Financial markets are notoriously fickle. Trying to time the market is a difficult task that few non-professional investors do with repeatable success. Still, there are some ways to make more educated investment picks based on publicly available data.
Once an investor selects which securities to buy, how do they decide a good price to enter into a trade at? One of the simpler ways to make a more informed decision regarding when to buy or sell a stock involves using trend indicators.
Trend indicators give investors a sense about which direction the market has moved and for how long it has been heading that way. Trend analyses aim to anticipate futures based on previous patterns in buying, selling, and pricing over time.
Understanding Trend Indicators
Trend indicators are an aspect of technical analysis. Technical analysis uses either computer-generated mathematical information (indicators) or looking for visible patterns in the charts of stock prices.
This investment approach isn’t guaranteed and doesn’t always boost investors’ returns. But, trend analysis can provide investors with one way to try to appraise the market’s next move.
Although technical analysis involves the use of objective data rooted in mathematics and historical price movements, this kind of analysis also relies on human interpretation of that data.
So, it can be said that using indicators and patterns involves aspects of both art (aka interpretation and intuition) and science (aka data and math).
Commonly Used Trend Indicators
Here’s an overview of five commonly used trend indicators that investors may want to look into:
1. Moving Averages
A “moving average” (aka MA) is defined as the mean of time series data. In finance, this technical trading term means the average price of a security (aka a monetary instrument, like stocks, with monetary value)—as calculated over a certain timeframe.
When prices begin trading above a moving average, this can sometimes be seen as a bullish signal, but doesn’t always produce reliable returns over time. A much stronger signal comes when two moving averages of different time lengths cross paths.
When a shorter-time-frame moving average crosses above a longer-time-frame moving average, the move is referred to as a “golden cross.” The general consensus among traders is that the most significant golden cross involves the 50-day MA moving above the 200-day MA. Put another way, it’s when a security’s short-term average is heading above it’s long-term valuation average.
While a single moving average can convey some important information, MAs can be much more useful when used in conjunction with additional MAs of different lengths or with other trend-following indicators.
2. Relative Strength Index (RSI)
The Relative Strength Index (aka RSI) provides insight into whether a security might be overvalued or undervalued. This indicator oscillates between extremes, which is a fancy way of saying that it moves up and down.
The RSI is as straightforward as they come. It’s represented by a single line plotted on a graph with values that range from 0 to 100.
The higher the Relative Strength Index value, the more overbought a security is thought to be. In contrast, lower values are generally thought to indicate oversold conditions. So, for some investors, a low reading on the RSI could signal a potential buying opportunity.
Just how low should this indicator drop before it can be considered a buy signal? The answer to this question might depend on who you ask.
Fortunately, there is an easy way to estimate when the RSI becomes overextended in either direction. Between 30 and 70 is a shaded area sometimes called “the paint.” When the line breaches this zone, it’s thought that trading momentum in a given security has begun to reach its limits, and a trend reversal could be in the cards soon.
In other words:
• an RSI reading of below 30 is generally thought to indicate oversold conditions, meaning prices could be getting ready to move higher sometime soon.
• An RSI above 70 is generally thought to indicate overbought conditions, meaning a move downward could be coming soon.
As with most other trend following indicators, the RSI works best when used in conjunction with other metrics of a stock’s overall trading sentiment.
3. Moving Average Convergence Divergence (MACD)
The Moving Average Convergence Divergence (aka MACD) illustrates the relationship between two moving averages. While the Relative Strength Index (aka RSI) noted above tracks changes in pricing in a single stock or asset (typically represented as a fluctuating line graph), the MACD shows two lines in addition to a histogram that indicates trend strength.
This indicator is used in a similar way as the RSI, although there is a little more information contained in the MACD. Both indicators are known as momentum indicators because they try to gauge the strength of a trend.
Whereas the RSI oscillates between 0 and 100 based on average price gains and losses over a set period, the MACD measures the relationship between two exponential moving averages.
Subtracting the 26-period Exponential Moving Average (EMA) from the 12-period EMA is how the MACD is calculated. This calculation results in the MACD line. A nine-day EMA of the MACD, which is often referred to as the “signal line,” is shown on top of the MACD line. The lines are plotted atop a histogram meant to give traders an idea of momentum strength.
As with most trend indicators, there are multiple ways to interpret the MACD. One of the most common interpretations involves the MACD crossing its signal line.
A cross above the signal line is considered to be a potential buy signal, while a cross below the signal line is considered to be a potential sell signal.
4. On Balance Volume (OBV)
On balance volume (OBV) is a measurement of the selling and buying pressure on a given security. Volume gets added on up days and subtracted on down days.
On a day when the security closes at a higher price than its previous closing price, all of that day’s volume is considered upward volume. When the security closes lower than its previous closing price, that day’s volume is considered downward volume.
The numerical value of the OBV isn’t really important – it’s the direction that counts. Declining volume tends to indicate declining momentum and price weakness, while increasing volume tends to indicate rising momentum and price strength.
While the RSI is an indicator that signals bullishness when weak, OBV works in the opposite way. One of the most striking signs of a potential pullback in price can be seen using OBV. This can happen when the price of a security continues making higher highs even as OBV stalls or begins declining.
When this happens, it’s referred to as a negative divergence, and may mean that fewer traders are pouring money into a trade—potentially indicating that prices could start falling.
Here are a few other quick notes about OBV:
• When both OBV and price make higher highs and higher lows, there’s a higher likelihood that the upward trend may continue.
• When both OBV and price make lower highs and lower lows, it’s likely the trend could continue.
• When prices are confined to a tight range, and OBV is rising, this may signal a period of accumulation. An upward breakout could be on the horizon.
• When prices are confined to a tight range, and OBV is falling, this may signal a period of distribution. A downward breakout could be on the horizon.
5. Average Directional Movement Index (ADX)
The ADX is another trend indicator that aims to measure trend strength. It works by averaging the differences in price range over time. So, if an asset’s price barely move from day-to-day, the ADX will show a lower reading—while a big change in price will show a higher reading.
The Average Directional Movement Index is represented by a simple line graph beneath a stock chart. This trend line is even easier to use than most. It’s thought that an ADX above 25 indicates a strong trend and an ADX below 20 indicates little to no trend.
Here are some notes about potential ways to interpret the ADX:
• When the ADX nosedives from a high point, it could signal a coming trend reversal.
• A downward trend in the ADX could suggest that trends are dissipating overall. And, so, using any trend-following indicators could prove less reliable.
• If the ADX rises by 5 points or more after a long period of staying low, this could be interpreted as a trade signal (a time to potentially buy or sell, depending on the direction of price movement).
• A rising ADK generally means the market is entering into a stronger trend. The slope of the ADX line will be steeper when prices change faster. Steady, gradual trends tend to lead to a flattening of the ADX.
Keeping Tabs on Market Trends
There’s an old saying among traders—“the trend is your friend.”
Simply put, trends tend to keep moving in a certain direction when they have enough momentum. That’s why traders try to take note of them by studying trend-following indicators.
Trend indicators are a key way that many traders try to discern things like:
• Which way a trend is moving
• How strong that momentum is
• How long the trend is likely to continue.
Some traders even go as far as trying to pick the exact time when a trend will change, using advanced strategies like options and futures contracts to try and profit from market volatility.
For most novice investors, adopting this kind of exact-timed technical strategy could prove highly risky, and might not always be necessary to earn returns over time. Individual investors might find it easier to use trend indicators to try determine when to buy and sell orders.
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