There are hundreds of technical indicators, many reliables, others not so much. They exist for the taste of each, knowledgeable or not, trader and his trading style. And new indicators are always appearing, for novice traders who are still waiting for that "magic" one that gives almost infallible entry and exit points. Unfortunately, there's no infallible or magic indicator: all of them sometimes give false signals. But, there are some more efficient indicators than others and everything will depend on the intelligent use that the trader gives it, nothing more. Ultimately, unlike price action, all of them depend on the stock's past movement: they are lagging indicators.
In my case, after having tried many of them during my years of trading, it can be said that I returned to the beginning of the road, staying mainly with only two, essential and present in all my charts and in all my timeframes, and they are really the only ones that I needed: the Moving Averages and the Relative Strength Index RSI. A trend indicator and an oscillator. The two are well-known by all traders and have already been mentioned in previous Price Action posts, as both work in conjunction with this main framework. And believe me, you don't need more indicators.
1. Importance of Moving Averages for Trend Trading
Perhaps the most basic of all indicators, moving averages are also the most useful and powerful. Learning its logic is so simple: if the stock is above it is doing good, if it is below it, the stock is doing badly. Therefore, moving averages are a form of dynamic support-resistance level, due to their change over time. And in trend trading, the same as S/R levels or trendlines, traders look for the rebounds in them.
A second key feature of two moving averages (MA) in one chart, in any timeframe, is its crossovers. Again, it's simple the theory: when the fast MA moved above the slow one, indicates that the short-term trend was stronger to the upside than the long-term one, and the stock could hit some nice highs. The opposite happens when the fast MA is below the slow MA, weakness is kicking in the stock. And, as traders use the daily moving averages DMA50 and DMA200 simply because are the most popular (also smart money and institutional use them in their decisions), their important crossovers get the popular names of golden cross and death cross respectively.
It's nearly mandatory to have a long and a short-term simple moving average in a daily chart. In conjunction with the mentioned DMA50 and DMA200, I use a third one, quicker, the simple moving average 20 (DMA20). Using these three averages in a chart, especially in the daily timeframe, is great as it allows to classify the trend trading due to its rebounds in these dynamic lines, a third feature of the moving averages:
- Strong trend: show shallow pullbacks, with the price rebounding on the DMA20, with its max-retracements below the Fibonacci 38.2% level of its recent swing. Traders usually ride the trend here, buying the breakout of the swing high, and moving the stop-loss.
- Healthy trend: show obvious pullbacks, with the price rebounding on the DMA50, with its max-retracements below the Fibonacci 50% level. The "logical" trade here is to buy the pullback on DMA50.
- Weak trend: the trend has deep pullbacks, with price supports on the DMA200, with its max-retracements at the Fibonacci 61.8% level. A break of this level usually represents the end of the previous (weak) trend. Risky traders buy here the pullback on DMA200.
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I try to be orderly in all aspects of trading, especially dealing with charts. It is definitive: a clean graph helps a better analysis. The one shown above, from the SP500 futures is an example. In all my daily charts through the blog, you will see as main (and only) indicators mentioned in this post: the RSI (in black lines its divergences), three simple moving averages: DMA200 (wide light blue), DMA50 (skinny light blue), and a quicker DMA20 (green). And the horizontal S/R levels, trendlines, and price patterns are drawn with different colors according to their term: short-term (ocher), mid-term less than 1 year (purple), more than 1 year (red), and long-term (black). Finally, the zones are in yellow. I always use different colors for a quick review at a glance. |
2. Relative Strength Index (RSI): quite simple but powerful
I never take its signal as an indication of action (with any indicator it should be done!), because the RSI has an important weakness:
- It can be a very long time overbought while the stock continues trending. That's due to greedy traders still in their positions trailing their stop-loss.
- On the other side, RSI oversold usually gives more clean information: the time it stays below 30 is more punctual, due to traders' natural fear.
And finally, for me, clearly its better feature: its accurate bullish or bearish divergences with the price.
And finally, for me, clearly its better feature: its accurate bullish or bearish divergences with the price.
- The most popular strategy with RSI considers first identifying the divergence and then using price action to find any trend-change pattern that confirms that divergence. This setup is even better when happens at a support or resistance level.
- A different strategy is also valid: first identify a price reaction through price action at an S/R level and then look inside that formation on a lower time frame for a divergence with further confirmation.
Some notes about these divergences:
- Price divergences are more reliable when happening between wide (much better than tight) swings.
- The divergence line is even more reliable when drawn at (or inside) the overbought or oversold area.
- Take note that not all divergences work: again, they need a further trend-change or structure confirmation, that came from any form of Price Action, that's a candlestick or price pattern.
- Keep an eye on the bullish or bearish hidden divergences, useful to identify trend continuation entries into an already moving trade (with confirmed bias and confirmed momentum). Occurs when the price makes a higher low when RSI makes a lower low (in case of a bullish hidden divergence), or the price makes a lower high when RSI makes a higher high (for the bearish ones).
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The chart above, taken from tradingsetupsreview.com a recommended site for price-action traders, shows a bullish hidden divergence. In a practical way, draw an uptrend line between the two pullbacks during the bullish trend, and check if diverge from the RSI ones. If so, it means the price is temporarily losing bullish momentum, taking a breath for the next ride. Being above its EMA50 reinforces the trend-continuation bias. Tip: As noticed, you can detect if a breakout is false, or not: before entering right after the initial break, wait for a hidden divergence that confirms the trend continues. |
Additional indicators can be useful, but they should only be used for confirmation of the previous signal, never for an entry strategy, a typical error that we traders have all had at some point. These include the popular MACD and Bohlinger Bands, and the less-known Volume Profile and VWAP. The Volume Profile was discussed in a previous "Trading Tools" post. The VWAP in a next "Day Trading with Price Action" post.
Good trading,
@BravoTrader
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