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- When it comes to decision-making, traders can vastly improve their performance by adhering to a set of evidence-based technical indicators.
- Visualizations help mitigate the cognitive and emotional biases traders experience in high-pressure scenarios.
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Technical analysis should be an integral piece of any stock-picker’s tool belt.
When properly analyzed, technical indicators can help traders identify inflections points that are crucial for making sound decisions.
That’s because a firm’s stock price is oftentimes detached from its intrinsic value, leaving those who can properly identify that dissonance with an opportunity to make an informed buy/sell decision.
But this is easier said than done.
With an array of trend, momentum, volume, and volatility indicators readily accessible, investors can mix and match to find what suites their strategy best. However, this is both a blessing and a curse, as it can be harder to know which are significant, and which are redundant.
For clarity, think of it this way: Visualizations are akin to bloodhounds, helping a trader sniff out discordance in the market.
The goal is ultimately to use technical indicators to stack the deck as heavily in your favor as possible. This helps alleviate some of the cognitive and emotional biases that undermine rational thought and sound trading.
With that being said, lets take a closer look at three of the most important technical indicators available.
Relative Strength Index (RSI)
What it is — RSI is a leading momentum indicator that measures the velocity and change in trend over time.
How is works — RSI oscillates between readings of 0 to 100. A reading of below 30 is generally considered oversold, while a reading above 70 is usually considered overbought.
How you can make money — You can make money using RSI by confirming and forecasting new trends. For example, if price and RSI confirm one another, the trend at hand should continue. However, if RSI and price diverge, look for a reversal in the current trend. Traders set up buys/sells along overbought/oversold thresholds to anticipate trend direction, and profit when plans comes to fruition.
Remember, trends often run out of steam when they reach overbought/oversold thresholds.
Fidelity Investments / RSI
On Balance Volume (OBV)
What it is — OBV is a leading indicator that relates volume to price change.
How it works — OBV attempts to compute the level of accumulation by comparing volume to price. Don’t worry about the actual numbers. The trend line is what’s important.
How you can make money — The direction of the OBV line is where you want to aim your focus. Use this tool with the price line to either confirm or dispel a current trend. If both the OBV and price line are moving in the same direction, look for the current trend to continue. If they are diverging, look for a reversal in price.
Remember, price follows volume.
Fidelity Investments / OBV
Simple Moving Averages (SMA)
What they are — Simple moving averages are lagging trend indicators, used to identify trends/reversals and support/resistance over a specified timeframe.
How it works — Measures the previous closing prices and divides by the number of periods (20-, 50-, 200-day) in order to determine the current value of the SMA.
How you can make money — Use crossovers to identify potential points of entry or exit. For example, when a short term moving average (50 SMA) falls below it’s long term moving average (200 SMA), it’s called a death cross — a highly bearish signal. However, when a short term moving average rises over its long term moving average, it’s called a golden cross — a highly bullish signal. Position appropriately, and reap the rewards.
Remember, the trend is your friend.
Fidelity Investments / SMA
Although technical analysis can help a trader cut through uncertainty, it’s best to use a combination of fundamentals and technicals to confirm or dismiss a trend and make a final decision.
In addition, have an entrance or exit plan for every trade, and make sure to thoroughly back test your strategies with "paper money" before setting real capital to work. An evidence-based approach should work best. Always vet your findings.
Technical analysis helps to take the emotion and excitement out of trading, vastly improving a trader’s odds of success. However, bear in mind that principal loss is always a risk when putting capital to work.
Oftentimes, a trader’s worst enemy is staring back at them in the mirror. It’s important to be disciplined.
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