Signal Lines: What It Is, Calculation, and Limitations

What Is a Signal Line?

Signal lines are average lines used in technical indicators, especially oscillators. They generate buy and sell signals, or they can suggest a change in a trend. They are called signal lines because when another indicator or line crosses, them it sends a signal to execute a trade.

An indicator crossing a signal line can also signal that something potentially important is happening with the price of an asset. It could be that the price was trending, pulled back, and is now starting to trend again, or it could signal that a new uptrend or downtrend is starting.

Signal lines are often moving averages of a technical indicator, such as the moving average convergence-divergence (MACD) or stochastic oscillator. The signal line is applied to the indicator to generate more trade signals than would be available without the signal line.

A signal line is also commonly known as a "trigger line."

Signal Line Formula

Because a signal line is not itself an indicator, it will be calculated differently for each indicator in which it is used. The creator of an indicator will often generate a formula for the signal line when making the indicator. The signal line is part of the indicator.

Signal lines are usually simple calculations. For example, the signal line for the MACD is a nine-period exponential moving average (EMA) of the MACD value.

The signal line for the stochastic oscillator is a three-period simple moving average (SMA) of the stochastic (called %K in this case).

How to Create a Signal Line

To create a signal line:

1. Find the formula for the signal line of the indicator you are using. This is typically an EMA or SMA of the indicator.
2. Calculate the indicator or add it to a chart in charting software.
3. Calculate the EMA or SMA of the indicator.
4. Alternatively, apply the applicable moving average to the indicator on the chart to create the signal line.

How to Use a Signal Line

Most signal lines are created by using a moving average of the indicator values. These moving averages are usually simple moving averages (SMAs) or exponential moving averages (EMAs).

Signal lines may also be used to indicate a change in the momentum of a trend. For example, if an indicator crosses above the signal line it indicates the price is starting to move up. If an indicator crosses below the signal line it indicates the price is starting to move down.

These signals are typically used in conjunction with other pieces of information. For example, if the price is visibly in a longer-term uptrend, a trader may consider only taking long trades on bullish crossovers. They may sell when there is a bearish crossover, but they wouldn't enter a short position because that would go against the longer-term uptrend.

Other pieces of information that signal line crossovers are often used in conjunction with include forms of technical analysis, such as technical indicators, chart patterns, or candlestick patterns that provide confirmation. As another example, traders may use pivot points to identify potential turning points and then look to MACD crossovers for confirmation of a reversal.

Limitations of Signal Lines

Signal lines are usually just a moving average of an indicator. In this way, the signal line lags the movements of the indicator. As the indicator reacts to price changes it moves quicker than the signal line and this generates a crossover.

While signal lines can produce good signals at times, which result in large trend changes and price moves, many crossovers will be false signals. A false signal is when the indicator crosses the signal line but the price fails to move in the direction expected. The price may also crisscross the signal line, resulting in multiple signals which lose the trader money if the trade signals are traded.

For these reasons, signal line crossovers are rarely used in isolation. Other forms of technical or fundamental analysis are used to confirm trade signals or rule out taking certain signal line trades.

The Bottom Line

In investing, a signal line marks the point when a trade should take place if it is crossed by another indicator (such as price price). It can also signal to investors that a significant change has happened. By itself, it is not a technical indicator, but it is often paired with other technical indicators.

Usually, if an indicator crosses above the signal line, it's considered bullish for the price; if the indicator crosses below, it's considered bearish. In general, signal lines are a moving average of the indicator they are paired with. This limits their utility, as they may lag the movement of the indicator. They are also prone to sending false signals. Because of this, signal lines should be paired with other types of technical analysis in trading and investing.