In this post, we’re going to focus on the technical indicators that are most commonly used for trend following.
The original article has been edited here for length (…) and clarity ([ ]) by munKNEE.com – A Site For Sore Eyes & Inquisitive Minds – to provide a fast & easy read.
1. Moving Averages
Probably the most common type of technical indicators, moving averages are the cornerstone of any trend following strategy…The definition of a moving average is exactly what it sounds like – an average of the market price (which is always changing).
- An X day moving average is created by adding the market’s close price over the past X days and diving that total by the number of days (X).
- For example, the most common type of moving average is the 200 day moving average (in trading lingo, we call that the 200 DMA). The 200 DMA is created by adding the market’s close price over the past 200 days and dividing that total by 200. The reason why this average “moves” is because as the days go by, we drop the earliest day in this time frame (e.g. 200 days ago) and add the most recent price (e.g. yesterday’s price).
The reason why moving averages are so important for trend following is that they smooth out the market’s price fluctuation. Thus, the moving average shows the market’s trend and, as you know, trends are the name of the game for trend followers!
Trend following is all about the relationship between a moving average and the market’s price.
- If the market price is going down, the X day moving average (e.g. 50 day moving average) will also fall but because the moving average takes the average price over the past X number of days, the moving average will remain above the market price. Thus, both the price and the moving average are going down, but the price is below the moving average.
- The opposite is also true. If the market price is going up, the moving average will go up too. However, because the moving average takes the average price over the past X number of days, the moving average will remain below the market price.
Here is a picture of moving averages.
In the above graph, we have 2 different moving averages: the 50 DMA and the 200 DMA. As you can see, the shorter time frame moving average (in this case, the 50 DMA) sticks more closely to the price.
The prime use moving averages have for trend followers is that they wait for the price to cross the moving average.
- If the market price was rising but now it’s falling, that’s a bearish sign but, if the price falls below the moving average, then it’s a new bearish trend is starting.
- The opposite is also true. Let’s assume that the market was falling but then starts rising, and it rises above the 200 day moving average. Thus, a typical trend follower will buy stocks because a new bullish trend has formed.
Remember, the trend is your friend and now you have an arsenal of such indicators to make an extensive and in-depth assessment of whether you should be buying or selling. If ever there was a “cut and save” investment advisory this article is it.]
MACD (which is short form for Moving Average Convergence Divergence) is derived from moving averages. As I mentioned above, you can create any type of moving average you want. You can create a 5 day moving average, a 50 day moving average, a 200 day moving average, etc.
A MACD technical indicator always involves two moving averages: a short term time moving average and a longer time frame moving average. In this post, I’m going to use the 50 dma and the 200 dma as examples. The MACD is based on a simple tenet:
- In a downtrend, the shorter time frame moving average (e.g. 50dma) should fall below the longer time frame moving average (e.g. 200dma). The opposite is true in an uptrend
This makes logical sense – the shorter time frame moving average more closely “hugs” the market price. What the MACD does it signal crossovers between the moving average. When the shorter time frame moving average rises above the longer time frame moving average, the MACD signals that a bullish trend has started and it’s time to buy. The opposite is also true.
Related Articles From the munKNEE Vault:
Bollinger bands are one of the most popular and widely used technical indicators. They can help you find excellent entry and exit points and, as such, many successful trading strategies are based on just Bollinger bands and a few complementary indicators. Below are a number of such trading strategies.
Buying and selling based on a moving average of monthly closes can be an effective strategy for managing the risk of severe loss from major bear markets. In essence, when the monthly close of the index is above the moving average value, you hold the index; when the index closes below, you move to cash. A chart of the S&P 500 monthly closes since 1995 shows that a 10- or 12-month simple moving average (SMA) strategy would have ensured participation in most of the upside price movement while dramatically reducing losses.
Many of us think Wall Street is using sophisticated tools to make money. It is…but big Wall Street firms also use simple tools to make money. One tool many large firms use is the advance-decline line.
People seem to think that since they hear that so few people are successful in trading, that there must be a complicated process to complete in order to make money. The truth is that the simpler we make trading, the more profitable it seems to be…so this week I decided to discuss a simple technique that is often overlooked when traders are reading charts, specifically candle charts.
Remember, the trend is your friend and now you have an arsenal of such indicators to make an extensive and in-depth assessment of whether you should be buying or selling. If ever there was a “cut and save” investment advisory this article is it.
It is hard to know what to buy or sell let alone just when to prudently do so. Thank goodness there are indicators available that provide information of stock and index movement of a more immediate nature to help you make such important decisions. This article describes the 6 most popular Momentum Indicators. If ever there was a “cut and save” investment advisory this is it!
There are many indicators available that provide information on stock and index movement to help you time the market and make money. Market strength and volatility are two such categories of indicators and a description of six of them are described in this “cut and save” article. Read on!
Exactly what is RSI and how is it calculated?
Research has found that investors using technical analysis had some performance advantage over those who didn’t use these methods. The research also found that the performance advantage was more evident during down markets. If that has piqued your interest, read on to learn more about a few of the more popular types of technical analysis.
Investing in the Dogs of the Dow, which refers to the 10 highest-yielding stocks in the Dow Jones Industrial Average at the end of the year, is a very simple strategy you can use in 2018 to beat the market. Here’s everything you need to know.