How Technical Analysis Tools work
A Trader uses technical tools to attain insight into the supply and demand of trades. These indicators make up the footing of technical analysis. Components like the trading volume, give indications if a price trend continues or reverses. In this article, you’ll learn about the 7 best technical analysis tools needed for your trades. However, you don’t need to employ all of them in trade, you just pick the few that you find helpful in your trades.
Tools of the Trade
Day traders and technical analysts use tools that consist of charting tools. These tools produce signals that detect the entry and exit of a trade. They also indicate the price trends or patterns in the financial market.
Generally speaking, the market is divided into two main types of technical indicators.
There are:
- The Overlays
- The Oscillators
The Overlays
The overlays are technical signals that employ the use of the same order as prices are overlaid or plotted on the top of prices in a chart. Examples are Bollinger bands, the Fibonacci line, and Moving averages.
Oscillators
These are technical indicators that oscillate over time within a band. They are plotted at the top or on the bottom of a price chart. Examples are, (MACD) moving average convergence divergence, (RSI) Relative Strength Index, and Stochastic Oscillator.
We will be looking at all the listed technical indicators above.
Normally, many traders use more than one technical indicator at a time when analyzing a trade. There are several types of indicators to choose from, and they all work perfectly well when used properly. Traders need to choose the best technical analysis tool that best suits their trading plan. Traders can also use more than one indicator in a trade. For instance, a trader can be monitoring chart patterns, to form a good trade idea. Technical signals can also be used in an automated trading system depending on their quantitative system.
How Technical Analysis Tools work – Explained
1. On-Balance Volume
The On-balance volume indicator (OBV) is used to calculate the positive and negative progression of the volume of trade.
The indicator is the subtotal of the high volume subtracted from the low volume. The high volume is the highest volume on the day the trade was bullish. The low volume is the amount of volume it was the day it was bearish the most. The daily volume is summed up or subtracted from the indicator depending on if the price increases or decreases.
When OBV increases, it indicates that buyers are ready to take hold of the market and increase the price. When OBV decreases it indicates a low price, which means more traders are selling rather than buying. This indicator works as a trend verification tool. If price and OBV increase, it indicates the continuation of the trend, and trend reversal when it decreases.
Traders also use OBV to check out for Divergence. This happens when the price and signal are moving in separate directions. If the price is increasing but OBV is decreasing, it signals that the trend is not supported by tough buyers; it indicates a future trend reversal.
Calculation:
When it comes to calculating On-balance volume (OBV), there are three things you should note.
If today’s closing price shows a higher increase compared to the previous day’s closing price it is calculated as:
Current OBV= Previous OBV + today’s volume.
If today’s closing price shows a lower value than yesterday’s close price
Thus:
Current OBV= Previous OBV – today’s volume
If yesterday’s close value is the same as today’s price
Thus:
Current OBV = Previous OBV
2. Accumulation/Distribution Line
This is a technical indicator that is used to specify the money inflow and outflow of a trade.
This indicator is not so different from the on-balance volume indicator (OBV). However, it doesn’t evaluate only the price, but also the trading range for the time and where the range relates to the close. If a trade closes near its high, the signal notes an increase in volume, then when the trade finishes close to the midpoint of the range. The various analyses show that OBV will function better in some cases and A/D will do better in others.
If the signal line is bullish, it indicates a buy, since the trade is finishing on top of the midpoint of the range. This signal confirms an uptrend in a trade. However, if A/D is decreasing, it suggests that the price is closing below the point of its daily range, and therefore, there is a decrease in volume. This signal confirms a downtrend.
Traders trading with the A/D line also look out for divergence. If A/D starts to decrease and the price keeps increasing, it indicates that the trend is not strong and could reverse. Likewise, if the price is moving down and A/D starts increasing, it could indicate a future increase in price.
Calculation:
The money flow signal is evaluated by:
(Close – low) – (high – close)
The value obtained is divided by the difference between the high and the low.
(Close – low) – (high – close) / (high – low)
The final value is the money flow
3. Average Directional Index
The average directional index is an indicator trend used by traders to calculate the momentum and stability of a trend. When ADX is recorded higher than 40, the trade is said to have strong momentum, either bullish or bearish.
When the level of the Average directional index records is below 20, the trend is unstable with no momentum.
The ADX is the major line on the signal, it is usually black. The other two lines can be shown periodically. They are called DI+ and DI-. The lines are red and green respectively. The three lines work in unison to indicate the direction and momentum of the trend.
If ADX is above 20 and DI+ above DI-: it suggests an uptrend or bullish trade.
If ADX is below 20 and DI- is above DI+: It suggests a bearish trend or a downtrend.
When ADX is under 20, it shows a weak trend, always related to the DI- and DI+ quickly crossing one another.
