These indicators are used to gauge the strength and direction of a trend. As their name suggests, they are most useful in trending markets, and their usage in ranging markets is to be avoided because of the tendency to give false signals.
The importance of trends has been a recognized fact for many years, and of all the methods used by technical analysis, trend following has granted its followers the greatest profits over the years. Before we begin examining the indicators in detail, let us first try to understand the reasons behind the success of the trend following method.
Trend following is simply the identification of a (preferably long-term) trend, and maintenance of positions in harmony with it without much regard to other sources of technical data, or analysis. That is not to say that trend following requires that we disregard everything else other than the trendline, but it does suggest that the trader attach utmost importance to the trend once it is identified, and minimize the impact of other concerns unless they are very convincing (for instance, we’ll disregard most short- or medium term resistance lines, but we won’t disregard a powerful multi-year resistance line). With this method, the trader will attempt to buy or sell depending on the direction of the trend once the trend line is touched by price action.
Why is this method so successful? Because major economic changes and fundamental events are long lasting, and by following the trend (which is just another name for the big picture, or the scenario depicted by the present fundamental situation), the trader is merely aligning himself with the main economic drivers of his era. Trends last long, because economic events often reinforce and compound themselves (for example, the impact of interest rate reductions is compounded by increased bank-lending, and increased lending leads to more employment, which leads to more economic activity, which leads to more lending and so on), and the trend follower is simply recognizing the results of these powerful driver forces, while he may not be aware of their causes.
The best way to identify trends is confirming them with their sustaining fundamental drivers. When the trader is unwilling to adhere to this healthy practice, he can make use of the indicators developed by technical analysis in order to identify trends at their early or intermediate phases of their development. We should caution him on the likelihood of many trends to develop bubbles in their final stages, and it’s perhaps a good idea to avoid late stage entries, unless we know what we’re doing.
We will now examine some of the different types of indicators used to identify and evaluate various trends.
Moving averages are the most simple kind of trend-following indicators. They simply take the data of the latest n-period (n-hour, n-day, and so forth), divide that by the n of the period to reach at the indicator’s present value. The main difference between exponential and simple moving averages is that while the former attaches greatest significance to the most recent period, the latter weighs each period (the present included) equally. In other words, the exponential moving average is more sensitive to the price action of today. In general, the longer the period of a moving average, the slower it responds to price action, and the later its signals will be.
Moving averages are simple, and their strength and utility is in their simplicity. In many cases, a one hundred day moving average is an excellent trend indicator in its own, with its one drawback lying in its tardiness in giving signals. But the tardiness is as much an advantage as it is a disadvantage: While it’s unlikely to alert us to trend changes quickly, the signals it gives are likely to be more reliable. Even in the worst case, the moving average can be a good reference point and a reliable indicator for setting up entry/exit points for a trade.
The beginner may simply regard a long-term moving average as his trend line. Read more on:
This indicator was invented and developed by John Bollinger, a financial analyst, in the 1980s. It consists of a moving average, and two bands placed at the upper and lower boundaries of the moving average.
A buy or sell signal is thought to be generated when the price action moves beyond the upper or lower Bollinger bands, returns back to the same, and then reverses and continues with the breakout. While breakout from Bollinger Bands does signify increasing volatility, and therefore also a shift in trend, experience over the years has convinced technical analysts to seek a confirmation of the breakout signal by a return and reversal.
Apart from the belief that it’s a good indicator for identifying trend changes, the Bollinger bands are a good indicator of volatility (the speed and severity of price fluctuations). The bands respond to price action by contracting when volatility is low, and expanding when it is high. In that sense, the indicator can be employed to decide on whether the present conditions in a market are suitable to the volatility tolerance of a trader. If your trading style or leverage ratio does not allow you to interact with the markets during periods of high volatility, you can use Bollinger Bands to evaluate the situation. Of course, it’s crucial to keep in mind that the indicator shows present volatility, without telling us much about the future of it. Learn more about the Bollinger Bands indicator.
This indicator was developed by J. Welles Wilder, a trader and mechanical engineer, in 1978. It compares the highs and lows of consecutive periods, terms them +DM, and -DM, and on the absolute difference between these values, it reaches at the value of the indicator.
The indicator is used to evaluate the strength of a trend. The ultimate value of the ADX is between 0 and 100, and a value below 20 is thought to sign weakness, while a value above 40 shows that the trend remains strong. On this basis it can be used to determine if (but not when) the trader should join a trend, and also on possible reversals, when the value of the indicator is too weak. The ADX is a lagging indicator, and by definition, it will only evaluate a trend once it’s already on course. In the absence of a trend, the ADX is bound to give many false signals, and the trader should use other methods, such as trend lines or moving averages, to decide on the presence of a trend, before using this indicator to gauge its strength.