First thing to know: What are technical indicators?

A technical indicator is a series of data points that are derived by applying a formula to the price data of a security, whether it is a forex pair, a stock, bond or any other derivative.

Technical indicators have three main functions:

1- confirm other technical analysis tools.                

it is very useful to combine different technical indicators with other technical analysis tools so that their noisy negative features cancel each other out while their signals (positive features) remain undisturbed.

 2- alert to study price action a little more closely.

unusual spikes or declines, divergences, or some classical chart patterns shown inside the technical indicator window are early signs of a probable important price move that worth watching closely.

 3- Helps at better timing entry and exit positions.

better timing is an essential component in active portfolio management strategies. Good fundamental trading ideas can go awry with poorly timing entry and exit levels.

It is important for traders to know the different types of technical indicators, and in which classification each indicator falls. most essentially, to understand how do they work to generate signals and how significant those signals are. The aim is to answer the question of which indicator a trader should use and in what circumstances.

Generally technical indicators are classified as either leading, coincident or lagging indicators. And here is brief explanation of each type and when you use it.  

Leading indicators:

    many leading indicators come in the form of momentum oscillators, and are designed to lead price movements.  (example: CCI, MOMENTUM, RSI, STOCHASTIC, WILLIAMS %R, ROC …)

   they catch turning points in flat markets, but give premature and dangerous signals when markets begin to trend.

   Leading indicators are best used in trading ranges, they can also be used in trending markets but usually with the major trend not against it.

   In a market that is trending up, the best use is to help identify oversold conditions for buying opportunities. While in a market that is trending down, the best use is to help identify overbought conditions for selling opportunities.

Benefits

  1. early signaling for entry and exit.
  2. generate more signals and allow more opportunities to trade.
  3. forewarn against potential strength or weakness

Drawbacks

  1. more signals and earlier signals mean that chances of false signals and whipsaws increase.
  2. false signals will increase the potential for losses, and whipsaws can generate commissions that may eat away profits

Lagging indicators:

Moving Averages, MACD and the Average Directional index are among the Most known and used lagging indicators, they are commonly referred to as trend-following indicators because they follow price movement and turn only after trends reversals. Usually, they work best when markets develop strong trends, and their role is to keep traders in as long as the trend is intact.

Benefits

  1. They are designed to get traders in and keep them in as long as the trend is intact.
  2. The longer the trend, the fewer the signals and less trading is involved.

Drawbacks

  1. these indicators are not effective in trading ranges or sideways markets, and may lead to many false signals and whipsaws.
  2. trading signals tend to be late. and late entry and exit points can skew the Risk/ Reward ratio.                              

oscillators

An oscillator is an indicator that fluctuates above and below a centerline or between set levels, as its value changes over time. oscillators identify the emotional extremes of market participants. Oscillators could be either coincident or leading indicators and often turn ahead of prices.

  Centered oscillators (ex: MACD, ROC …)

they fluctuate above and below a center line, and are best suited for analyzing the direction of price momentum and its strength or weakness. Momentum is bullish when a centered oscillator is trading above its center line, and bearish when it is below.

  Banded oscillators (ex: RSI, STOCHASTIC …)

They fluctuate between overbought and oversold extremes, and are best suited for identifying overbought and oversold levels. most banded oscillators rely on divergences and overbought / oversold levels to generate signals.

The middle ground for this type of banded oscillators is a bit of a no man’s land and is probably best left to centered oscillators.

  Oscillator signals

Divergences:

A divergence is a clear difference between the price trend and the trend of the indicator, it can be caused via a deceleration of prices or a matter of time, which decreases the angle of each lower low in the downtrend, or higher high in the uptrend compared to the previous one. In addition, what can cause a divergence is that the price movement has the same strength compared to the previous one in the same direction, but the amplitude of previous correction is greater.

A divergence signals a waning of momentum but it does not necessarily signify new momentum in the opposite direction. Divergences are best thought of primarily as warnings to exit, and second as opportunities for a reversal.

Overbought and oversold extremes:

Overbought and oversold extremes are a price level that a security reaches, and that analysts believe it is well above or below its intrinsic or average value. Markets usually expect a stock or security price to correct toward its average value after trading at an extreme.

This situation involves what is known in the market as a mean reversion trading strategy, it considers that prices over time will revert towards their mean or average.

Centerline crossovers:

Centerline crossover signals apply mainly to centered oscillators that fluctuate above and below a centerline. Movements above and below the centerline indicate that momentum has changed from either positive to negative or negative to positive. Traders have been also known to use centerline crosses with the Relative Strength Index in order to validate a divergence or a signal generated from an overbought or oversold reading.

Another way to categorize technical indicators

cycle indicators

Generally, a cycle refers to repeating patterns of market movement. markets have a tendency to move in cyclical patterns, and cycle indicators may potentially determine some of those particular market patterns.

As an example, we can site the father of technical analysis CHARLES H DOW, where he mentioned through his theory and its principles that bull and bear market cycles have a tendency to move in a zigzag way; either higher highs higher lows, or lower highs lower lows.

Momentum indicators

Momentum is a term used to describe the speed at which prices move over a given time period. Momentum indicators determine the strength or weakness of a trend as it progresses over time. momentum tend to be higher at the beginning of a trend and lower at trend turning points. a divergence between price and momentum is a warning of weakness.

if price extremes occur with weak momentum, it signals a probable end of movement in that direction. stochastic and RSI are examples of momentum indicators.

Strength indicators

market strength or sentiment describes the intensity of market opinion with reference to the price through examining market positions taken by various market participants.

among this category we can find various trading volume indicators as well as commitment of traders data.

volatility indicators

they describe the intensity of fluctuations in the asset price , Bollinger bands, historical volatility, and options market implied volatility are useful examples of volatility measures. generally, changes in volatility tend to lead changes in prices.

Conclusion:

Before using any technical indicator or rely on its signals to enter trades, it is very important to understand what type it is, in which conditions it is used, and what signals it does generate.