Demystifying Indicators: Definition and Classification
Have you ever been to the dentist? Maybe you are wondering what the relationship between dentistry, financial markets, and technical analysis is. So let’s begin.
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Pejman Zwin - 12 min read
Have you seen the dentist’s instruments? Which one cures you? The dentist or the medical instruments?
Your answer is definitely the dentist. Tools help the dentist to treat you more easily. That means, in the end, the expertise and knowledge of the dentist are essential; and dental tools can never cure anyone.
If the dentist doesn’t have the necessary knowledge, these tools will not work either. There is a similar situation in financial markets and technical analysis.
Some tools help you analyze better and more quickly in the financial markets. But in the end, it is you who must decide.
You can trust them and do your transactions based on the approval of one or more of these tools. On the other hand, these tools can even reduce your possible mistakes, and you can use them on any chart you like and even personalize them.
Money doesn’t grow on trees, so you have to check many factors for any investment. Fortunately, some tools help you to find the necessary information for trading in the financial markets, like an assistant. On the other hand, they don’t get paid, but they bring you money and profit. They are called Indicators.
When I started trading, I didn’t know anything about these tools. One day on social media, I saw a post whose thumbnail caught my attention. “These two Indicators predict the future of the market.”
I wondered, what is an Indicator? How can it predict the future of the market? I took a look at that post, but since I had no background in Indicators, to be honest, I didn’t understand it. But it was a spark for me to pursue learning Indicators seriously.
It seemed that they could simplify my work, but if you use the Indicators without any study, you will get into trouble like me, and you will definitely get confused.
Long story short. I made the mistake of trading without learning the basics of Indicators and made some lucky profits and, of course, more losses.
After many losses, I decided to change my method. I took a break from the market to at least research some of the indicators I only knew the names of and learned some basics.
After this break and learning better, I started to practice; believe me; these Indicators are like a miracle with learning and practice. They made trading more effortless, and like the thumbnail I saw that day, they could predict the market and guide me.
I could also earn more profits with the help of them. First, by knowing the types of Indicators and then knowing the efficiency of each one, and finally, after a lot of practice, I increased my trading profit from 28% to 35% in a trading period.
If you don’t want to repeat my mistakes and decide to understand Indicators thoroughly, you have chosen an excellent article to read. So let’s get to learn more about these money-making tools.
The Definition of Indicators
Indicators are mathematical functions and algorithms designed from the raw materials of technical analysis such as price, time, and volume and their combination with mathematical functions.
Today’s famous and popular tools have come a long way to get here and be accepted by traders. Many of them have even been rewritten several times.
Indicators were created to help traders. They were programmed to collect and analyze all past and present market information for you in seconds, which would take you days to do alone.
Simply put, the Indicators extract information from the price and time chart and put it into certain mathematical functions. The output of this process provides information to analysts for making future decisions. The priority for analysis and decision-making is the price chart; the Indicators only help us to make better decisions.
Let me explain a little more about this because it is one of the essential points you should pay attention to before using Indicators.
Consider crosswalks on the road surface; you slow down or even stop when you approach them. These lines are the basis of your driving decisions; a traffic sign next to the crosswalk refers to the same issue.
But if the crosswalks are the basis of your decision-making, why is it necessary to have a traffic sign next to them? On some days when the weather is not good and the road surface is not visible, this sign can help us greatly. Like the example above, Indicators are not the basis of our decision-making and only help us make better decisions.
Now that you know the basic definition of Indicators, it’s time to familiarize yourself with the types and classification of Indicators.
Classification of Indicators
As you know, financial market charts are drawn based on two essential axes: the time axis and the price movement axis. Indicators can also be classified in terms of time or in terms of price movements.
- Indicators in terms of price movement
Trend Indicators:
In previous articles, you learned about various trends in the market and how to identify them. I used to try to identify trends by using simple tools.
I practiced a lot, and of course, I was successful to some extent. But I wondered if there were better and faster ways to analyze market trends. When researching different Indicators, I came across a type of Indicator called a Trade Indicator or Trend Follower.
I realized these Indicators are designed to determine whether the market is trending or in a range. If there is a trend, they would also show the direction of that trend.
It was an excellent chance to spot a market trend quickly; in addition, these indicators did not suffer from my possible mistakes.
I needed to know the trend of the market before each trade. Because as I said in previous articles, trading in ranging and trending markets is entirely different.
Some common Trend Indicators are Simple Moving Averages (SMA), Exponential Moving Averages (EMA), Bollinger Bands (BB), Average Directional Movement Index (ADX), Parabolic Stop and Reverse (Parabolic SAR), etc.
In the past, it was difficult for me to recognize a trend in shorter time frames because in shorter time frames, the price is a bit tricky and behaves excitedly. As a result, it becomes difficult to use most technical analysis tools in short time frames. But it was interesting that Trend Indicators were useful even in shorter time frames and solved this problem for me.
The most famous Trend Indicator, which might be the first innovative Indicator in the history of technical analysis, is the Moving Average Indicator. I have used the Exponential Moving Averages (EMA) Indicator on the OPUSDT chart below.
As you can see, I have drawn trend lines in this chart. Looking carefully, you will notice that the EMA Indicator has performed like a trend line and can help us to find the direction of the trend.
In this example, where I have drawn the upward trend line, you can see that the price has permanently moved above the EMA too.
It was interesting for me that the EMA Indicator was introduced by a person named Haurla, who was a rocket scientist doing research and working in a laboratory in California in the early 1960s and used the mathematical concept of EMA from those rocket days.
