5 Important Tools Used In Technical Analysis For Trading

Flabia Maharjan

Technical Analysis tools are frequently used for analyzing technical charts to determine whether the market trend will continue or reverse. Such tools can provide buying and selling signals by giving an insight into the demand and supply of securities and predicting price trends. Let’s look into five technical analysis tools that are used for trading.

1. On-Balance Volume (OBV)

On-balance volume (OBV) indicates a positive volume pressure or a negative volume pressure, resulting in an increase or a decrease in the stock prices. Therefore, it establishes a relation between volume change and price. Rising OBV indicates more buyers, which creates a positive volume pressure resulting in higher prices. Conversely, falling OBV indicates more sellers, which indicates a negative volume pressure resulting in lower prices.

Calculation of OBV: OBV takes into consideration the closing price of the stocks.

If today’s closing price > yesterday’s closing price then, OBV = Previous OBV +Today’s Volume

If today’s closing price < yesterday’s closing price then, OBV = Previous OBV -Today’s Volume

If today’s closing price = yesterday’s closing price then, no change in OBV

OBV shows that if the volume changes without a significant change in stock prices, the prices are expected to move higher or lower depending upon trade volume. Therefore, it helps predict price trends. Traders do need to be careful when the volume and price patterns diverge. If prices are rising while OBV is falling, it shows that the trend lacks strong buyers and is likely to reverse.

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2. Accumulation/Distribution(A/D) Line

This indicator uses volume and price to see whether a stock is being accumulated or distributed. Accumulation reflects demand, while distribution demonstrates the supply of stock. Therefore, A/D measures the demand and supply of security by overviewing where price has closed within the period’s range then multiplying it by volume.

If the A/D is rising, this demonstrates buying pressure as the stock closes above the midpoint of the period’s range which confirms an uptrend. However, if the A/D line is falling, it illustrates selling pressure as the stock closes below the midpoint of the period’s range which confirms a downtrend.

Traders should also look out for divergence. If the A/D line is falling while the security price is rising, it reflects a possibility of higher distribution which could signal a fall in price. If the A/D indicator is in an uptrend while the security price is in a downtrend, then this reflects the possibility of higher accumulation which could signal a higher security price.

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3. Moving Average Convergence/Divergence (MACD)

MACD is the solution to whether one should use a short-term moving average or a long-term moving average. It is a movement indicator that shows the difference between short-term moving average and long-term moving average. The difference highlights the upward or downward movement of price in the recent past compared to longer movement. When MACD is in the positive zone, it sends a buying signal as prices are likely to move up. Conversely, when MACD is in the negative zone, it sends a selling signal as prices are likely to fall. MACD can provide the following signals.

Buying Signals:

a) MACD line is above the moving average line of MACD, and it moves towards the average line but fails to penetrate it, thus rising upward, supported by an upward movement of the average line.

b) MACD line is below the moving average line of MACD. It moves towards the average line, successfully penetrates it, continuing to rise upward, supported by an upward movement of the average line.

c) MACD line is above the moving average line of MACD and continues to move upward, supported by an upward movement of the average line.

Selling Signals:

a) MACD line is below the moving average line of MACD, and it moves towards the average line but fails to penetrate it, thus starts declining, supported by a downward movement of the average line.

b) MACD line is above the moving average line of MACD. It moves towards the average line, successfully penetrates it, and continues to decline, supported by a downward movement of the average line.

c) MACD line is below the moving average line of MACD and continues to move down, supported by a downward movement of the average line.

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4. Relative Strength Index (RSI)

RSI is a momentum and trend strength indicator whose value can range between 0 to 100, and depending on this value, we come to know if a security is overbought or oversold. When RSI is above 70, security is overbought, and the RSI is expected to decline. In contrast, when RSI is below 30, security is oversold, and the RSI is expected to rise. However, this is only an assumption; therefore, traders ought to be careful. When price and RSI are moving in opposite directions, then the price trend could reverse. For instance, if the price is rising while the RSI is falling, then the price is expected to fall and vice versa.

RSI also indicates support and resistance levels. RSI holds above 30 and usually reaches 70 or above during an upward trend, and it holds below 70 and usually falls to 30 or lower during a downward trend. In conclusion, we can say that RSI compares gains to losses and charts the greater one. If RSI shows an uptrend, the stock gains surpass losses daily for the time period chosen, usually 14 days. So, ten days of 15% gain and four days of 1% loss would denote a sharp rise in RSI.

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5. Parabolic SAR

Parabolic SAR is a technical indicator that determines the direction of price movement. As it aims to identify the potential reversal in price movement, it is also called the “Stop and Reverse” system, abbreviated as SAR. It is graphically plotted in the chart by placing a series of dots above and below the candle. If the dots are placed below the price bars, it indicates a bullish trend and is taken as a buy signal. Conversely, if the dots are placed above the price bars, it indicates a bearish cycle and demonstrates a sell signal. Trade signals are produced when the direction of the dots is reversed.

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