Using the best technical indicators can make a big difference to the success of your short-term trading strategy. Make sure you’re not using the wrong ones! Read more to find out.
Definition: What is a technical indicator?
Technical indicators are mathematical equations that use price data, including the opening price, closing price, price highs and price lows (OHLC). They are displayed either on top of price, known as overlays or beneath the candlestick chart, known as underlays.
Technical indicators can be used in day trading in any market. Popular short-term trading markets, where technical indicators can be used include forex trading, commodity trading, indices trading and are very popular with crypto traders.
The reason for technical indicators is to present what the price action is showing in a different visual way that can inform the trader on information such as trend, volatility, overbought or oversold conditions or give buy and sell signals.
Types of technical indicators
We have chosen 3 different types of technical indicators, where each indicator performs a separate function from the others. This means there is no conflicting information, and each technical indicator compliments the others.
These 3 functions are: trend following, momentum and volatility.
3 Best Technical Indicators
The following list of what we think are the best technical indicators for day trading is not exhaustive but includes some of the most popular indicators for day trading on short timeframes. Over time, you might choose to change the settings on the indicators, use customized indicators or even create your own custom technical indicator.
- Moving Average (SMA or EMA) for Trend following
- Relative Strength Index (RSI) for Momentum
- Average True Range (ATR) for Volatility
1) Moving Averages
What is the moving average indicator? Anybody who has looked at a price chart will know that prices fluctuate wildly. The moving average attempts to smooth out this price action by taking the average price over a rolling number of periods. The result is smooth line that tracks behind the candlesticks or price bars, overlayed on your chart.
How moving averages are used: The smoothed line makes it easier to determine the trend of the market. If the line is sloping up, the trend is up, while if the line is sloping down, the trend is down. Moving averages can also provide trade signals when price crosses the moving average or when a shorter term moving average crosses a longer-term moving average.
Why a moving average is good for short term trading: Moving averages are primarily designed for trend following. SMAs and EMAs are lagging indicators, which means the price needs to move first and then the indicator will react to that change. The benefit is that they smooth out the market ‘noise’ but the downside is that they can be slow to show that the trend has changed at turning points.
While popular settings for long term traders include the 50-day moving average and the 200-day moving average, the indicators will adjust according to the timeframe you are trading. Using a one-hour chart, the 20-period moving average will adjust to 20 hours.
2) Relative Strength Index
What is the RSI indicator? It is an oscillator, which means it displays as an underlay indicator and fluctuates between readings of zero to one hundred. The math behind the indicator is comparing the size of ‘up moves’ versus ‘down moves’ – so the idea is it compares the ‘relative strength’ of the bulls versus the bears.
How the RSI indicator is used: It is most commonly used for finding overbought and oversold conditions in the market. Meaning price might have moved too far too quickly, and could be about to reverse. Traders will also compare the swings in the RSI indicator with swings in the price to find divergence between the two. Divergence is another signal to show the current price move might be about to reverse.
Why it is good for short term trading: On short timeframes, price can change direction quickly. Momentum indicators like RSI are a leading indicator, which means the RSI will often change direction before the price. This can give traders an early warning signal to exit a trade before the price reverses. The drawback is that RSI can display false signals, suggesting a trend will change when it doesn’t.
The default settings for RSI are using 14-days but dropping down to lower time frames like the one-hours chart will produce an RSI constructed using 14 hours of price data instead.
3) Average True Range (ATR)
What is the ATR indicator? The Average True Range can be written as a single number or presented on the chart as an underlay, tracking how the figure has changed over time. It shows the average number of points a market has moved over a certain time period. The typical setting is 14, meaning it measures over 14 periods.
How the ATR indicator is used: It is used as a measure of realized volatility, i.e. how much the price of a market has been moving over a certain period of time. This is useful information for day traders who are trying to decide where to place stop loss and take profit orders. For example if a stock or forex trade is expected to last several hours, typically the stop loss would need to be at least 1X of the 1-hour ATR(14).
Why it is good for short term trading: As a short term trader, it can be tempted to get drawn into longer term trades as the price moves up and down. The ATR can serve as a benchmark for where to set profit targets and cut losses.
Like with the above indicators, the trading platform will adjust the time frame settings to lower time frames to adjust for short term trading. Thus, the trader can use an 14-hour ATR instead of a 14-day ATR for more accurate information on short term volatility.
Putting it all together into a trading strategy
The following chart shows each technical indicator performing a function, which combined can form part of your day trading rules based strategy.
Good short-term trading opportunities come about when all three indicators work together.