Moving averages, MACD and RSI: what chart indicators can and can't tell you

Trend and momentum indicators are formulas that turn past prices into lines on a chart. Moving averages smooth the price to show the trend; MACD, RSI and the stochastic oscillator measure how fast the price has been moving.

They describe what already happened. None of them predicts the next move, and trading on every signal costs real money.

What these indicators are

The CMT Association, the professional body for technical analysts, describes technical analysis as analysing "statistical patterns in market data." The four tools below use only past prices of a share or an index, never the company's profits.

Moving averages: the trend, smoothed

A simple moving average (SMA) is the average closing price over a set number of days. Each day the oldest price drops out and the newest comes in, so the average "moves".

Worked example: a 5-day SMA

These prices are an example, not market data. A share closes at the following prices over 10 trading days.

Check day 5: 10 + 11 + 12 + 11 + 13 = 57, and 57 ÷ 5 = 11.4. On day 6, the 10 drops out and the 14 comes in: 57 − 10 + 14 = 61, and 61 ÷ 5 = 12.2.

Notice the lag. The price peaked at $15 on day 7 and was falling by day 8. It only closed below its average on day 9, at $13 against $13.80. By then it had already dropped $2 from the top.

SMA vs EMA

An exponential moving average (EMA) gives recent days more weight, so it reacts faster. Its weight on the newest price is 2 ÷ (days + 1). For a 5-day EMA that is 2 ÷ 6, or one third.

Start the EMA from the SMA, 11.4 on day 5. On day 6 the close is 14:

11.4 + (14 − 11.4) × 1/3 = 11.4 + 0.87 = 12.27

The EMA reads 12.27 against the SMA's 12.2: closer to the new price, which is the point. It also means more false turns.

The 50-day, the 200-day and the crosses

The 50-day and 200-day averages are the most watched. Many traders treat a price above the 200-day as a long-term uptrend.

• Golden cross: the 50-day average crosses above the 200-day.
• Death cross: the 50-day average crosses below the 200-day.

Both are lagging signals. A 200-day average needs months of prices to turn, so a cross often arrives after much of the move has happened.

MACD: two averages racing

MACD (moving average convergence/divergence) was developed by Gerald Appel in the late 1970s. It has three parts, with default settings of 12, 26 and 9:

Example, not market data. Say a share's 12-day EMA is $52.50 and its 26-day EMA is $51. The MACD line is 52.5 − 51 = 1.5. If the signal line is 1.2, the histogram is 1.5 − 1.2 = 0.3.

What traders read: MACD above zero means the fast average is above the slow one. A cross above the signal line is read as momentum improving, and a cross below as weakening.

Where it misleads: MACD is built from moving averages, so it lags too. In sideways markets its crossovers flip back and forth (whipsaws). It has no upper or lower limit, and its values scale with price, so you can't compare two shares by it.

RSI: gains against losses

The relative strength index (RSI) was introduced by J. Welles Wilder in his 1978 book, New Concepts in Technical Trading Systems. It runs from 0 to 100 and usually covers 14 days.

In plain words: compare the average gain on up days with the average loss on down days.

1. Add up the gains over 14 days and divide by 14. Do the same for the losses.
2. Divide the average gain by the average loss. This is RS.
3. RSI = 100 − 100 ÷ (1 + RS).

Worked example: RSI of 75

An example, not market data. Over 14 days, a share's up days add up to $6.30 of gains, and its down days to $2.10 of losses.

After this first reading, Wilder's method smooths each new day into the averages, so charting software may show slightly different numbers.

What traders read: Wilder treated readings above 70 as overbought and below 30 as oversold. Traders also watch divergence: the price makes a higher high while RSI makes a lower high, a sign the rise is losing strength.

Where it misleads: overbought can stay overbought. In a strong uptrend, RSI can sit above 70 for weeks while the price keeps rising. ChartSchool notes the 70 and 30 levels work best when prices move sideways in a range, and divergences mislead in strong trends.

The stochastic oscillator, briefly

George Lane developed the stochastic oscillator in the late 1950s. It shows where today's close sits within the highest high and lowest low of the last 14 days.

%K = (close − 14-day low) ÷ (14-day high − 14-day low) × 100

Example, not market data. The 14-day low is $40, the high is $50 and today's close is $48. %K is (48 − 40) ÷ (50 − 40) × 100 = 80. A 3-day average of %K, called %D, is drawn beside it.

Readings above 80 mean the close is near the top of its recent range, and below 20 near the bottom. Like RSI, these readings can last a long time in a strong trend.

Where all of them go wrong

• They lag. Every one is built from past prices, so signals come after the move starts.
• Sideways markets. Prices zigzag across the lines, giving signal after signal that goes nowhere.
• Settings change the answer. Change 14 to 9 and you get different "signals" from the same prices.
• Crowds. When everyone in a group watches the same line, it can fuel herd behaviour.

The limits: evidence, speculation and fees

The evidence is mixed. Park and Irwin (2007) reviewed 95 modern studies of technical trading rules. 56 found positive results, 20 negative and 19 mixed. But they flagged serious testing problems, such as picking rules after seeing the data and underestimating trading costs. Earlier studies they reviewed found the rules unprofitable in stock markets.

Short-term trading on signals is speculation. Trading on chart signals bets on price moves, not on a business. That is speculation. The SEC warns that day traders typically suffer severe losses in their first months. FINRA's day-trading disclosure says you should be prepared to lose all the money you use for it.

Costs add up with every signal. Each trade can carry a brokerage commission, small exchange or regulatory fees, and the bid-ask spread: you buy at the higher asking price and sell at the lower bid. FINRA, the US brokerage regulator, notes that "zero-commission" trading does not mean free investing.

Worked example: what 20 round trips cost

All rates below are examples, not quotes; check your own brokerage's fee schedule.

On $20,000, one round trip costs 20,000 × 0.5% = $100. Say a sideways market makes the lines cross 20 times in a year, and you trade each time. That is 20 × $100 = $2,000, or 10% of your money, before any gain or loss on the price.

Your plan

1. Learn what each line measures. Switch on a 50-day average and a 14-day RSI on any free stock chart, and check them against the formulas above.
2. Use them to read, not to act. When a news story says a share "broke its 200-day average" or "looks overbought", you now know what that means and what it leaves out.
3. Count the costs. Before any trade, work out the round-trip cost on your amount, as in the table above.
4. Never trade on autopilot. No indicator, level or cross is a reason to buy or sell by itself. Decisions about a share belong with the business, your goals and your time horizon.
5. Keep your base first. Keep your emergency fund in cash and clear expensive debt before you put money in shares.

What to watch out for

• "Signal" groups and paid tips. Screenshots of a golden cross or an RSI level are not analysis. The SEC warns that some newsletters and websites are paid to promote shares.
• Backtests that look perfect. A rule tuned to past prices often fails on new ones.
• Mixing up trend and value. A rising line says nothing about whether a company is profitable or fairly priced.

This guide is for education only. It is not advice to buy or sell any share, or to trade on any indicator.