formulas applied to the price and volume trading data of a security. Traders rely on these indicators to gain deeper insights into the market’s current state and to spot potential trading opportunities. By analysing patterns and trends revealed by these indicators, traders can make more strategic decisions. For example, technical indicators help traders identify market trends and detect overbought or oversold conditions. A solid grasp of these indicators can be invaluable when constructing an effective trading strategy.
Importance of Trading Indicators
Trading indicators play a crucial role in CFD trading, serving as an additional tool for analysing market conditions and helping in making more informed investment decisions. These indicators utilise mathematical calculations based on historical price action and trading volume among other things to forecast future price movements, thereby providing traders with signals for potentially entering and exiting trades. By understanding and interpreting the wealth of information provided by technical indicators, CFD traders, whether new to this market arena or seasoned, may be better placed to implement their trading plans and make adjustments as needed.
For CFD traders, charting tools can be utilised for generating buy or sell signals and identifying market trends or patterns. These tools broadly fall into two categories: overlays and oscillators.
Overlay Indicators
Overlay indicators are technical tools that are plotted directly on top of the price data on a stock chart. Since they use the same measurement scale as the prices, they provide a visual representation of how the indicator interacts with the price movements. Later on, we will take a more in-depth look at the different subcategories that fall under the 'overlay' umbrella.
Oscillator Indicator
Unlike overlays, oscillators are technical indicators that oscillate between a local minimum and maximum value. These indicators are typically plotted above or below a price chart, rather than directly on it. Oscillators are particularly useful for identifying overbought or oversold conditions in the market.
Leading Indicators
In CFD trading, technical indicators are divided into two main categories: leading indicators and lagging indicators. These indicators attempt to predict future price movements by analysing market data over a shorter period, thus leading the price movement.
Leading indicators are valuable because they can alert traders of potential market reversals or new trends early. However, this early warning system comes with the risk of generating false signals, as these indicators can sometimes predict movements that do not, in the end, come to fruition. Therefore, it can be highly beneficial to use leading indicators in conjunction with other analytical tools, such as candlestick patterns, classic chart patterns, and support and resistance levels.
Using leading indicators can be particularly effective in sideways or ranging markets, where price movements are not strongly trending in one direction. By identifying these conditions early, traders can better position themselves to potentially capitalise on upcoming price shifts.
Lagging Indicators
Lagging indicators, also known as trend-following or trend-confirming indicators, provide signals after a trend or reversal has begun. These indicators are based on historical price data and help traders ascertain the direction of the market, assisting them in the effort to align their personalised trading strategies with established trends.
Lagging indicators are beneficial for reducing risk because they can help traders avoid false signals that might occur with leading indicators. However, the downside is that they tend to generate signals later in the trend, meaning traders might miss the initial phase of the price movement. Despite this delay, lagging indicators are effective for maintaining positions within the prevailing trend, helping traders stay on the right side of the market.
Types of Trading Indicators
Within the broader typology that we’ve explored above, there are a plethora of different categories of technical indicators, each with their own characteristics and uses within the CFD trading arena. Here are some of the key indicators that you may encounter, and even make use of when performing technical analysis, on your CFD journey.
Momentum Indicators
Momentum indicators are essential tools in technical analysis, and are widely used by traders to gauge the rate of price change of a security. The core idea behind momentum indicators is that a security’s price tends to continue moving in its current direction until there is a significant shift in market sentiment or trend. This can help traders identify when a trend is weakening and anticipate potential trend reversals.
Momentum indicators help traders assess the strength of a price movement and determine overbought or oversold conditions. By analysing these indicators, traders can gain insights into potential buying and selling opportunities. However, it is important to remember that momentum indicators should not be used in isolation. They are more effective when combined with other technical analysis tools and supplemented with fundamental analysis.
Key Momentum Indicators
- Relative Strength Index (RSI): The RSI helps indicate whether a given asset may be overbought or oversold by measuring the shifts in its price over time. An RSI value above 70 typically indicates that a security is overbought, signalling a potential selling opportunity. Conversely, an RSI value below 30 suggests that a security is oversold, indicating a potential buying opportunity. By monitoring the RSI, traders can make more informed decisions about entering or exiting trades based on the strength of the current price trend.
