The top five tools to improve your trading
Master technical analysis, but don’t get too bogged down in the details, says Katie Hope
Any body logging onto a retail contracts for difference (CFD) trading platform for the first time could end up a bit dazzled. It’s like an online 80s disco, all flashing lights and neon colours. Just add some leg warmers and put on Madonna’s Holiday and you’d be away.
It doesn’t stop there, either. Fully embracing the era of customisation, most platforms offer an array of technical analysis instruments that you can add to your charts. CFD provider GFT, for example, offers 85 and CMC Markets has 42. It’s like pick and mix sweeties without having to pay out at the end.
The obvious temptation is to add in as many as possible, in order to improve your market trading knowledge. Surely it’s a case of “the more information the better”? According to experts, this is a typical error for technical analysis newcomers.
“Keep it simple, so it’s easy to notice the buy and sell signals. It’s really a matter of finding something that works for you,” says James Hughes, market analyst at CMC Markets.
Trading on technicals makes three key assumptions. Firstly, that market price action leads everything else, meaning that within a few minutes of a piece of news breaking, an instrument’s new value will be incorporated into the price. Secondly, that prices move in trends and tend to follow simple patterns over periods of time. And thirdly that history repeats itself, meaning that prices that have been important in the past can potentially become more important again. We look at the top five indicators that you should have on your screen.
Support and Resistance Levels
One of the simplest forms of technical analysis. Despite all investment disclaimers to the contrary, this analysis is based on the concept that the past really can be a guide to the future.
A support level is an area lower than the current price where the buying is strong enough to overcome the selling pressure, creating a “trough” or a “low”.
For example, if a price drops to 150 then bounces up to 170 then drops back down again to 150, you would make the assumption that the price is likely to bounce back up to 170.
A resistance level is the same idea, but in reverse. So an area higher than the current price, where the selling is strong enough to overcome the buying pressure, creates a “peak” or a “high”.
Using these levels as a guide can help you to place orders in the market, and also help you to know where to place stop orders.
Just draw a line on a chart connecting pivot points where the market has previously bounced or sold off, extend this out and you get a basic extrapolation of future support or resistance levels. The key is to choose a time period for the chart that corresponds with your trading strategy.
Moving Averages
The moving average shows the average value of an instrument’s price over a period of time. Moving Averages are particularly useful for smoothing raw, noisy data, such as daily prices. Price data can vary greatly from day-to-day, obscuring whether the price is going up or down over time. By looking at the moving average of the price, you can get a more general picture of the underlying trends.
Typically, when a market moves below its moving average it’s a bad sign because the stock is moving on a negative trend, whereas the opposite is true for instruments that go above their moving average.
There is no correct time period to look at a moving average for, and traders use anything from nine days to 200 days. Bear in mind that the longer the time span you look at, the less sensitive the moving average will be to daily price changes. Because moving averages can be used to see trends, they can also be used to see whether data is bucking a trend. Entry or exit systems often compare data to a moving average to determine whether it is supporting a trend or starting a new one.
Bollinger Bands
Sadly, other than name these have no connection to the bubbly stuff (unless you have a good day, of course). Bollinger bands evolved to provide a relative definition of high and low prices to previous trades.
Basically, they are a pair of values placed as an “envelope” around a data field. The values are calculated by taking the moving average of the data for the given period and adding or subtracting the specified number of standard deviations for the same period from the moving average.
This is useful for determining whether current values of a data field are behaving normally or breaking out in a new direction.
For example, when the closing price of a forex market increases above its upper Bollinger band, it will typically increase in that direction. Bollinger bands can also be used for identifying when trend reversals may occur. If a price hits the upper Bollinger band then it could suggest the price is at an unsustainable level, indicating a reversal is about to take place.
Relative Strength Index
This is an indicator that compares the recent gains to the recent losses of an investment, to try to determine overbought and oversold conditions. It has a range of 0 to 100, with values typically remaining between 30 and 70.
When the RSI approaches 30 it could be an indication that an instrument is oversold and likely to become undervalued. If it approaches the 70 level, it is a sign that you may want to close any long positions, or you could take out a short position.
The RSI is typically used with a 9, 14, or 25 calendar day period against the closing price of a forex market or commodity. The more days that are included in the calculation, the less volatile the value is.
Stochastics
Stochastics are used to compare the closing price of an instrument to its price range for a given period of time.
The idea behind this indicator is that prices tend to close near past highs in bull markets and near past lows in bear markets. There is a “fast” stochastic as well as a “slow” stochastic, which you can use together to identify overbought or oversold conditions.
Generally, a level of above 80 suggests something is overbought, and a level below 20 indicates something is oversold. Stochastics can also help identify false turning points. For example, a new high in price, without a new high in stochastics, may indicate a false breakout.