Market Indicators and Their Types: How to Use Them

What is a Market Indicator?

Market indicators are best defined as quantitative tools used by investors or traders to provide an approximation of what’s in store for future market movement. Essentially, market indicators will include a subset of technical analyses that differ from conventional ones only in the way data is aggregated across securities.

They help paint the picture of the general health and trends of the markets, not just companies or assets. The tracking of some key market metrics such as breadth, sentiment, and volume gives a better understanding of the current market environment allowing for more insightful trading and investment decisions.

Unlike the simplistic price charts, market indicators allow you to extract much more meaning from this sea of financial data. They can be very helpful in tracking emergent trends, finding possible reversals, and assessing the strength or weakness of a move in the markets. It is, therefore, one skill that a serious investor or trader should strive to learn: how to read and interpret indicators.

Types of Market Indicators

Market Breadth Indicators

These are indicators that quantify the balance of advancing against declining stocks in an index or market. Those metrics are going to give way to the underlying participation and strength of a market move, rather than just simply observing the performance of the biggest or most heavily weighted constituents.

Advance-Decline Line (A/D Line)

The advance-decline Line is the cumulative difference in the amount of advancing and declining issues each trading day. It rises when more issues are advancing than declining or else declines in case more issues decline.

The A/D Line confirms the direction of the general market trend. An advancing A/D Line shows more stocks participating in an uptrend, while a declining A/D Line shows weakening market breadth and is likely a trend reversal. Divergences between the A/D Line and the underlying index can also be an important signal.

To derive the A/D Line, subtract declining issues from advancing issues each day and add the results cumulatively:

A/D Line = Previous A/D Line + (Advancing Issues – Declining Issues)

A/D Line data for major US indexes like the S&P 500 and Nasdaq Composite are available on financial websites and data vendors.

New Highs-New Lows

New Highs-New Lows is another breadth indicator that counts the number of stocks making new 52-week highs versus those making new 52-week lows on any trading day. When the New Highs are more than the New Lows, it shows broad market participation and strength. Likewise, when New Lows rise faster than New Highs, it shows an increasing possibility of market weaknesses.

To calculate the New Highs-New Lows line:

New Highs-New Lows = Number of Stocks at New 52-Week Highs – Number of Stocks at New 52-Week Lows

Like the A/D Line, this indicator is often charted with the major market indexes to look for divergences and confirm the overall trend.

McClellan Oscillator

The McClellan Oscillator is a more complex measure of market breadth that smooths out the fluctuations in the Advance-Decline data by taking the difference between two different exponential moving averages of the Advance-Decline Line.

The formula for the McClellan Oscillator is:

McClellan Oscillator = 19-day EMA of A/D Line – 39-day EMA of A/D Line

The resulting oscillator normally ranges from -150 to +150, with plus values showing bullish breadth and vice versa. Divergences between the McClellan Oscillator and the broader market can be a red flag as well.

Market Sentiment Indicators

Whereas the market breadth indicators are meant for participation and momentum in respect of a market move, sentiment indicators seek to get information relating to general psychology and investors’ positioning. These indications might apply in attempts at showing how overbought or overly bullish markets – or vice versa if these markets are becoming oversold or too bearish-end.

Put-Call Ratio

The Put-Call Ratio is perhaps the most-watched indicator for market sentiment. It reflects the volume of trading in put options relative to call options, and hence it portrays the amount of fear and greed among investors.

A high Put-Call Ratio, in which the volume of puts exceeds that of calls, reflects more bearish sentiment because that means investors are taking a protective put position. On the other hand, a low Put-Call Ratio means that the call buying is higher compared to buying of puts.

The Put-Call Ratio is defined as:

Put-Call Ratio = Total Put Volume / Total Call Volume

A Put-Call Ratio above 1.0 is normally bearish, and below 0.85 it may be considered bullish. Another important analysis made is a divergence between the Put-Call Ratio and the general market.

Bull/Bear Ratio 

The Bull/Bear Ratio is much the same in concept as the Put-Call Ratio in that an attempt is made to measure investor sentiment directly by polling. An investment research firm, say the American Association of Individual Investors, conducts a regular weekly poll in which it asks what portion is bullish on the market, as opposed to bearish on the market.

A high Bull/Bear Ratio would imply a situation where the share of those feeling bullish was very large compared with the bearish portion and might indicate over-optimism, thereby leaving the market vulnerable. If it is low, there are more bearish investors than the bullish investors which means the market is highly pessimistic and hence due for a change in trend.

The Bull/Bear Ratio may be calculated as:

Bull/Bear Ratio = Bullish Percentage / Bearish Percentage

The readings above 1.0 are normally considered bullish, while the readings below 1.0 are bearish.

Volatility Index (VIX)

Volatility Index is a measure reflecting the sentiment of the market in respect of the predicted level of volatility over a forthcoming period of 30 days to the option on the S&P 500 index. It reflects a perceived notion by investors of where markets would stand in subsequent periods, especially with their behaviour of market risk.

On the other hand, a spike in the VIX may indicate that this is a market-selling climax and hence time to buy, since investors have become extraordinarily fearful. Conversely, low VIX levels may indicate complacency and an overbought market environment.

The VIX is a real-time calculation of the Chicago Board Options Exchange based on the prices of S&P 500 index options. It usually runs between the teens in placid markets and well over 30 in very volatile times.

Moving Averages

Moving averages are a staple of technical analysis, and they can also be used as effective market indicators. These metrics smooth out the day-to-day price fluctuations of an index or asset, helping you identify the underlying trend direction and momentum.