- Stochastic Oscillator: The Stochastic Oscillator compares a security’s closing price to its price range over a specified period, providing insights into potential market reversals. This indicator oscillates between 0 and 100, with values above 80 indicating overbought conditions and values below 20 indicating oversold conditions. The Stochastic indicator can help traders identify potential buy and sell signals by highlighting when a security’s price is near its high or low relative to its recent trading range.
Momentum indicators are valuable tools in CFD trading for assessing the speed and strength of price movements. By identifying overbought and oversold conditions, these indicators can signal potential entry and exit points. However, traders may be well-advised to implement the use of momentum indicators as part of a broader trading strategy that includes other technical and fundamental analysis techniques. Furthermore, even when implementing the use of indicators, financial losses are an ever-present risk given the ultimate unpredictability of market phenomena.
Trend Indicators
Trend indicators help traders identify and follow the direction of an underlying security's price movement. A trend represents the general direction in which the price is moving, providing traders with potential opportunities for profit. By using trend indicators, traders can make better-informed decisions based on the identified direction of the market.
Trend indicators not only help identify the direction of the trend but also signal potential trend reversals. For instance, changes in trend lines or crossovers in the MACD (Moving Average Convergence Divergence) indicator can indicate a trend reversal, potentially allowing traders to adjust their strategies and make trading decisions accordingly, although a positive trading outcome is never guaranteed.
Key Trend Indicators:
- Moving Average (MA): Averages the price of a security over a set period, smoothing out price fluctuations and clarifying the trend direction.
- Ichimoku Kinko Hyo: Despite its complex appearance, this Japanese indicator is a comprehensive tool that shows current trends, support/resistance levels, and potential trend reversals.
- Average Directional Index (ADX): Measures the strength of a trend without indicating its direction. It helps traders determine whether the market is trending or ranging, making it an effective filter for trend-based or range-based strategies.
- Parabolic SAR: A price-and-time-based system that tracks the trend direction. The indicator trails the price and reverses its position when the price trend changes, assisting traders in identifying potential entry and exit points.
Each of these indicators reflects market trends in a unique way and may provide a useful addition to a trader’s toolbox.
Volatility Indicators
Volatility indicators can become a very useful tool for the CFD trader, as they measure the magnitude of price fluctuations of a particular underlying asset. High volatility indicates large price swings, while low volatility suggests more stable prices. Understanding the volatility level of a CFD's underlying asset can be critical when deciding to open a position, as this factor can impact trade size, stop-loss, and limit levels.
Key Volatility Indicators:
- Bollinger Bands: Bollinger Bands consist of three lines plotted on a chart: a 20-period simple moving average (middle band) and two outer bands drawn two standard deviations above and below the middle band. Wider bands indicate higher volatility. This indicator is versatile and applicable across various types of assets when the trader seeks to understand its current price in relation to longer-term trends.
- Average True Range (ATR): The ATR measures the average distance between the high and low prices over a set number of bars. It is expressed in pips, with higher values indicating greater volatility.
- Standard Deviation: Standard deviations quantify the size of price movements and helps traders gauge the likelihood of future volatility. While this measure does not predict price direction, it indicates the extent of price fluctuations. By comparing current to historical price movements, traders can infer potential volatility patterns.
These volatility indicators provide critical insights into market dynamics, helping traders make better-informed decisions with regard to their level of risk tolerance, since when trading CFDs the risk of significant financial losses can never be fully eliminated.
Support & Resistance Indicators
Two key concepts often used in trading are support and resistance levels. A support level can be understood as the price point at which the price of an underlying asset on a downtrend tends to stop, reverse, and begin to rise. Conversely, resistance levels are the point at which the price of an asset, which has been rising, ceases its climb and shifts back downwards.
Gaining a solid grasp of these concepts are important for CFD traders who wish to take a wider view of price trends, and therefore indicators that show support and resistance levels are fundamental concepts in technical analysis.
Key Support and Resistance Indicators
- Trendlines and Channels: These are lines drawn above and below recent price action, indicating high and low prices over an extended period, and can function as an illustration of dynamic support or resistance levels.
