What Is Indicator-Based Trading?

Definition and Example of Indicator-Based Trading

An indicator uses price data, mathematical formulas, graphs, and charts to create a visual signal for a trend in a market. Using indicators is called "technical analysis," because it uses technical instruments rather than fundamentals like balance sheet ratios.

For example, one popular indicator is the simple moving average, which is used to indicate the direction of a trend and ignore the price spikes that can occur in the short term. The moving average displays the average price taken over a specific period, which is why it "moves"—the interval doesn't change; prices are measured during a moving period, and their average is displayed on the chart.

How Indicator-Based Trading Works

The indicator shows a visual representation of the mathematical formula and price inputs. To an unskilled chart reader or trader, an indicator often won't reveal more than what is visible just by analyzing the price chart (or volume) without any indicators. Indicators give you a visual clue as to how prices are moving.

Here's an example: You log into your favorite trading platform and choose the market you want to participate in. Most platforms allow you to select the type of chart you prefer and offer many indicators.

The trading platform then automatically does the math to display whichever indicators you have chosen. In the chart below, you can see the long price drop in Apple (AAPL) that started in early April. Through May, the moving average (blue line) continued to drop. A trader would have noticed this indicator a few weeks into April and would have begun investigating the circumstances surrounding the decline. Once they were comfortable with the information that supported the moving average, they would make trades based on whichever outlook they had for the stock.

There are many indicators that traders can use. Many do not use more than one or two on a chart at a time, because it can get cluttered and become confusing. Here are a few of the indicators that traders use besides moving averages:

• Moving average convergence and divergence (MACD)
• Relative strength indicator (RSI)
• Bollinger bands
• Price volume trend
• Fibonacci retracement

Types of Indicator-Based Trading Strategies

There are thousands of indicators, and new ones are being created constantly. There are also countless trading methods and strategies involving indicators, but generally they all fall into one of two categories.

Crossover Strategies

A price or an indicator can cross paths with another indicator. Price crossing a moving average is one of the most straightforward indicator strategies.

An alternative version of the price-crossover strategy occurs when a shorter-term moving average crosses a longer-term moving average. This is called a "moving average crossover."

Crossovers occur in many indicators. For example, the moving average convergence divergence (MACD) provides crossover signals when the MACD line crosses the signal line or when the MACD or signal line crosses above or below zero. Signal indicators are usually a moving average, but they are not used as an indicator in these strategies. Instead, they are used with other indicators to create trading signals.

Other crossover signals include a relative strength indicator (RSI) moving above 70 or 80 and then back below, indicating an overbought condition that might be pulling back. Similarly, a drop below 20 or 30, followed by a rally back above 20 or 30, could indicate an oversold condition that could be relieved by a rally.

Uptrend and Downtrend Strategies

Many indicators act as confirmation tools. If a trader sees an uptrend on the price chart, indicators such as the RSI, MACD, or moving averages (as well as many other indicators) help assess the strength of that uptrend. These indicators also aid in confirming reversals and downtrends. 

Pros and Cons of Indicator-Based Trading

Pros Explained

• Simplify price moves: Indicators make it so you don't need to understand what is going on to make the chart trend up and down.
• Easier to interpret: New traders may find the simple movements of an indicator easier to interpret than the complex gyrations of the price chart. Note that "easier" in this case doesn't mean more profitable. Indicators are excellent tools for learning how to spot weakness or strength in the price, such as when a trend is weakening.
• Excellent for training: New traders may find it challenging to assess a price chart, but with the aid of some indicators, they are made aware of subtle changes they have not yet trained themselves to see on the price chart.

Cons Explained

• Only reveal price movement: The indicator shows a visual representation of the mathematical formula and price inputs.
• Doesn't predict future prices: Indicators only show what prices have done, not what they are going to do. A moving average might keep trending down, but that does not guarantee that it will continue that way.
• Doesn't benefit skilled chart readers: A trader who understands how and what a candlestick or bar chart is telling them doesn't get any more information from those charts by adding indicators.

What It Means for Individual Traders

These are just examples of strategies and indicators and not recommendations. Each trader must find indicators that work for them and produce a profit. Many strategies do not produce a profit, even though they are popular and well known.

Indicators should be used with caution, and you should practice trading them by using training software before venturing into the market and using your money. Various trading simulators out there can help you get started; moreover, they can help you find out whether indicator-based trading is for you.