What Are Technical Indicators in the Stock Market and How Do They Work?

6Mins Read 3 Mar 2025 0Comment Share

If you’ve ever looked at a stock chart on a trading platform and seen multiple lines moving in different directions, you’ve likely encountered technical indicators. These tools are crucial in helping traders understand price movement, predict market direction, and make informed decisions.

But what are the top 5 technical indicators, and what are the 4 types of indicators used in technical analysis? This guide will walk you through key concepts and essential indicators every trader should know, especially if you're trading on platforms like PSX or PMEX.

What Are Technical Indicators?

A technical indicator is a mathematical calculation or visual overlay derived from historical price, volume, or open interest data. Traders use indicators to:

  • Identify market trends
  • Predict potential price reversals
  • Confirm signals from other technical tools (like candlestick patterns or support/resistance levels)
  • Set entry and exit points for trades

These indicators act as decision-support systems. They don’t guarantee success but help increase the probability of accurate analysis.

What Are the 4 Types of Indicators?

Technical indicators generally fall into four categories based on their function:

  • Trend Indicators: Help identify the direction of the market (e.g., MACD, Moving Averages)
  • Momentum Indicators: Measure the speed of price movements (e.g., RSI, Stochastic Oscillator)
  • Volatility Indicators: Gauge how much the price is moving (e.g., Bollinger Bands, ATR)
  • Volume Indicators: Measure the strength of price movements using trading volume (e.g., OBV – On Balance Volume, Volume Oscillator)

Each of these types gives a different insight into market behavior. Traders often use a combination to reduce risk and confirm signals.

What Are the Top 5 Technical Indicators?

Let’s explore five of the most widely used technical indicators and how they assist in trading decisions:

1. Relative Strength Index (RSI)

RSI is a leading momentum indicator developed by J. Welles Wilder. It helps identify whether a stock is overbought or oversold, indicating potential trend reversals.

  • Scale: Ranges from 0 to 100
  • Overbought: Above 70 – may signal a price correction
  • Oversold: Below 30 – may suggest a rebound

Formula:

RSI = 100 - (100 / (1 + RS))

Where: RS = Average Gain / Average Loss (typically over 14 periods)

Example: Let’s say PPL's 14-day average gain is 2.07 and average loss is 0.714:

RS = 2.07 / 0.714 = 2.899

RSI = 100 - (100 / (1 + 2.899)) = 74.35

A value near 74 suggests the stock may be overbought. RSI is especially useful during sideways markets.

2. Moving Average Convergence Divergence (MACD)

Often referred to as the “grand old daddy” of indicators, MACD is a trend-following momentum indicator. It shows the relationship between two exponential moving averages (EMAs):

  • MACD Line = 12-day EMA − 26-day EMA
  • Signal Line = 9-day EMA of the MACD Line

Uses:

  • Crossover Strategy: Buy when MACD crosses above signal line; sell when it crosses below.
  • Divergence: If price is making higher highs but MACD isn’t, it can signal reversal.
  • Zero Line Cross: A move above or below zero can confirm trend strength.

MACD is particularly helpful for identifying trend strength and changes.

3. Bollinger Bands

Created by John Bollinger, Bollinger Bands (BB) are volatility indicators that adapt to market conditions. They consist of three lines:

  • Middle Band – 20-day Simple Moving Average (SMA)
  • Upper Band – 2 standard deviations above the SMA
  • Lower Band – 2 standard deviations below the SMA

Trading Logic:

  • Overbought: Price hits or exceeds the upper band — may be time to sell.
  • Oversold: Price touches or drops below the lower band — may be time to buy.
  • Squeeze: When the bands contract, it signals low volatility and potential breakout.

BBs work best in range-bound markets and can provide early signals in periods of low volatility.

4. Moving Averages (Simple & Exponential)

Moving Averages (MA) smooth out price data to reveal the underlying trend. They are of two main types:

  • Simple Moving Average (SMA): Equal weighting of all past prices.
  • Exponential Moving Average (EMA): Greater weight to recent prices.

Traders use MAs to:

  • Spot trend direction
  • Identify support/resistance zones
  • Trigger crossover signals (e.g., 50-day MA crossing above the 200-day MA signals a bullish trend)

Moving averages form the foundation of many other indicators like MACD and Bollinger Bands.

5. Stochastic Oscillator (Bonus Indicator)

While not covered in the original draft, the Stochastic Oscillator is another momentum indicator worth knowing. It compares a stock's closing price to its price range over a specific time.

Formula:

%K = ((Current Close - Lowest Low) / (Highest High - Lowest Low)) × 100

  • Readings above 80 indicate overbought
  • Below 20 suggest oversold

Commonly used with RSI for confirmation.

Do Technical Indicators Guarantee Success?

While indicators like RSI, MACD, and Bollinger Bands are powerful, they should not be used in isolation. Always combine them with:

  • Price action
  • Volume analysis
  • Support and resistance levels
  • Fundamental analysis (for longer-term investors)

No indicator can predict markets with 100% accuracy. They are best used as decision-support tools, not decision-makers.

Quick Recap:

  • MACD is a trend following system
  • MACD consists of a 12 Day, 26 day EMA
  • MACD line is 12d EMA – 26d EMA
  • Signal line is the 9 day SMA of the MACD line
  • A crossover strategy can be applied between MACD Line, and the signal line
  • The Bollinger band captures the volatility. It has a 20 day average, a +2 SD, and a -2 SD
  • BB works well in a sideways market. In a trending market the BB’s envelope expands, and generates many false signals
  • Indicators are good to know, but should not be treated as the single source for decision making

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