Technical analysis can benefit or harm an investor. The benefit results from a careful analysis that can help with the buy and sell decision. The harm can come from too much or too little thought about the process.
Too much thinking about technical analysis is a problem that is easy to overlook. The problem is that many indicators use the exact same data. For example, the default parameters for both the relative strength indicator (RSI) and the stochastic indicator are both 14 days.
Calculations are different, but both use the same time frame to provide trade signals. This is not an anomaly. Many indicators use the same data and many indicators will offer signals at very nearly the same time.
That means many indicators will be redundant and thinking about which ones to add to a chart will not add much value to the decision process.
Too little thinking is also a problem that is common for traders. They may not think about what the indicator is truly telling them. For example, a high reading in the stochastic indicator could signal that the trend is likely to reverse or that the market is very strong. It requires more thought to understand the signals.
Solving the Problems of Charting Indicators
First, traders do need to consider the problem of which indicators offer the best signals. Here there is no clear answer.
The truth is that many traders have found success with a variety of indicators. The key to success appears to be a disciplined approach to following the indicator rather than using any special tool.
As an example of that idea, consider the chart below. This is a chart of the SPDR S&P 500 ETF (NYSE: SPY) with three indicators. The stochastic indicator, RSI and MACD are shown below price, in that order.
Looking at the right side of the chart, the indicators are all reaching higher lows than they did a month ago. All are saying the recent selling pressure has been less severe than the selling seen in late June. This means the shape of the curves created by all three indicators is the same.
Given the similar appearance of all three indicators, it becomes clear that only one is needed. The question for traders then becomes which one of the three to use. The answer is that it depends on which one the trader feels most comfortable with.
The indicators are shown with default settings. That means there are clear signals from the stochastics and from MACD while RSI signals infrequently and less clearly most of the time. MACD signals less frequently than stochastics.
With that information, a trader who is active may prefer stochastics. A trader with less time to devote to analysis could prefer MACD. Traders who prefer a more discretionary may choose RSI since it allows more room for interpretation.
Each indicator, in other words, could be useful to some traders and less useful to other traders. The choice is a personal one, but the trader should limit their choice to just one indicator to avoid delaying action at the rare times the signals conflict.
These, of course, are not the only three indicators available. There are dozens of tools a trader could select from. But, the same caution applies. The trader should select just one, or perhaps two if the indicators are truly different and avoid too many indicators on the chart.
Technical Analysis Offers More Than Indicators
In addition to indicators, technical analysts also often use moving averages, or MAs. An MA is a tool that helps identify the direction of the trend. The trend is up if prices are above the MA and the trend is down when prices are below the MA.
Here, too, the process of adding MAs to a chart can be complex and can perhaps become overly complex. The chart below adds several MAs to the price of SPY.
The 200-day MA is the blue line which has not offered any trading signals in this time frame. Breaks of this MA will be significant when they do occur.
The gold line is the 10-day MA and there are frequent trading signals with this indicator. That means a trader will be on the right side of long term trends but will have to trade frequently. Using averages of lengths that are between those two extremes will generate more or less signals.
The questions here are which average is best and how many averages should be used. Again, it comes down to how much time the trader has for analysis and personal preferences.
A single longer term average will give signals less often. Some traders prefer two or three moving averages because they believe that will be more accurate. The truth is that any set of indicators can work in the long run with a disciplined approach.
Putting it Together
The next chart shows SPY with the MACD and a 50-day MA.
This is an example of a chart that could be used for trading. MACD signals will be the primary driver of the trades and MA crossovers that conflict with MACD’s signals could be ignored. Or the MA could be the primary driver of trading decisions.
But, the example shows that clear signals can be obtained from a relatively simple chart. Many traders will find that they need just one or two indicators to complete a detailed analysis that offers the potential for significant profits in the long run.
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