If you trade technically and believe that price action drives future price movements, there are several tools that you can use to make your trading decisions. When the market is range bound, you can use oscillators and overbought/oversold indicators. When a market is trending, you’re best off using momentum and trend following indicators. Lastly, your entry and exit should be based on support and resistance levels.
The Market Environment
Prior to evaluating which indicator you should use to enter or exit a trade, you should first determine what kind of market environment you are in. Is the market choppy or trending? Is volatility high or is it low? Once you get a feel for the market environment, you can then pick out the most efficient technical indicator.
Momentum and Trend Following
When prices are breaking out, they are likely at the beginning or middle of a trend. You can determine if a market is trending by using a moving average crossover strategy. For example, when the 20-day moving average crosses above the 50-day moving average, a medium term up trend is in place. The reverse is true for a downtrend. You also want to consider if momentum is accelerating or decelerating. A very efficient technical indicator is the moving average convergence divergence index known as the MACD. When the MACD generated a buy signal, momentum is accelerating. When the MACD generates a sell signal, negative momentum is accelerating. When the MACD is diverging, momentum is decelerating.
When a market is choppy or trading sideways, you may want to use technical indicators that tell you if the range is stretched too far. There are several indicators that you can use to determine if a security is poised to snap back. One of the most popular and efficient is the relative strength index. The RSI describes situations where the markets has accelerated to fast moving; either higher or lower. The RSI calculates an index between 1-100. When a security is overbought, the RSI has readings above 70 and when it is oversold, it represents readings below 30.
Another popular technical indicator you can use to determine if the price of security has stretched too far, too fast are Bollinger bands. A Bollinger band creates a standard deviation range around a specific moving average which represents the period you are evaluating. If you want to evaluate a month, the 20-day moving average is best (there are approximately 20-trading days in a month). If you want to evaluate a year, you can use a 250-day moving average. The Bollinger bands are a specific standard deviation around the moving average. Two standard deviations represent 95% of all the points in the range. When a security moves above the Bollinger band high, it can represent a sell signal which means that the price is now at the upper end of the historical range. When the price moves below the Bollinger band low, a buy signal is generated as the price of the security is now at the lower end of the historical range.
What is important to understand is that each of the technical indicators discussed perform the best in specific market environments.