Swing Trading for Dummies (C5): Technical Indicators

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Like chart patterns, there are many technical indicators which you can use to guide you in your trading decisions.

But not all are made equal.

Some are better suited for when a security is trending, and some are better for when a security is in a trading range. Using the wrong type of indicator will give you unreliable signals.

Also, depending on your chart's time-frame (daily, weekly, etc.) some are more reliable than others.

And just like chart patterns, no technical indicator will yield you profitable results 100% of the time. That’s why having a solid risk management plan is vital for trading success.

With all the different indicators out there, it is easy to go overboard.

Using too many indicators will put you in analysis paralysis. This is because the more indicators you use, the more likely you will get mixed signals.

The best thing to do is pick two or three indicators you are comfortable with and stick with them.

Also, be careful not to customize indicators too much. Adjust the settings to fit your overall strategy, but don’t change settings trade-by-trade. This is like forcing a puzzle piece to fit and will not end well in the long run.

Divergences are among the most accurate signals you can get from a technical indicator.

They occur when the signal from a technical indicator goes one way while the price chart goes another.

Divergences are hard to screen for, but look out for them.

Before you can decide which technical indicator to use, you need to know whether a security is trending or not.

One way to do this is by eyeballing the chart. If there are a series of higher highs and higher lows, the security is in an upward trend. If there are a series of lower highs and lower lows, it is in a down trend. And if there are clear horizontal support and resistance lines, then the security is in a trading range.

If you cannot easily determine whether a security is trending or in a trading range, then avoid it.

A chart’s time frame will affect what you see. As a swing trader, it is best to look at the daily chart.

Other than eyeballing, you can use the Average Directional Index (ADX). This indicator measures the strength of a trend. The standard setting for the ADX is to calculate over a 14-day period.

• If the ADX says that the security is 20 or below, the security is in a trading range.
• If the ADX says the security is 30 or higher, it is trending.
• For a reading between 20 and 30, incorporate the direction of the ADX to decide. If it is falling, expect a trading range. If it is rising, it is more likely to enter a trend.

The following indicators should only be used on a security that is trending.

Don't forget, only use a maximum of three.

The DMI will tell you if a security is trending, and if so, what direction it is going.

It has three plots:

• +DMI: Represents the strength of the bulls. The higher the reading, the more bullish the trend.
• -DMI: Represents the strength of the bears. The higher the reading, the more bearish the trend.

ADX: The same ADX previously discussed. It measures the difference between +DMI and -DMI, hence telling you the strength of a trend.

If the +DMI is above the -DMI, the security is in an uptrend (assuming the ADX says the security is trending.)

Most charting software calculates DMI over 14 days and uses 25 as the ADX average. Stick with this.

You can use the DMI crossovers as an exit signal, but it is not reliable as a buy signal. To make a trade, do the following:

• Confirm an uptrend
• Enter on a moving average or MACD buy signal
• Exit when the +DMI crosses below the -DMI

Moving averages are a very popular technical indicator. They represent the rolling average over a period of time. For example, a nine-day moving average averages the last nine days of price history.

The shorter the average, the faster it reacts to the market. Too short and it will generate too many signals, i.e. more noise. But too long and you won’t get enough signals to make any trades.

As a swing trader using the daily charts, use a moving average of 18-days or less.

There are simple moving averages (SMA) and exponential moving averages (EMA). The EMA responds faster because it puts more emphasis on recent price action. The downside is that it may lead to more false signals.

Always trade in the direction of the trend! With a moving average, this is the direction of its slope.

You can make trades based solely on the slope of a moving average:

• Ensure there is an overall uptrend
• Buy when the slope of the moving average turns from flat or negative to positive
• Place your stop below a recent low
• Exit when the moving average turns flat or negative

You can also trade the crossovers of moving averages. These signals will occur more frequently than slope changes. This means earlier signals. The downside is more frequent false signals.

• Plot a four-day moving average and a nine-day moving average.
• When the four-day moving average crosses above the nine-day moving average, buy
• Place your stop loss just below a recent trough
• Sell when then four-day crosses back below the nine-day, or, when the +DMI crosses below the -DMI

The Moving Average Convergence/Divergence shows the direction and strength of a trend.

It consists of several plot lines and a histogram. A rising histogram signifies bullish strength, and a falling one represents bearish strength.

The standard settings for the plot lines are a 12-day and a 26-day exponential moving average as well as a 9-day moving average to smooth out the MACD line. Stick with these settings.

When a security makes a new low but the MACD histogram fails to confirm that low, it is a positive divergence. Your buy signal is when the histogram starts turning up.

You can also trade using MACD crossovers.

• Ensure the security is in an overall uptrend
• Buy when the MACD line crosses over its nine-day moving average
• Set your stop just below a recent low
• Sell when the MACD line crosses below its nine-day moving average
• Ensure you enter or exit within 24 hours of the signal

Securities are in trading ranges more often than they are in trends. When this happens, you must use different indicators, known as oscillators.

Remember, when the ADX is below 20, the security is in a trading range. The overall strategy is to buy near the bottom of the range and sell near the top. The wider the trading range, the more potential your profit.

Stochasitcs calculates the position of today’s close relative to a specified range over time. This tells you whether a security is overbought or oversold, with the expectation that it will revert to its average.

There are two components:

• The %K plot shows how the current closing price of a security compares to its highest and lowest prices over a certain time period. As a swing trader, use a 14-day stochastics period.
• The %D plot is a three-day average of the %K plot.

A positive divergence in stochastics occurs when the price falls to a new low while the stochastics indicator traces a higher trough. When you see this, buy when the %K turns up over the %D

You can also trade on the crossovers of the plot lines. A security is considered overbought at above 80 and oversold at below 20.

• Ensure the security is in a trading range
• Wait for the %K to enter an oversold zone (below 20)
• Buy when the the %K crosses above the %D and is above the oversold zone
• Exit once the stochastic enters the overbought zone

Similar to the stochastics indicator, the RSI can tell you when a security is overbought or oversold.

The term relative strength usually refers to the comparison of one security to another. The RSI is different. It compares the security to itself over a certain number of days. 14-days is the standard setting. Stick with it.

A reading on the RSI below 30 indicates an oversold level. A reading above 70 indicates an overbought level.

Although not common, the RSI can also form chart patterns, such as the cup and handle, which can be interpreted and traded in the same way they are in the price charts.

When the RSI fails to confirm a new high or low in a security’s price, you have a divergence. To trade a divergence:

• Confirm the trading range and the divergence
• In the case of a positive divergence, wait for the RSI to turn up and then enter a position
• Keep a tight stop loss below a recent trough

Another way to trade on the RSI is by using the overbought and oversold zones.

• Confirm the security is in a trading range
• Wait for the RSI to enter the oversold zone (below 30)
• Buy when the RSI turns up from an oversold reading and though the oversold zone
• Exit when the RSI reaches the overbought zone

When you combine chart patterns with indicators you will increase your accuracy for picking winning trades.

Choose a few indicators and patterns you are comfortable with and only enter trades when at least one chart or candlestick pattern matches up with the technical indicator.

Read the next chapter here.

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