Technical analysis, a popular tool among forex traders, is based on an assumption that all relevant information about a trading instrument is reflected in the market price. All you need to do is analyze historical market data like price or volume and spot patterns that could repeat in the future. Over time, technical analysts have developed many indicators to help them solve this problem.
The math behind an indicator doesn’t have to be very complicated. It can be a simple moving average or a difference between the closing price for two periods, but it can also be more complex as standard deviation or linear regression.
Forex Indicators: Overview
It’s tough to pick an indicator for a trading strategy. Some traders experiment with only one indicator, while others try to use a combination of indicators. If you want to use only one indicator, you’ll be focused on what time frame to use and what period you want to analyze. To calculate an indicator, you first need to choose the time frame. You can apply it to daily data, weekly data, hourly data or even higher frequency data. If you pick the daily data, you can calculate a moving average for the last 200, 100, 50 days and so on. Your strategy could be based on a couple of moving averages or you can try to use only one on your time series.
A combination of indicators is more complex. Besides choosing the time frame and the period, you need to choose indicators that complement each other. It’s usually recommended not to use two indicators from the same group of indicators because they’ll just confirm each other’s signals. The main groups of indicators are trend indicators, momentum indicators, volatility indicators and volume indicators.
Type 1: Trend indicators
Average Directional Indicators
“Trend is your friend” is a well-known saying. Average Directional Index is one of them. It has three components, Plus Directional Movement Index (DI+), Minus Directional Movement Index (DI-) and ADX line. If DI+ is higher than DI-, the currency pair is in an uptrend. If DI- is higher than DI+, it is in a downtrend. The ADX line is a smooth moving average of absolute values of DI+ and DI- and its value is in a range between 0 and 100. If the ADX value is between 0 and 25, there is no trend or it is very weak. Between 25 and 50, the trend is strong, and the trend is very strong if ADX values are between 50 and 75. Extremely strong trends have values between 75 and 100. The default period for ADX is 14 bars or candles, but you can experiment with different periods.
Moving averages can also be useful to identify a trend and the easiest way is to plot one simple moving average on a chart and check if the price is above or below the moving average. If it’s above, that would be a signal that the currency pair is in an uptrend. You can also use two moving averages, for example, 100-day and 200-day MA. In that case, you would get a buy signal when the 100-day MA moves above the 200-day MA.
Parabolic SAR is pretty simple to use. Technical analysts draw it on a chart as a series of dots, above or below a candle or a bar. When it is drawn above the price, that is an indication of a bear market. The indicator is good for spotting reversals. If the dots shift from above to below, you can interpret that as a start of an uptrend. A possible strategy could be to wait for a shift and buy when four dots in a row appear below candles.
Type 2: Momentum Indicators
This group of indicators measures the speed of a price change and they are also called Rate of change indicators.
Relative Strength Index
The Relative Strength Index or RSI can help you to figure out if the currency pair is overbought or oversold. The default period for calculation is 14 candles or bars and its value oscillates between 0 and 100. The RSI value of 70 or higher is considered as overbought territory, while a value below 30 usually means that the currency pair is oversold.
Moving Average Convergence Divergence
Moving Average Convergence Divergence, or MACD, is another momentum indicator. It has the MACD line, signal line and MACD histogram. The MACD line is usually calculated by subtracting the 26-day exponential moving average (EMA) from the 12-day EMA. The signal line is a nine-day EMA of the MACD line and the MACD histogram is the difference between the MACD line and the signal line. In a trading strategy, traders can look for crossovers between the MACD line and the signal line, but they can also look for a divergence between the price and the MACD. If the price records two rising highs and MACD records two falling highs, that would be a bearish signal.
For momentum, you can also use the stochastic oscillator and Ichimoku Kinko Hyo. The stochastic indicator is used to identify overbought and oversold conditions, while Ichimoku Kinko Hyo represents a combination of support and resistance levels, crossovers, oscillators and trend indicators.
Type 3: Volatility Indicators
Bollinger Bands can help you measure the volatility of a currency pair. To draw on a chart, you first need to calculate a standard deviation of a price. Then you add two standard deviations to a moving average and you also deduct two standard deviations from the moving average.
Now you look for the moments when the price gets above the upper band or below the lower band. Some traders would see the breakout above the upper band as a signal of a continuation of the move, while others would see it as the reversal sign.
Average True Range
Average True Range is calculated as EMA of the true range, which uses the greatest value of the difference between the high and low price of the day, high and close or close and low. It is used to measure volatility and it can be useful as a risk management tool.
Type 4: Volume Indicators
Chaikin Money Flow
Indicators can also include volume in the calculation. Chaikin Money Flow (CMF) is one example. Its possible range of movement is between 1 and -1, but it usually moves between 0.5 and -0.5. Values higher than zero indicate a buying pressure, while values below zero indicate a selling pressure.
Accumulation Distribution Line
Accumulation Distribution Line also uses volume. It is used to confirm the trend. When it moves in the same direction as the price it signals the confirmation of the trend.
There are many forex indicators out there, and as a trader, you have to use those that can help you make money. One approach would be to include a combination of indicators in your strategy. You could pick one indicator from each group. You could also use only one indicator, but you could apply it to different timeframes. You could decide to get a long position if your indicator makes a bullish signal on five minutes, 30 minutes and one hour chart at the same time. Before you trade any strategy, you should first test it on historical data. If it generates profitable trading signals in backtesting, you could then use it in a demo or live trading.