Simple Moving Average (SMA)

The SMA is the most straightforward type of moving average, calculated simply by taking an average of the close of an instrument over an arbitrary number of time frames.

The formula used to calculate the Simple Moving Average is given by;

SMA= Sum of Closing Prices Over n Periods / n

SMAs will come in handy in defining the trend direction on the whole, and also help in showing areas of support and resistance. Usually, a rising SMA confirms an uptrend, while a falling SMA signals a downtrend. Trading signals may also be triggered by the crossover between short-term and long-term SMAs.

Exponential Moving Average (EMA)

This puts more weight on the more recent data, or the Exponential Moving Average, which makes it very responsive to the recent price change. Hence, it is the main tool of measurement for changes in the short-run momentum.

An Exponential Moving Average would be calculated as follows:

EMA = (Current Close – Previous EMA) x Multiplier + Previous EMA

Where Multiplier = 2 / (Time Periods + 1)

It forms the basis of most indicators in giving buy and sell signals, such as that given by the MACD oscillator.

50-day and 200-day Moving Averages 

The 50-day and the 200-day simple SMAs are two major moving averages that most are aware of. The 50-day MA reflects a medium-term indication while the 200-day MA determines the long-term trend. These long-term moving averages are closely monitored by traders, investors, and market analysts to gauge the health and direction of the broader markets.

On-Balance Volume (OBV)

Another market indicator, OBV follows the flow of volume and thereby registers market momentum. Unlike the price, OBV zeroes in only on those data that relate to volume.

The formula for calculating the OBV

OBV = Prev OBV+ Current Volume if close > Prev close

Prev OBV -Current Volume if close<  Prev close then

Prev OBV-if close = Prev close

The OBV rises when volume is associated with a higher closing price than the previous close, and falls when volume is associated with a lower close. This way, the indicator can show the positive or negative volume pressure that moves the market.

Conversely, an uptrend is confirmed when the OBV line is rising-that is, volume is flowing into the market. The falling OBV line portends a possible downtrend since selling volume has begun to outpace buying volume. Divergences between the OBV and the underlying price action can also be an important warning signal.

How to Choose the Right Market Indicators

Trading Strategy and Time Frame

Some indicators may be more appropriate given your time frame and your trading approach. Shorter-term traders may put greater emphasis on momentum indicators, and volatility-type measures; longer-term investors will put more focus on trend-following and market breadth indicators.

For example, a day trader who wants to exploit intraday swings will get much more use from the McClellan Oscillator or VIX than the long-only investor using the 200-day moving average.

Market Conditions

The best set of indicators also changes with the market conditions at play. For uptrending markets, momentum indicators like MACD may be more valuable to depict when an issue has gone to overbought levels and when to expect a pullback. In choppy and range-bound markets, though, indicators of volatility, such as Average True Range—ATR—might show more relevant information.

Success requires paying attention to the broader market environment and a willingness to change with it by adjusting your toolkit of indicators accordingly.

Risk Tolerance

Your personal risk profile and trading style should also weigh in on the indicators upon which you decide to depend. More conservative investors tend towards market breadth and sentiment measures as these give a “big picture” view, whereas momentum oscillators are likely of more interest to more aggressive traders.

The bottom line is that the “best” indicators are those that work within your overall trading approach and risk management framework.

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Combining Multiple Indicators

While it is important not to get bogged down with information overload, the judicious use of a complimentary set of market indicators gives a better-substantiated analysis. The secret lies in finding confirmations and divergences by using multiple metrics to affirm your trading signals.

Specifically, you can actually combine the A/D Line with the Put-Call Ratio for an estimate of the overall market’s health, integrate the 50-day and 200-day moving averages to determine the direction of a trend, and so on.

Backtesting and Optimization

Having identified a core set of market indicators that you are going to monitor, the next step will be backtesting their past performance to find out whether they give consistent signals that provide meaning in your trading strategy. It may even be necessary to try different parameters and inputs for the indicators to optimize predictive power.

Tools such as grid search and genetic algorithms can systematically help determine the “best” indicator settings for your particular market environment and time frame. In other words, the key to keeping an edge in the markets is to keep backtesting and refining one’s use of the indicators.

Common Pitfalls and Mistakes in Using Market Indicators

Being Too Dependent on One Indicator

Over-reliance on any one market indicator creates blind spots and biases the analysis. Since all metrics have their strengths and limitations, it is always important to use a diversified set of indicators for a more holistic view of the market.

Misinterpreting Indicator Signals

Interpret the signals sprouting through the market indicators in order, starting from understanding how it works and what it purports to gauge. Disasters in trades are often a result of ignoring or not getting the finer points of the particular indicator.

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Failure to Account for Market Context

These market indicators do not operate in isolation; their meaning and importance may change with the overall environment of the market. It is always good to try and interpret the indicators in the proper context of prevailing trends, volatility, and investor sentiment.

Negligence in Risk Management

Even the most elaborate indicator-based trading strategy always has to put up with unforeseen events in the market and drawdowns. Unless you develop some efficient risk management practices that include the placing of stop-loss orders and position sizing, you are bound to expose your risk beyond acceptable limits.

Conclusion 

Market indicators are powerful analytical tools which give insight into health and directional trends in the financial markets. Paying attention to the different breadth, sentiment, and momentum metrics for complete clarity on the prevailing state of the market to facilitate insightful trading and investment decisions.