A Guide to Most Common Technical Indicators for Beginners: The most common problem for anyone willing to use the technical indicators, is to select the indicator which is the easiest and commonly used. This problem also arises because of the availability of hundreds of indicators.
Through this article, we aim to solve this problem. Here, we try and understand the two most common technical indicators that are comprehensive yet easy to use. We will be understanding the concept of moving averages and Bollinger bands. By the end of this article, we are sure that you would have a clear understanding of these indicators. Let’s get started.
Most Common Technical Indicators for Beginner
1) Moving Averages
Moving average is the most simple and commonly used technical indicators. If we read any research report or any article on technical analysis, the most commonly used technical indicators is the Moving average. There are generally two types of Moving averages – Simple Moving average and Exponential Moving average, which we’ll discuss later in this article.
In simple terms, a moving average creates a series of averages of different subsets of the full data set in order to analyze data points. To illustrate it with the help of an example:
In a game of cricket, if we were to analyze the performance of a batsman, consistency is the most common parameter. And the best way to analyze the consistency is the average number of runs scored by the batsman in each innings. For example, if the batsman scores 1,000 runs in the 20 innings, then the average number of runs scored by him in each innings is 50. This simple method of calculating the average is also known as the Simple Moving Average.
Moving Average is said to be a lagging indicator as is it is constructed with the help of the data, which is the End of day prices. Let us understand the concept with the help of a simple example:
Consider the following closing prices of shared of ITC limited:
Therefore, the average price of shares of ITC limited over 5 days will be = 920/5 = Rs. 184.
The average price changes as the closing price the next day changes. Imagine if the closing price of ITC on the next day changes to 185, then the 5 days simple moving average of ITC limited will also change.
The moving averages can be calculated for any timeframe. It could be 5 minutes, 15 minutes, hours, days, weeks, and so on. Depending on one’s trading style and trading objective, one can choose the charting pattern. If we are using 13 observations within the selected time frame, it is called 13 SMA, and if we are using 34 observations within the selected time frame, it is called 34 SMA and so on.
The daily chart shown below is that of Infosys limited and the red line plotted is 50 SMA.
If we carefully look at the chart above, 50 SMA clearly divides the chart into two halves. Till the end of April, the bears were having a higher say and 50 SMA was acting a resistance of the market. Any move till the red line was seen as an opportunity to short.
However, once the market closed above 50 SMA on daily basis, it started acting as a support to the market. Any move towards 50 SMA was seen as an opportunity to buy in the market. So, it can be summarized that if the market is trading below SMA, it is taken as an opportunity to sell or short in the market and if the market is trading above it, can be seen as an opportunity to go long.
— Exponential Moving Average
This is the more advanced and more trusted form of moving average. The main difference between EMA and SMA is the weightage given to values. In a simple moving average, all the values are given equal weightage. But in the case of Exponential Moving Average, the more recent values are given more weightage.
The chart below is the daily chart of Kotak Bank and the red line plotted is the 50 EMA.
If we carefully analyze the chart above, 50 EMA gives a better signal of buying and selling. If the market is trading above the EMA, it can be taken as an opportunity to buy and the level below this line can be kept as a point of stop loss for this trade.
Similarly, if the market is trading below EMA, it can be used as an opportunity to short in the market and the level above it can be kept as a point of stop loss.
Why EMA is more preferred?
The simple answer to this question is that EMA gives comparatively less false signals (than SMA), as the more recent values are given higher weightage.
2) Bollinger bands
The concept of Bollinger bands was introduced by John Bollinger in 80’s. This is the most common technical indicator and widely used by traders while making day to day trading decisions. With the help of Bollinger bands, we can understand if the price of an asset is trading at overbought or oversold levels.
When the price is overbought, it is generally an indication to sell and when the price is oversold it is generally an indication to buy.
Components of Bollinger bands:
- The Middle line, which is a 20 day Simple Moving Average
- The Upper Band which is a 2 Sigma (i.e. 2 Standard Deviation of the middle line)
- The Lower Band which is a 2 Sigma (i.e. 2 Standard Deviation of the middle line)
Note: The upper and the lower band can also be 3 Sigma i.e. 3 standard deviation of the middle line.
But before understanding the Bollinger bands, it is important to have a brief understanding of the concept of Standard deviation.
What is Standard Deviation?
The Standard Deviation is a statistical pillar, which measures the Variance from the mean/average price. The standard deviation in the equity/stock market represents volatility. A 10% standard deviation would mean a 10% volatility in the stock. In Bollinger Bands, the standard deviation is applied on the middle line i.e., the 20 SMA
Let us understand:
- The 2 Sigma upper and lower band means 2 SD
- Say, if the 20 SMA of nifty is 9500
- And say the Standard Deviation is 1%
- Then the Upper band SD = 2*95 = 190
- The Lower SD = -2*95 = -190
- So, the three components of BB will be
- SMA = 9500
- Upper Band= 9500+190 = 9690
- Lower Band = 9500 – 190 = 9310
In the Last Example-
- If the Market it trading near 9700, then a short/sell position can be initiated, by keeping a target of 9500
- If the Market it trading near 9300, then a long/buy position can be initiated, by keeping a target of 9500
Let us understand it with the help of an example. The image below is the daily chart of Axis bank.
If we carefully analyze the image above, all the trade opportunities have been circled. The circles near the upper band give us an opportunity to sell in the market and the circles near the lower band give us an opportunity to buy in the market.
If we were to take the example of the circle near the lower band, it gave an opportunity to buy near the lower band, and trade gave a return of nearly 20% (i.e., Rs. 50). And similar returns were achieved while shorting near the upper band circles.
Additional read for Beginners:
- 4 Best Intraday Trading Strategies for Beginners!!
- Fibonacci Retracements: How to use it in Technical Analysis?
- How to use Volume Profile while Trading? – Technical Analysis Basics
In this article, we covered two of the most common technical indicators for beginners. Here are the key takeaways from this post:
- Moving Average gives us a lot of buying and selling signals
- When the price is trading above a certain MA, it usually signals strength in the market and buyers are having more say. On the other hand, When the price is trading below a certain MA, it usually signals weakness in the market and sellers are dictating in the Market
- The Bollinger bands capture the volatility. The Upper bands and lower bands help us to understand the overbought or oversold levels
- Bollinger bands work in all types of markets but they are better suited for Rangy markets
- The most important thing is to have a predefined loss for every trade entered in the market.
That’s all for this post on common technical indicators for beginners. Happy Trading and making money!
Hitesh Singhi is an active derivative trader with over +10 years of experience of trading in Futures and Options in Indian Equity market and International energy products like Brent Crude, WTI Crude, RBOB, Gasoline etc. He has traded on BSE, NSE, ICE Exchange & NYMEX Exchange. By qualification, Hitesh has a graduate degree in Business Management and an MBA in Finance. Connect with Hitesh over Twitter here!