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Introduction to Trading Signals
In the stock and forex markets, timing is key. Knowing when to buy or sell can make the difference between a big win and a crushing setback.
Meanwhile, complex emotions can plague our decisions, causing us to sell too early or too late, further adding to our fears and doubts.
To help mitigate the challenges of unpredictable markets and emotional decisions, traders have developed decision-making systems based on solid data and objective indicators. These predictive algorithms are called trade signals.
Whether you want to use trade signals or expand your market IQ, you’re in the right place. In this brief introductory guide, we’ll explain what trade signals are, list some common indicators, and examine how this tool can support better investing decisions.
What Are Trade Signals?
A trade signal is a trigger to buy or sell a stock, forex pair, or other financial instrument based on predetermined criteria.
The idea is to make trades with rule-based, data-driven decisions rather than instinct, emotions, or other irrational motives. If designed correctly, trade signals can help you maximize profits while reducing – but not eliminating – risk. Consider a limit order.
A limit order automatically submits a buy or sell order to the market when a specific price is reached.
Rather than submitting your order when you “feel” it’s right, you submit it automatically based on a specific predetermined indicator – in this case, price. This is a simple example of a trade signal.
From here, trade signals can become much more complex, with several overlapping indicators combining to create a signal that specifically matches your goals and risk tolerance.
Trade Signal Indicators
Trade signals are derived from a wide variety of technical, fundamental, and market indicators. But remember, no single indicator is true 100% of the time.
All indicators must be confirmed and cross-validated with other indicators to improve reliability and produce meaningful trade signals.
Technical analysis of stocks, forex, or other investments examines historical price and volume data to identify trends and patterns that analysts use to predict future results. Technical indicators form the basis of most trade signals.
There are numerous technical indicators, but here are some of the most common and reliable options traders tend to rely on:
Price actions are the most basic indicators, focused on trading volume, trends, support, resistance, breakouts, chart patterns, and other technical analyses. When prices break through support or resistance, it often indicates a buy or sell opportunity.
Moving averages indicate the average prices of a stock or currency over a specific time period. It’s “moving” because the oldest data is removed as new data is added.
Moving averages can be simple (SMA) or exponential (EMA). EMA places more weight on recent data, so it’s generally a more useful indicator. When moving averages of different periods cross, it often indicates change is imminent.
Moving average convergence divergence (MACD) incorporates both market momentum and trend, so it helps qualify other indicators that are distorted by trending prices. First, subtract the 26-period EMA from the 12-period EMA to create the MACD line.
Next, a 9-day EMA is taken from the MACD line to create the actual buy/sell indicator, then plotted on top of the security price line. As the security price shifts above or below the line, it can indicate a buy or sell opportunity.
Relative strength index (RSI) measures bullish or bearish price momentum and indicates whether a stock is undervalued or overvalued.
RSI measures recent price changes on a scale of 0 to 100, with 70 and above indicating the stock is overvalued and 30 and below indicating the stock is undervalued.
When RSI crosses above 70 or below 30, it might indicate a buy/sell opportunity. However, RSI can often be less accurate in a trending market, so it must be validated with other indicators.
Fibonacci retracements and extensions are used to indicate where support and resistance are likely to occur. Analysts choose a high and a low, then populate Fibonacci lines in between at 23.6%, 38.2%, 50%, 61.8%, and 78.6%.
Theoretically, support and resistance should occur at one of these points. This indicator is less reliable, so it should be confirmed with other indicators.
Stochastic oscillators indicate price momentum and whether a stock is overbought or oversold based on a 0 to 100 scale.
Basically, it lets you know if the current price is high or low in the context of a specific time frame. Stochastics tend to be more accurate than other indicators, so analysts usually incorporate this option into their algorithms.
In contrast to technical analysis, fundamental stock analysis focuses on the business itself rather than random and unpredictable stock prices. Fundamental indicators are essential to cross-validate the technical indicators described above. Some common indicators are:
- Earnings reports often trigger price changes, especially if the actual results differ significantly from projections.
- Valuation fundamentals such as price-to-earnings ratio (P/E), earnings-per-share (EPS), dividend yield, and more can all affect stock prices. Changes indicate potential opportunities to buy or sell.
- Management changes can also cause price shifts as the market reacts to the hiring or firing of a CEO or other top personnel.
- Product launches often garner attention – for better or worse. A game-changing innovation can cause a stock price to jump, while a lackluster launch can cause investors to bail out and take their money elsewhere.
- News events can include anything from new regulations to scandals to natural disasters that affect supply chains – all of which can influence stock prices.
Economic & Market Indicators
As no stock or currency exists in isolation, broad macroeconomic changes and Intermarket relationships can also indicate stock or currency price movement.
Technical analysts might argue that these factors are already built into the price, but it’s still important to understand their role as indicators. Here are some common examples:
- Interest Rate Changes
- Bond Yield
- Put/Call Ratio
- Forex Pair Correlations
- Inflation Rate
- Commodity Prices
- Bullish/Bearish Sentiment
How Do Trade Signals Work?
Trade signals are usually set up in three ways. First, you can develop your own signaling system if you know how to write computer code (not for beginners).
Next, many online trading brokerages and forex systems allow you to set up your own trading signals.
Third, you can use a third-party system designed specifically for this purpose.
But remember, algorithms are only as good as the analysis that goes into them. Beware of lofty claims, and always check the details of how third-party systems design their trade signals.
For a good example, check out Elliott Wave Forecast’s forex trading signals. They provide a complete breakdown of their trading theory and the indicators that compose their trade signals. Any system you rely on should be equally detailed and transparent.
Trade Signals for Long-Term Investors
Often, trade signals are used for quick in-and-out trades as the market moves faster than we can. This means most signaling systems are oriented toward day traders and forex traders. However, long-term investors can still use trade signals for their benefit.
Beyond simple buying and selling, trade signals can be used for asset allocation or portfolio diversification.
If your portfolio diversification falls out of balance due to changing prices, you can set up trade signals that automatically realign your portfolio according to your goals.
Check out your online brokerage to see what trading signal options are available to you. You can also use a consolidated portfolio tracker like StockMarketEye to set up alerts based on simple technical and fundamental indicators.
Trade Signal Limitations
After 100+ years of stock market trading, nobody has figured out a way to accurately predict the future with 100% accuracy.
Even the best indicators are wrong sometimes. While good trade signals use overlapping indicators to mitigate this risk, trade signals are often wrong, too.
This is just the way it is. We can’t be right all the time. All we can do is try and mitigate our risk, which is the main goal of trade signals. Don’t get caught in a trap thinking that trade signals are a ticket to risk-free investments.
Also, trade signals still require interpretation to be effective, which means you must understand the underlying indicators. A certain level of experience and knowledge is required before putting this tool to work.
Don’t use trade signals as an excuse for not doing your due diligence.
Finally, trade signals are not a complete solution. This tool is only part of the comprehensive analysis required before investing in securities or trading forex.
However, it’s a powerful tool, so it’s worth it to put in the time and learn how it works.
We hope this article gave you a better understanding of what trade signals are and how you might use them to automate aspects of your decision-making process.
But remember, this is just a brief introduction to the topic and far from a complete analysis. We recommend conducting thorough research before putting trade signals into practice.
And don’t forget, nobody – and no algorithm – can perfectly predict the market. All we can do is use as much data and analysis as we can to try and be less wrong. Trade signals are just another tool in our toolbox to help us achieve this goal.