- Fibonacci Retracement: Fibonacci retracements are generally used to identify the extent to which a market might move against its current trend. They help traders and market watchers to ascertain potential levels of price support and resistance during market shifts. This indicator class has the potential to assist CFD traders in determining where to place stops, limits, and to make decisions on opening or closing positions.
- Pivot Points: This type of indicator is widely used by participants in various markets including equities, commodities, and Forex. Pivot points are calculated using a formula based on the high, low, and close prices of a given past period, and can indicate potential support and resistance levels, beyond which an asset's price is unlikely to shift.
How Are Trading Indicators Used?
CFD traders can integrate the trading indicators to analyse the market conditions of an underlying asset on which they wish to trade, and thus have access to more information that may be key when making trading decisions. By understanding and interpreting these indicators, traders can develop better trading strategies, determining optimal entry and exit points. Whether using overlays or oscillators, trading indicators are essential for generating buy or sell signals and recognizing market patterns, potentially enabling traders to navigate the volatile world of CFD trading, albeit the ever-present risk of trading losses.
Example of Trading Indicators
Now let's take a look at how a CFD trader could make use of a technical indicator when trading share CFDs.
Mary, a CFD trader, wants to integrate volatility indicators into her personal trading strategy, so she studies Bollinger Bands before opening a position on Apple (AAPL) shares. Bollinger Bands show an underlying asset’s price deviation from the average of a longer period, and help Mary identify what may possibly be overbought and oversold conditions in the market.
One day, Mary observes that Apple's share price is touching the lower Bollinger Band, indicating that the stock might be oversold. Based on her analysis, she decides to open a long position, anticipating a price rebound. The price soon begins to rise and moves towards the middle band. Mary holds her position until the price reaches the upper Bollinger Band, suggesting it is probably overbought. She then closes her position, securing a profit.
In another instance, Mary notices Apple's share price breaking above the upper Bollinger Band. She decides to open a short position, expecting a price drop. However, instead of reversing, the price continues to climb due to unexpected positive news about Apple. The share price keeps moving higher, causing Mary to incur a loss as she eventually closes her position to prevent further losses.
Through these scenarios, Mary demonstrates how Bollinger Bands can be a valuable tool in her trading strategy, while also highlighting the inherent risks associated with CFD trading and the importance of staying informed about market conditions.
It is important to highlight that, while indicators provide valuable insights, they should be used in conjunction with other analysis methods as they shall not be interpreted as providing trading signals.
Conclusion
In the dynamic realm of CFD trading, making use of indicators can be a key step in gaining an ever-deeper understanding of market dynamics and trading strategy adaptation. These mathematical formulas, applied to price and volume data, offer insights into market states and potential trading opportunities. By interpreting patterns and trends revealed by indicators, CFD traders, whether experienced traders or beginners in this market sphere, have access to important information that may be useful when trading with Plus500.
FAQs
Are technical indicators reliable?
Technical indicators can provide insights into market conditions, but their reliability depends on various factors such as market volatility, timeframe, and the specific indicator used.
Why should I use trading indicators?
Trading indicators help traders analyse market conditions, identify trends, and spot potential trading opportunities, although CFD trading always includes the risk of financial losses, whether indicators are used or not.
What should I know before using trading indicators?
Before using trading indicators, it's essential to understand their underlying principles, strengths, limitations, and how they align with your trading strategy and risk tolerance.
Can I trade with indicators only?
While trading solely based on indicators is technically possible, it's generally advisable to complement indicators with other forms of analysis, such as fundamental analysis and the assessment of market sentiment, for a more comprehensive trading approach.
How many indicators should a trader use?
There's no fixed number of indicators a trader should use; rather, it depends on his or her individual preferences, trading style, and the complexity of their trading strategy.
What are the most commonly-used trading indicators?
Some of the most commonly-used trading indicators include moving averages, relative strength index (RSI), stochastic oscillator, Bollinger Bands, MACD (Moving Average Convergence Divergence), and Fibonacci retracement levels. These indicators help traders assess market trends, momentum, volatility, and potential support/resistance levels.
