CHAPTER 11

Technical Indicators

Any intelligent fool can make things bigger, more complex, and more violent. It takes a touch of genius—and a lot of courage to move in the opposite direction.

— Ernst F. Schumacher

What Is an Indicator?

Technical indicators are mathematical formulas based on market data—most often prices, but also occasionally volume and open interest. (In the equity market, other data, such as the number of advancing or declining issues, are sometimes incorporated in these calculations.) The implicit goal of most technical indicators is to signal potential changes in market direction that might not be apparent through direct price analysis or fundamental analysis. The implicit assumption underlying this approach is that indicators extract or distill useful forecasting information from market data.

Most indicators attempt to translate price action into directional signals in one of two ways:

  1. Comparing current price levels to past price levels to determine the prevailing direction and magnitude of price change.
  2. Using a smoothing function, such as a moving average, to filter out what are deemed to be random fluctuations (“noise”), thus revealing a market’s prevailing trend.

There are any number of ways to accomplish either of these goals, or to combine them. Consider the simple case of comparing today’s closing price with the most recent 20 days of price action to determine how much price has changed and whether the close is relatively strong or weak. The ...

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