The use of indicators makes it possible to anticipate the future direction of a share price’s movement, however no single indicator will be right all the time. Technical analysts will often use several indicators at once, looking for confirmation or alignment. I’m often asked which indicators are best and there is no correct answer to that question. There are so many indicators available to use and all are a function of time, price and volume in one way or the other.
Several concepts that I always use in conjunction however are trend, relative strength comparison and momentum. There are a different ways to measure each of these and which way is best is open for interpretation. Momentum is a force in nature that the famous scientist Sir Isaac Newton spent a lot of time studying. I had no idea at the time in High school that those lessons would ever have come in handy a few years down the track when looking at the financial markets. Newton once famously said, ”a body in motion tends to stay in motion”, and this is certainly true when it comes to the flow of money into or out of a stock or sector.
Martin Pring in Technical Analysis explained, discusses the use of Relative Strength Comparison and gives some great insight into the force behind it. Pring discusses the rotation of funds out of one sector into another as part of the cyclical nature of the markets. Those sectors where money is flowing into will experience an increase in their rate of change of price in comparison to the broader market. Likewise, the rate of change in an individual stock can also be compared to the broader market. Lurking behind this flow of money are the big participants like fund managers for example, with a huge wave of money. Once the wave is in motion…well… you know the rest, it tends to stay in motion.
Measuring a change in price over different time frames is a useful way to pick up changes in the overall trend. Short term trends are the first to move, then medium followed by longer term. When all three are in alignment and pointing in the same direction, the market is telling us something. Once a trend gets underway it can go for a very long time, so being able to detect changes in trend is is a very useful skill, particularly as a smaller participant.
Understanding the concepts of trend, momentum and relative strength comparison, should be the cornerstone of any serious investing strategy in my opinion. Couple that with some simple entry and exit rules and sound risk management and you’ve got the makings of your own market blueprint. Which indicators to use, is up to you. Hopefully some assistance has been provided today.
David McCulloch is a market educator and consultant to Share Wealth Systems.