You have likely heard about terms like moving averages and relative strength index if you are a regular watcher of financial media like Bloomberg and CNBC. These terms are used to refer to the technical indicators that Wall Street traders use to predict the future movement of assets. Their use is known as technical analysis. The other common strategy the traders use is fundamental analysis, which involves looking at the performance of the broader economy. In this article, we will look at the most popular tools that are used in technical analysis.
Fibonacci Retracement is a tool that is found in most charting software. The tool is based on the old mathematical concept of the Fibonacci sequence. As a trader, you don’t need to understand the Fibonacci Retracement formula. Instead, you just need to know how it is applied on market charts. First, you need to look at a chart that is moving in an upward or downward trend. Then, you need to use the Fibonacci tool to connect the highest point and the lowest point. The one-year Facebook chart is a good example. As shown below, the stock is trading at $184, which is slightly below the 23.6% and above the 38.2% Fibonacci Retracement levels. This means that the price will likely move lower to test the 38.2% level of $175.
Elliot Wave is a tool found in most charting software. The idea behind it was developed by Ralph Nelson Elliot, who identified important trends in stocks. The tool posits that financial assets move in phases. The first phase is known as the impulse wave and includes five steps. After completing the impulse wave, the asset then moves through a corrective wave. The two – impulse and corrective waves – have several characteristics. For example, in an impulse wave, wave 1, 2, and 3 moves in the direction of the trend. Wave 2 cannot retrace to the beginning of the first wave. Wave 3 must always be the longest, wave 4 does not overlap with wave 1, and wave 5 needs to end with momentum divergence. A good way to use the Elliot Wave tool is to combine it with the Fibonacci Retracement tool. The chart below shows the impulse wave of an Elliot Wave on the Brent crude oil chart.
Moving averages are popular technical indicators in the financial market. As the name suggests, the indicator is developed by adding the closing prices of the financial asset and dividing by the number of periods. There are several types of moving averages, which include simple moving averages (SMA), exponential moving averages (EMA), smoothed moving averages, and weighted moving average. Most traders use the simple and exponential moving averages. A popular way of using moving averages is to take a longer-dated and a shorter-dated average and identifying a reversal. On the 3-month EUR/GBP chart, the 14-day and 28-day EMAs have made a crossover as shown below. This implies that the downward trend will continue.
Relative Strength Index (RSI)
The Relative Strength Index is an oscillator indicator, which is used to identify the overbought and oversold levels. The index is derived by calculating three parts, which are the relative strength, the average gain, and the average loss. The average gain is calculated by adding the gains over the past 14-day period and dividing it by 14. The average loss is calculated by adding the sum of losses over 14-days and then dividing by 14. Next, you do a calculation of 100 minus 100 divided by 1 and the RS. The RS is the average gain divided by the average loss. As with the other indicators, you don’t need to know the math behind it. When used on a chart, when the index passes 30 headed lower, the asset is said to be oversold. When it crosses the 70 level, it is said to be overbought.
Money Flow Index (MFI)
Money Flow Index (MFI) is an oscillator that is calculated in a similar way to the relative strength index. The only difference is that the MFI factors in the volumes of the financial asset. As such, calculating it is relatively complex because you first need to calculate the typical price. This is done by adding the high, low, and close prices and dividing it by three. Next, you should calculate the real money flow by multiplying the typical price with the volume. Next, you should calculate the money flow ratio and the MFI. As a trader, knowing all this is unnecessary. Instead, you should learn how to use it. The chart below shows a good example of the MFI indicator at work.
As a professional trader, it is very important to understand the concepts of technical analysis. This is because these concepts work and are used by most Wall Street investors. This article has just touched on the popular indicators. You can read about more of these indicators so that you know how to use them well.