Forex technical analysts often use indicators derived from exchange rate levels as they evolve over time. Futures traders also look at market observables like volume and open interest.
You can incorporate many very useful forex indicators into your trading plan and you can start using the “best” forex indicators right away, but it really helps to educate yourself on how to use them properly based on a thorough explanation of each indicator.
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What are Forex Indicators?
Forex technical indicators consist of mathematical calculations that forex traders often use based on the exchange rate, volume or open interest of a currency pair. Technical traders who operate in the stock market typically look at the price of a stock, but forex traders look at the exchange rate of a currency pair. The majority of the major forex indicators are computed from exchange rates.
Those trading currency pairs may also be able to use the volume and open interest numbers provided by futures exchanges that list currency futures contracts like the Chicago International Monetary Market or IMM.
Examples of common technical indicators include:
- The various types of moving averages
- The relative strength index (RSI)
- Moving average convergence/divergence (MACD)
- Stochastic oscillator
- Bollinger Bands.
Options traders and those looking to assess the risk in a position for position sizing purposes might also use historical volatility.
If you are new to the concept of forex indicators, you might want to select a good forex broker for beginners, since one of those will usually provide more detailed educational material on the technical analysis tools you can incorporate into your trading plan.
How They Help You Trade
Many people actively engaged in forex trading use forex indicators every day as part of their technical market analysis. They typically do this because such indicators help take the guesswork out of forex trading and allow their trading decisions to become far more objective.
Where to Find Them
Although most forex trading platforms will allow you to perform at least some technical analysis, a great selection of the most important forex indicators is very easy to find if you obtain a copy of MetaTrader 4 or 5. This very popular trading platform and technical analysis software can be downloaded free of charge from the website of its developer, MetaQuotes.
You can also get a customized copy of MetaTrader 4 or 5 from various online broker websites that provide the platform, such as the one operated by top U.S. broker FOREX.com, although you may need to open an account with the broker to obtain it from them.
MetaTrader 4 or 5
This platform also provides detailed information in its help files and associated website about how to use and compute each of the indicators it displays. MetaQuotes even shows its source code for each technical indicator supported by the trading platform that you can copy and use to create your own version of the indicator.
You can also modify the source code to create a new custom indicator if you have programming skills and you can incorporate the computation of indicators into scripts and expert advisors. Creating custom software to run on MetaTrader 4 or 5 can make your life as a trader much easier and it can even trade automatically for you when the right conditions exist.
What Makes a Great Indicator
Not all technical forex indicators have equal popularity or usefulness among traders. Some are just used in very specific cases, some are used primarily by derivatives traders and others might be seen in regular use on most technical trader’s screens.
In general, a great forex indicator has broad applicability to many traders, offers clear signals that can be readily observed and used to trade on, and provides useful information relevant to those looking to determine the future direction of exchange rates.
Some of the Top Forex Indicators
The following section will briefly discuss some of the top forex technical indicators used by forex traders and show examples of what they look like in practice.
Indicator 1: Moving Averages
Many forex traders use moving averages of one type or another to get a sense of the underlying direction or trend of the market. Using one or more moving averages can also be used to provide trading signals, such as when a shorter-term moving average crosses above or below a longer-term moving average.
The four fundamental types of moving averages that forex traders frequently use in trading currency pairs and for general technical analysis purposes are:
- Simple moving averages
- Exponential moving averages
- Weighted moving averages
- Smoothed moving averages
The averaging process used can be performed on the high, low, open or closing exchange rates; the close is the most popular.
For example, you can compute a simple moving average by first adding up the exchange rates over a given number of time periods. You then divide that sum by the number of time periods to obtain an average. This averaging process then proceeds over time or moves to create an indicator line usually shown superimposed over the exchange rate for a currency pair.
A simple 10-day simple moving average computed on daily closing prices appears in the chart below in red superimposed over a candlestick chart of the exchange rate for the EUR/USD currency pair. When the moving average lies above the exchange rate, it tends to send a bearish signal to a trader. A bullish signal would be suggested by the exchange rate that exceeds the moving average.
