Most successful traders rely on technical analysis and indicators to navigate the markets. Whether you’re trading the forex, commodities, stocks, futures, and other markets, indicators can be useful tools in your trading success.
And why not? Indicators provide helpful directions, visual signals and useful trends that traders can use in understanding and analysing the forex markets.
Whether you’re new to trading or have been trading the markets for years, technical analysis and indicators can help in making sense of market movements.
In this post, we will talk about the most basic and helpful indicators that a trader can use in trading the forex markets. We will describe two trend indicators and two oscillators.
In simple terms:
- Trend indicators help in determining a price direction (like downward or upward);
- Oscillators work best in a sideways trend (think choppy, directionless markets).
So, let’s start with the two best trend indicators:
Moving Average
The Moving Average (MA) indicates the median price of a currency pair during a specific period. The MA is measured automatically by averaging the price over a given period. Whenever the price changes in real time, it will affect the median price (the MA) as well.
Here is what you should consider when trading with the MA:
- If you longer period MA (say 200 periods), it will become less vulnerable to price changes;
- If you set a small period for the MA (say five periods), it may show many false signals;
- Always keep in mind that Moving Averages are lagging indicators and are very slow to move.
There are four (4) types of MAs:
- Simple Moving Average (SMA)
- Exponential Moving Average (EMA)
- Smoothed Moving Average (SMMA); and
- Linear Weighted Moving Average (LWMA).
However, the first two are by far the most widely used.
The Simple Moving Average (SMA) considers both earlier and recent results as being of equal importance, while the exponential moving average (EMA) gives more attention to the recent price changes against the older ones.
There are two key signals coming from the MAs:
- When the price action crosses the MA from the bottom to top, it shows it is time to buy, and vice versa.
- The MA direction shows the general trend direction, so you should always trade with the general trend and not get confused by price corrections.
Bollinger Bands
Bollinger Bands were developed by world renown technical trader John Bollinger. They are used to measure price volatility and are helpful to identify when prices may have moved too far relative to recent trading activity.
As the name suggests, Bollinger Bands (BB) are made up of a combination of bands using Moving Averages (MA).
The Bollinger Bands have three bands:
- The central band – which is a simple moving average (SMA);
- The upper band, which is a MA + 2 standard deviations;
- The lower band, which is MA – 2 standard deviations.
When trading on BB, you should know that the price is likely to keep within the upper and lower bands. It is like channel trading. When the volatility is high, the BB broadens, and when there is low volatility and the price is calm, the BB indicator becomes more compact.
Here is what the indicator shows:
- After the bands become narrow, one would expect a high volatility;
- If the price gets out of the upper band, you should expect a trend continuation up, and vice versa;
- When the highs and lows inside the bands come after the highs and lows outside the bands, you should expect a trend reversal.
One of the most common and simplest ways to use Bollinger Bands is to use the upper and lower bands as price targets.
For example, if you’re trading gold and the price bounces off the lower band and cross above the 20-day average, the upper band becomes the price target.
Now, here are the two most widely used oscillators:
Stochastic
This indicator was popularised by George Lane, a technical analyst, author and trading educator. He was instrumental in teaching investors and financial professionals the basics of technical analysis.
Stochastic oscillator is a momentum indicator, which means it signals the strength and speed of movement of prices.
The use of Stochastics is based on the observation that as prices increase, closing prices tend to closer to the upper end of the price range. On the other hand, during downtrends, the closing prices tend to be near the lower end of the range.
It is made of 2 lines: the fast one, knows as %K, and the slow one, called %D.
The latter is more important since it captures a wider picture. The indicator will help you set the close price to the high-low range over a given period.
The oscillator reading is done by using percentage (0-100%). When the indicators go above 80% line, it suggests the close price is closer to the upper limit of the range (close to the highs), and when it goes below 20% line, then it means the close price is closer to the bottom limit.
Stochastic comes with three types of signals: divergence, Stochastic line level, and the direction of the lines. With these signals, you can evaluate the tendency, such as bullish or bearish or the overbought and oversold state of the currency pair.
MACD indicator
MACD is the abbreviation of moving average convergence/divergence. It was developed by Gerald Appel in the late 1970s.
This indicator is supposed to show changes in the strength, direction, momentum and duration of the trend in price movements.
The MACD is displayed in the form of a bar graph. The indicator’s histogram will help you assess the performance of bears and bulls, meaning that you can evaluate the market sentiment.
The histogram shows the difference between 2 EMAs, a fast and a slower one.
To find the best market entry period, the indicator applies the signal line, which is a 9 period SMA. Every parameter of the EMAs and the SMA can be customized to suit your preferred timeframe.
When the MACD histogram goes up, it indicates the bulls have strength, so it is time to buy and vice versa.
The MACD key signal comes at the intersection of the histogram with its signal line: when the MACD goes below the signal line, you should sell, and when the MACD goes above the signal line – it is time to go long.
These are only four (4) of the basic and most commonly used indicators by FX traders. Many trading platforms, such as MetaTrader 4 will have charting packages that allow you to use a combination of these indicators.
Some traders use these indicators separately while others use them in combination to confirm trends and price movements.
It will be ideal to test and to become familiar with these indicators as you use them in trading different markets including the FX markets, commodities, futures and CFDs.
Over time you will find the combination best suited to your trading routine.