Oscillators:
Oscillators are helpful in trending and range markets; they can detect overbought and oversold areas and issue signals to enter or exit a position. They are beneficial and are used by traders and market analysts.
This Indicator will create an OverBought (OB) and OverSold (OS) area when price fluctuations on the chart begin and cross the OverBought or OverSold areas.
One of the best Oscillator Indicators is the Relative Strength Index (RSI), which you can use to measure buying and selling power in the market, identify saturated areas, and then decide to enter or exit the market.
The RSI Indicator shows you the OverBought (OB) and OverSold (OS) areas with a percentage. It is also one of my favorite Indicators, and I will explain more about it in later articles.
You can see the RSI indicator and the Overbought & OverSold areas in the chart below. I have determined that in the areas where the Indicator is overbought or oversold, the price has fallen or increased in the same places.
As you can see, the RSI Indicator gives you a signal by entering or leaving the overbought and oversold areas. It can be attractive for every trader that the Indicator shows market fluctuations with its movements and gives you signals. I will cover these exciting features in later articles.
Some of the famous Oscillator Indicators are Stochastic Indicator, Commodity Channel Index (CCI), Relative Strength Index (RSI), Moving Average Convergence Divergence (MACD), and other Oscillator Indicators that you can use to identify fluctuations, oversold and overbought areas.
Volume Indicators:
These Indicators measure the amount of liquidity in the market or the amount of money leaving the market. You probably always want to be aware of this market information and know the flow of smart money in the market.
Volume Indicators try to collect information about how smart money enters and exits the market by using calculations and measurements on the volume of transactions and help you to surf on the wave of liquidity flow.
Some Volume Indicators, like Volume, Money Flow Index (MFI), and On Balance Volume (OBV) are well-known among traders. Take a look at the chart below. I’ve used the Volume Indicator.
Volume Indicators were not attractive to me in the past, and I did not use them. But later, I realized that the volume of market liquidity is significantly related to its trend.
For example, when the volume of liquidity is high and there is a lot of smart money circulating, the market is usually trending. Or, if you remember, one of the conditions for the validity of some cases was the volume of liquidity.
For example, on the topic of support and resistance levels, you learned that breaking support and resistance levels by increasing the volume of liquidity can be more valid.
As I mentioned, Volume Indicators may be less popular among traders than Trend and Oscillator indicators, But all these indicators work better together and complement each other.
- Indicators in terms of time:
Leading indicators:
These Indicators are designed to predict the future behavior of the market. They are often used as a trigger in trading systems to issue buy and sell signals.
For example, the Leading Indicators try to predict and warn you before the trend changes. I can mention Stochastic, RSI, and MACD Oscillators among the most famous Leading Indicators. In the chart below, let’s see an example of a Leaning Indicator called Stochastic, which is also an Oscillator Indicator.
As you can see, I have marked the OverBought (OB) and OverSold (OS) areas in this chart. When the Indicator’s lines enter the OverBought and OverSold areas, they will leave them after a while. And this change in the Stochastic trend direction is apparent in the price movement in the above chart.
Entry or exit from these areas can be buy and sell signals for you and provide you with exciting information. I use Stochastic and RSI Indicators to detect a trend or even the end of a trend. I will discuss it in the coming articles and tell you how to get useful information from these Indicators.
In the end, it is interesting to know that the creator of this Indicator, Mr. Jane George Lane, believed that Stochastic could be very useful in combination with other Indicators.
Lagging Indicators:
As their name suggests, these Indicators are slightly behind the price. They try not to get involved in the temporary fluctuations and excitement of the market and only show the main body of the price movement.
These Indicators are often used to filter the signals of other Indicators. In general, all Trend Indicators belong to the category of Lagging Indicators.
Among the Lagging Indicators in the chart below, I would like to mention the Bollinger Bonds (BB) Indicator, which I’ll discuss more in later articles.
When I had just learned about Leading and Lagging Indicators, I was more interested in using Leading Indicators, because they could predict the trend of stocks; but as I told you, Indicators are not magicians, and there will always be errors.
Later, when I understood the market and Indicators better, I realized the importance of Lagging Indicators. And in general, I realized that I should use both Leading and Lagging Indicators in technical analysis to reduce possible errors. I will tell you more about this in the coming articles.
Conclusion
Financial markets are similar to a chess game. A chess player has to predict several moves ahead in each move, and a wrong move may even affect the chess player until the end of the game.
In the financial markets, the same issue prevails. Every trader’s decision should be defined within the jigsaw puzzle of their trading strategy and line with the realization of their overall trading goals. A position may not earn you in the short term, but it can bring rich profits over a long time.
A chess player has no tools except thinking and chess pieces to progress the plans, but traders have several tools at their disposal in financial markets to make decisions. Indicators are one of those wonderful tools in technical analysis.
Indicators are designed to help you and make your work faster; you should learn and collect a little information about each Indicator to make the best use of each one.
In this article, you got familiar with the concept of Indicators and their categories, and even with the names and efficiency of some of them. In the next steps, you can learn how to use each Indicator.
Ultimately, as mentioned before, all Indicators are like dental instruments. They cannot cure anyone alone. In the end, you should use them together with your knowledge and expertise.
So, as in the previous articles, I emphasize: read, learn and practice to be successful. And never forget risk management. Stay with me, as I will tell you more about Indicators and their uses in future articles.