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The Best Stock Trading Indicators

This blog post is a direct copy from Chapter 12 of The Options Trader's Bible.

Available direct: https://bit.ly/2tyLqVN

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Indicators and studies: What are they?

Indicators, sometimes referred to as studies, are advanced calculations based on a variety of inputs from price, volume, or open interest of an underlying stock. People often believe that by analyzing the history of price action, they can get a good indication of what might be in store for the future. However, more often than not people rely too heavily on indicators to dictate their trading. Indicators should always be used as a helping hand in your analysis, trading, and scalping and not as a rule!

There are two types of indicators: overlays and oscillators. Overlays quite literally overlay the price action on the chart. Oscillators move between minimum and maximum values and are usually plotted below the chart. 

Indicators are another way for traders to get the dreaded analysis paralysis. Personally, I occasionally use relative strength index, volume-weighted average price, and moving averages—the basics of these will be discussed below. While I do find that these are useful tools, I always come back to what is absolute—and what’s absolute is price. As you are likely starting to gather, I am a huge proponent of a “less is more” approach when it comes to trading. Why cloud your judgment and potentially cause yourself to second-guess with messy indicators? There is a time and place for everything, but in my experience in the day trading arena and in coaching and educating others, students and amateurs are overusing indicators. As we go through the various indicators listed, keep in mind that I do not view them all simultaneously. Each paints its own picture of what is happening with the price, so I prefer to view them individually in most cases. 

Relative strength index (RSI)

RSI is an oscillator indicator that is based on momentum. It is perhaps one of the most popular indicators used today and compares the size of recent gains and losses over a designated period of time to calculate speed (and change) of price in the underlying security. If this sounds complex, it’s because it is. What you really need to know about RSI is that it can indicate when a stock is overbought or oversold. As previously mentioned, oscillator-style indicators move between minimum and maximum  values, in this case (and in most cases) it is between 0 and 100. Conventional RSI wisdom says that values above 70 indicate overbought and values below 30 indicate oversold. 

$MCD 1h chart with RSI shown at the very bottom. We see the silver oscillator line turn red when it crosses above the tan line at the 75 level, indicating that it was overbought.

$MCD 1h chart with RSI shown at the very bottom. We see the silver oscillator line turn red when it crosses above the tan line at the 75 level, indicating that it was overbought.

I prefer to set RSI overbought and oversold values at 75 and 25, respectively. This gives an even stronger indication of whether a stock is overbought or oversold. RSI works on any time frame that you choose. The indicator’s standard settings will be 14, 70, 30, which means its movement is based on 14 trading periods and uses the conventional 70/30 levels of bought and sold. The 14 would mean 14 trading days if using a daily chart, but if you are using an hourly, 5m, 1m or any other time frame, the period is based on the most recent 14 candlesticks. 

Volume weighted average price (VWAP)

VWAP is used by institutional traders as well as algorithmic traders. It is very similar to moving averages (MAs) in that it is an overlay indicator and tracks similarly to MAs, but it can be more useful than MAs because it takes volume into consideration. 

VWAP shown on the $NVDA 5m chart. You can clearly see how price action moves between the purple lines.

VWAP shown on the $NVDA 5m chart. You can clearly see how price action moves between the purple lines.

VWAP can be a great indicator for support and resistance when a stock is reaching all-time highs or if you are presently in a trade and don’t have time to look back at the chart. Notice above in the $NVDA example (5m chart) how the stock seems to move between the midline and the lower line. This is not a coincidence. 

On the VWAP indicator, the middle line represents the actual volume weighted average price, while the upper and lower lines are +2 or -2 (for upper and lower, respectively), standard deviations from the midline. Load this indicator on various charts of various time frames and see just how useful it is. We have a strategy in the Opinicus Holdings Options Mastery Course that is built around VWAP entirely! 

Moving Averages

MAs are likely the most popular indicator out there. Like all indicators, they have a time and place and can be useful in your analysis, but far too many people rely too heavily on them. 

What are MAs? Moving averages help to identify trends in the price action by showing a smoothed-out line mimicking the action. MAs filter out the noise and give a simplified idea of what the price is doing. MAs are both an overlay indicator and a lagging indicator, the latter because they are derived from past price performance. 

How do they work? Moving averages take the average of the period you select and overlay a line on the chart for that period. For example, if you were looking at the 12MA on a daily chart, the MA would be calculating the previous 12 days’ average price and overlaying the indicator on your chart, with each candle representing 1 day; if it were a 5m or 1h chart, it would be calculating the 12 most recent candles.

The orange line in this $MA 1d chart is a 48MA.

The orange line in this $MA 1d chart is a 48MA.

In the graphic above, we can see a 48MA. Notice how it kind of “guides” the price action and resembles a trendline. For this reason, MAs are very informative when used in conjunction with your overall technical analysis. My personal favorite periods to follow are 8, 12, 50, and 200 days. 

In closing...

If you are new to indicators, use them sparingly and do your absolute best not to rely on them too heavily. Remember, they are a helping hand, not an absolute! You want to avoid analysis paralysis at all costs. It is best to try to get a grasp of what is happening with price action without having to use indicators at all. The more complex you make things, the harder it will be for you to be successful. Keeping things simple works in both life and in technical analysis!