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What Are Technical Indicators?
Technical indicators are the very foundation of technical analysis. It may be prudent to first answer the question of technical analysis and then delve into why technical indicators are such an important piece. Technical analysis is one of the methods that is used to help predict the future movement of an asset's price.
Technical analysis can be based on subjective chart patterns that reoccur. Some of the most popular reoccurring chart patterns are the double top, double bottom and head and shoulders. For example, the double top is simply a point where the prices seem to hit a ceiling and bounce off of that ceiling only to hit the ceiling again in a relatively short period of time. This is a sign to a chart reader that the buyers are drying up at the top point and without the ability to break through the top, there is likely a good play to the downside. A person holding a long position in this asset may want to consider selling their holdings to find another play with strong technicals. A riskier speculator may want to take a short position when the asset fails to break through the second peak.
Still another form of subjective technical analysis comes in the form of candle stick charts. Most technical analysts prefer these charts to bar or line charts when representing price data. Some technical traders believe that repeatable patterns exist within the candlesticks themselves. These are known as candlestick patterns.
Subjective chart patterns are difficult to "train" a computer to see. Many of them are conditional based on previous bars and other subjective items within the chart. There have been efforts made to code these patterns in such a way that the computer can identify them, however, it's not a perfect fit.
This makes technical indicators an automated system developers natural choice. An indicator is a self contained algorithm that takes a series of values, performs some computation and returns a single value. Based on the indicator author's direction, the value of the indicator means something. While there is still room for subjective interpretation, a single number is something that can easily be developed against to make decisions.
The simplest of technical indicators is the simple moving average. A simple moving average (SMA) takes the previous prices from an asset and performs a mathematical average. Most of the time, the SMA uses the closing price of the asset in the calculation, however, it is not forbidden to use other parts of the bar (open, high, low) for the calculation.
Most technical indicators take input parameters. In the case of the simple moving average, the parameter is simply number of bars to look back. For a fast moving average line, a period parameter of five would generate lines that close in fairly close step with the actual price. A period parameter of 200 would make the SMA line lag significantly. Some simple technical analysis performed by some would be trend analysis. Since the 200 period SMA lags, a price above a rising 200 day SMA line would be considered bullish. A line below a falling 200 period SMA would would be considered bearish.