Indicator 2: The Relative Strength Index
The RSI was the brainchild of the famous technical analyst J. Welles Wilder and has been used by traders since first being published in 1978. It now holds a top position among the technical indicators used by traders, and most technical analysis software includes it.
You can compute the RSI indicator by comparing the amount of a currency pairs’ most recent exchange rate increases to that of its most recent exchange rate drops. The RSI has an adjustable time period parameter and most traders use the default 14 periods based on Wilder’s preference.
Technical analysts refer to the RSI as a bounded oscillator, since it fluctuates inside a range bounded by an upper value of 100 and a lower value of 0. Since its value does not have the same vertical scale as the exchange rate, the RSI is typically displayed below the exchange rate in an indicator box.
When the RSI moves to extreme high territory above the 70 level, the market is considered overbought. When it lies below the 30 level, the market is considered oversold. Traders also look for divergence between peaks or troughs in the exchange rate versus the RSI to provide trading signals, especially when the RSI is in extreme territory.
The image below shows the 14-day RSI based on daily closing exchange rates in orange in the indicator box below a candlestick chart of the exchange rate for the EUR/USD currency pair.
Indicator 3: Bollinger Bands
Bollinger Bands were created by John Bollinger in the 1980s to provide trading signals that adapt to market conditions. They are typically drawn using a given number of standard deviations around a central moving average.
A common set of parameters for Bollinger Bands involves drawing lines two standard deviations around a 20-period simple moving average. Since standard deviations are used as a measure of market volatility, this gives traders a sense of the risk involved in taking positions, as well as a sign that an exchange rate movement is overdone and hence ripe for a correction.
A basic Bollinger Band trading strategy can involve selling a currency pair when it trades above the indicator’s upper line and buying when it trades below its lower line. You can refine that strategy further by only taking trades that follow the existing trend as suggested by the slope of the central moving average.
The image below depicts two standard deviation Bollinger Bands drawn around the 20-day moving average based on daily closing exchange rates in red superimposed over a candlestick chart of the exchange rate for the EUR/USD currency pair.
Indicator 4: The Stochastic Oscillator
The stochastic oscillator was developed in the 1950s by George C. Lane and helps traders identify market extremes ripe for corrections. Like the RSI, the stochastic oscillator is normalized to range between 0 and 100, although overbought values exceed 80, while oversold values are below 20.
The stochastic oscillator comes in full, fast and slow varieties that each have the characteristic %K line based on the market’s close relative to the high-low range for a certain time frame, plus the %D signal line computed as a moving average of the %K line.
The indicator also informs traders about accumulation and distribution in the market. When the market closes around the stochastic high values, then that suggests buying pressure exists so the market is accumulating. In contrast, market closes near the indicator’s low value reflects selling pressure that involves distribution.
The image below shows the stochastic oscillator computed based on low/high exchange rates with a %K period of 5 and a %D period of 3 and a slowing parameter of 3 in red using simple moving averages in the indicator box below a candlestick chart of the exchange rate for the EUR/USD currency pair.
Indicator 5: The MACD
The Moving Average Convergence Divergence (MACD) indicator was invented by Gerald Appel. The MACD histogram is unbounded and it generally appears below the price action and uses the same time scale as the exchange rate chart it corresponds to.
The MACD is based on the difference between two exponentially weighted moving averages (EMAs); usually a faster one of 12 periods and a slower one of 26 periods, and it includes a smoothed moving average (SMA) line of usually nine periods used to signal trades.
The image below shows the MACD oscillator in red computed based on closing exchange rates with a histogram computed using a slow EMA of 26 periods versus a fast EMA of 12 periods and an SMA line of 9 periods in the indicator box below a candlestick chart of the exchange rate for the EUR/USD currency pair.
While only the best forex indicators have been touched upon in the preceding sections, many more indicators can be computed and used in a trading plan to make it more objective.
Unless you fully automate your trading system, simplicity and ease of use are important when as you make trading decisions. You don’t want to get stuck in analysis paralysis and miss opportunities while the market moves away from you.
Finally, even the most well-thought-out trading plan with the best indicators can fail if you do not have the right trading partner. FOREX.com is among the best forex broker option you can choose if you live in the U.S. and want the extra security of dealing with a U.S. broker.