Technical indicators are mathematically defined tools that are used to analyse past stock price movements, and based on this, to anticipate future price fluctuations and patterns. Stock analysis based on ‘fundamentals’, in contrast, uses economic data, annual reports and other measures of company profitability to assess a company’ stock price. These indicators can be used to devise an overall trading strategy that attempts to predict price fluctuations in advance.
Technical indicators are used to highlight trading opportunities based on past price movements. These indicators can include a stock’s moving averages, it’s index of the relative strength and various stochastic (probability distribution) oscillators. Trading strategies based on these indicators are used to decide when to enter or exit a stock and the rules by which trades are executed. However, as the name suggests, these are only signals and there is no evidence that one particular indicator always provides desired results or is foolproof. Traders often use a combination of indicators to identify price movement trends for a particular stock.
It is important to note that technical indicators are not a trading strategy in themselves. Instead, a given strategy uses these indicators as objective measures to inform trading decisions. Technical indicators in a strategy define the exact parameters under which trades are executed or positions are adjusted (this is referred to as a ‘setup’). A trading strategy will typically include detailed use of multiple indicators to decide trading activity. Referred to as technical analysis, the use of these indicators allows traders to identify high probability movements in a stock price and to act on them in a timely manner.
A trading strategy based on technical indicators is thus a set of objective measures of price movements that are used to set strict rules for making trades. A strategy will usually define filters and triggers for action that are based on indicators. Filters define the setup conditions for purchase of a stock at a particular price while triggers specify exactly when certain position adjustments are made. A trade filter may, for instance, may specify that a stock be purchased when it has closed above its price average within a specific period. The filter sets the condition that must be met for the trade trigger to be met which causes the trader to execute a given stock trade.
Strategies must be carefully designed. They usually specify which indicators are to be used, how far they need to move above or below certain parameters, the actions that are undertaken when these parameters are met and the specific type of trade that will be executed.