Popular Chart Indicators that You Should Know About: Part 1
In simple words, chart indicators are technical tools that help traders analyze the market scenario using price charts. You can use them to understand past and present actions and even apply them to forecast future trends to strengthen your trading strategies. There are a variety of chart indicators available for traders to perform technical analysis. Read further to understand what Bollinger Bands, Keltner Channels, and the MACD indicators are and how you can use them to make trade effectively.
Created by John Bollinger, Bollinger bands are trading indicators that measure the market volatility using the high and low prices with respect to the historical prices. The bands are a type of chart overlay that appears over the price line for an asset. Standard deviation is applied to check for the rise or fall in market volatility. The standard deviation expands or contracts in the band to denote various levels of volatility. A highly volatile market has wider and broader bands, whereas a less volatile market has relatively thin or narrow bands.
The upper, the middle, and the lower band together form the Bollinger bands. The upper and the lower bands are set at twice the standard deviation’s distance from the middle band, which is a moving average line. The default time period for most charts is 20-period, traders are advised to experiment with the moving average periods once they have some experience with using the bands. Shorter periods work well for day traders, whereas longer periods work more efficiently for long-term traders.
The Bollinger bands are a great tool to check for overbought or oversold signals. Prices are deemed overbought when they touch the upper band, and they are regarded as oversold when they touch the lower band. Since the bands oscillate between extreme market values, traders can develop entry and exit strategies using support and resistance levels.
The price reaching from the middle to the top is a buy signal, whereas reaching for the bottom is a sell signal for traders. When the bands work contrary to the price movement, it can lead to divergences, resulting in trend reversals in the market.
Here is an example of Bollinger Bands. The upper and lower bands are denoted using a red line above and below the candlesticks. The middle band is set for a 20-period moving average. The distance between these bands at different points determines the ongoing price deviation in the market.
Much like Bollinger bands, Keltner channels are also made of three individual lines. Here, the middle line is made using an exponential moving average, which uses weighted values of recent price changes to measure the MA.
The Keltner channels use the Average True Range (ATR) to measure market volatility for different securities. The bands expand when they experience high volatility and contract when they experience low volatility. The lines above and below the EMA are set at 2 ATRs apart from the EMA line. The default time periods for Keltner channels are generally 20-period EMAs. Traders are free to customize this value while using this indicator.
Created by Chester Keltner, the Keltner channels are a great indicator to check for trend reversals and market divergences. Traders can also use them to observe overbought or oversold pricing conditions for assets. They are a type of lagging indicator, which means that they make use of past price data to generate conclusions.
The movement of the channels informs the traders about price behavior. In the example above, the rise in channels denotes an uptrend, while a fall in channels denotes a downtrend. When the price remains steady for some time, the channels move sideways. Movement above or below the perimeters of the trend represents very strong trends. This generally happens when a trend is about to end, and another trend is about to start.
The Kelter channels give smoother lines than the Bollinger bands. This happens because the standard deviation registers more volatility than the average true range. Using average true range filters out irrelevant price fluctuations from the channels.
The Keltner Channels can be computed using the following formulae:
Upper Band = EMA + 2(ATR)
Middle Band = Exponential Moving Average (EMA)
Lower Band = EMA - 2(ATR)
The Keltner channels overlay on a candlesticks chart.
The moving average convergence divergence is a lagging indicator that analyzes the behavior of price using two or more moving averages. It is a momentum-based indicator and works on price fluctuations to derive market analysis.
It is an effective indicator to observe the beginning of a new trend for two moving averages. Convergence happens when these two averages meet or cross each other, and divergence occurs when the averages move away from each other. Traders can also use MACD to generate buying and selling signals. Depending on the speed of the indicator, traders can also notice overbought or oversold signals.
This indicator makes use of exponential moving averages. Exponential moving averages are calculated using weighted values of recent price fluctuations. The MACD line is created by measuring the difference between the 26-period EMA and the 12-period EMA. An important aspect of the MACD is the signal line, which is basically a 9-period EMA.
MACD Line= 12-Period Moving Average - 26-Period Moving Average
Signal Line = 9-period EMA
When the movement of the MACD line is above the signal line during convergence, it is a buying signal. When the movement is below the signal line during convergence, it is a selling signal. Using the moving averages of past values, the MACD is able to filter out irrelevant price fluctuations and useless price action for traders. This adds to the lag but gives a good trend analysis.
A regular MACD is made up of the signal line, the MACD line, and the histogram. The histogram accounts for the difference between the values of the MACD line and the Signal Line. A smaller histogram means that the distance between the two fast and slow averages is less. When the size of the histogram grows, the difference between the two moving averages also grows.
No indicator provides a foolproof reading - before using any indicators, traders are advised to check for their limitations as it can lead to false signals. It is best to use them in a group of two or three uncorrelated tools to develop proper market analysis. Traders also need to understand the working of indicators properly to adjust them for different market situations. The default settings of indicators should be customized for different securities and market situations.