4. Aroon Indicator
The Aroon oscillator is known as a technical tool that is used to check if a trade is trending. It focuses on indicating if new highs and new lows are reached by the price within the estimated time (normally 25).
The signal tool can be used to specify when a fresh trend is about to start. The Aroon signal tool is made up of two lines: an Aroon-down line, and an Aroon-up line.
If the Aroon-up line passes over the Aroon-down line, it indicates a future change in trend. If the Aroon-up gets to 100 and remains at or close to the level, while the Aroon-down hits near zero, it confirms an uptrend.
However, if the Aroon-down passes over the Aroon-up and remains at or near 100, it confirms a downward trend.
Calculation:
The Aroon is calculated thus:
Aroon Up minus (P – Days Since N-day High) divided by N) x 100
Aroon Down minus (P – Days since N-day Low) / N) x 100
The “p” represents the number of periods used in the indicator. Several traders always use the 14 periods.
5. Moving Average Convergence Divergence (MACD)
MACD is known as the moving average convergence divergence. This is one of the best technical analysis tools used to specify the momentum and direction of a trend. It also shows the number of trade signals.
When the MACD hits over Zero, the value is on the rise. However, if the MACD hits below zero, the price is bearish.
The signal tool is made up of two lines: A signal line and the MACD line. When the signal line crosses over the MACD line, it shows that the price is bearish. However, when the signal line crosses below the MACD line it shows that the price is bullish.
Judging from when it’s in Zero.
The signal helps to indicate which trend to trade. For instance, if the signal tool is above Zero, and MACD crosses above the signal line, it indicates a buy trend. Similarly, if the signal tool is below zero, and the MACD crosses below the signal line, it shows a sell signal.
Calculation:
The calculation will be done in 4 steps.
Step1. Estimate a 12-period exponential MA of the close price.
Step2. Estimate a 26-period exponential MA of the close price.
Step3. The 12- period moving average minus the 26- period moving average. This is the fast-moving average convergence divergence.
Step4. Evaluate a 9-period exponential MA of the fast MACD line estimated above. This is known as the slow signal.
6. Relative Strength Index
The (RSI) relative strength index serves three main purposes. The indicator moves from 0 – 100, showing present price gain versus current price losses. The relative strength index levels show the strength and momentum of a trade.
The major work of the RSI is to indicate an overbought and an oversold trade. If the RSI crosses above 70, the trade is said to be overbought, it suggests a trend reversal. When the RSI is below 30, it indicates an oversized trade suggesting a bullish trend.
However, it is not advisable to give this hypothesis. Traders need to wait for confirmation before trading the trend. The RSI needs to drop below 30 before a trader buys, and climb above 70 before a trader sells.
The RSI is used as a divergence. When the signal tool is going in a different direction than the price, it indicates a weak price about to reverse.
The RSI also indicates the Support and Resistance levels. In an upward trend, a trade price will climb above the 30 levels and touch the 70 level or above several times. When a trade is indicated to be in a downtrend, the RSI will decrease below 70 and touch 30 or below several times.
Calculation:
RSI is divided into two main features
RSI average gain
RS8 average loss
The RSI is estimated depending on the 14 periods.
Step 1:
The first average gain = the total gains over the last 14 periods divided by 14.
First Average loss = the losses in the last 14 periods /14.
Average Gain = (Previous Average Gain) multiplied by 13 + present loss) divided by 14.
Average Loss = (Previous Average Loss) multiplied by 13 + current loss) divided by 14.
7. Stochastic Oscillator
A stochastic oscillator is a technical tool that indicates the present price relative to the previous price trends over time. The signal is formed from 0 to 100, the signal indicates a new high during an uptrend. It also indicates a new low during a downtrend. The Stochastic oscillator indicates if these events are accurate.
The stochastic oscillator also indicates an overbought and oversized trade. When the value crosses above 80 it indicates an overbought trade, and when it goes below 20 it indicates an oversold trade.
The general price of the trend when employing the oversold and overbought levels should be evaluated. For instance, in the course of an uptrend, if the indicator falls to 20 and increases back above it, it indicates a buy signal. However, if it crosses above 80 and then falls below the signal line it indicates a sell signal.
Calculation:
The calculations are thus:
The Stochastic indicator is represented by %K, which is a mathematical indication of a ratio.
%K equals (today’s close value) minus (lowest value over a period) minus (lowest value over a period).
Conclusion
A trader going short aims to determine the direction of the momentum of a specific asset with the hope of profiting from it. There are many indicators and oscillators created for this particular aim. So many brokers provide their traders with these technical tools that help them make trade decisions. Before using an indicator, make sure to test the signal in a demo account. Do not start using the indicator in a live trade without knowing how it works. Choose any best technical analysis tools that fit your trading plan.
