Trading based on technical analysis tends simplify Forex trading based on price action. It can feel overwhelming to pick the right one from all of the available technical indicators.
We narrowed down our options to the five effective forex trading indicators Forex traders use. These are the ones you should be familiar with and can apply to your own trading activities.
1. Bollinger Band
John Bollinger invented the Bollinger Band as a technical analysis indicator. This is why it’s called that. It is used to detect short-term price changes and measure market volatility.
It appears on the chart in two trendlines, which move on two standard deviations. This represents positive and/or negative movements from a simple Moving Average (SMA). Bollinger Bands are a way to determine if an asset has overbought/oversold or can help you make a better profit.
How it works
This indicator uses two parameters, Standard Deviations (default values 20 and 2) and Period. This combination can be customized to suit your preferences.
It signals low market volatility if the bands become tighter/narrower. As this condition is known, the squeeze signals sharp price movements that can trigger trading opportunities.
The SMA will move away from the bands, increasing volatility and possibly ending any current trend. This could be the best moment to exit a trade.
Trading breakouts occur when price action is above or below the bands.
Pros
This is useful for helping with volatility, trends and momentum.
It is a good indicator of market volatility when the bands are narrower or wider.
This helps you to determine when a trend is ending and how to find new ones.
Cons
This is not an independent system
Can’t predict price pattern
Bollinger Bands can’t be used alone as they only provide information on price volatility. They should be combined with non-correlated indicators. John Bollinger suggests using relative strength index (RSI), moving average divergence/convergence (MACD), and on-balance volume.
2. Moving Average (MA).
A moving average captures the average value of a series of data over time. A moving average is a technical indicator. It represents the average closing prices over a period of time and signals market momentum. MA with an upward trend can signify an increase in momentum or price. A downward trend is considered to be a decline.
There are many moving averages today. They can be simple or complex, and require a computer program to calculate.
How it works
MA is calculated so that you can see the price movement over a given period. This is done by creating a constant updating average price.
MA can be exponential or simple. Simple moving average (SMA), which is based on the arithmetic median of a set price spread over a number of days like 15, 100, or 200 days. SMA is preferable by traders who prefer longer timeframes.
Exponential moving average (EMA), a weighted mean that focuses more upon current prices, is called a weighted average. Exponential moving average (EMA) is a popular choice for traders who like intraday trading and trading in shorter time frames.
The SMA can be set to run for 5-20 days if you trade in a shorter time frame. The SMA can be extended to 100-200 day for trading on a longer timeframe.
You can use moving averages to determine a trend in one of two ways (EMA or SMA).
1. Take a look at the slope of your moving average. If the slope is constantly moving higher, it indicates an upward trend. However, if the slope is constantly moving lower, this indicates that the price is in an uptrend.
2. Take a look at the cross-section of two moving Average lines. One is the shorter duration and one the longer. The 5-day EMA can be used with the 50 day EMA. If the 5-day EMA crosses above the 50 day EMA line, then it is an upward trend. If it moves in an opposite direction, it’s a downtrend.
The pros and cons of using Moving Average (MA).
Pros
SMA is a smooth line which is less affected by short-term price swings
Rapid price fluctuations are met with prompt response by the EMA
EMA is excellent for trading intraday swing highs/lows
For algorithmic traders, it is simple and appealing enough
This simplifies trading and helps to prevent or deal paralysis by analytic analysis
Cons
SMA takes a while to react to price changes.
EMA is prone for false signals and backward whipsawing
If the market is volatile, it’s possible for the average movement to be distorted. This could make timing your entry into the market a problem. It may be called noise because it fluctuates too fast from the ups or downs of market conditions.
3. Relative Strength Index, (RSI).
Relative Strength Index (RSI), which measures price momentum, is used to measure the speed at which prices move as well as the amount of change that takes place. J. Welles Wilder Jr. first developed it. He also included other technical indicators like the average directional indicator (ADX) and Parabolic SAAR in 1978’s New Concepts in Technical Trading Systems.
RSI basically measures the speed at which traders increase or decrease a security’s prices. This information is then displayed on a chart that uses a scale ranging from 0 up to 100.
Stocks that have RSI below 30 indicate oversold.
Stocks that have RSI higher than 70 indicate overbought.
How it works
Technical traders use the RSI for signals about whether price momentum favors bullish or bearish.
What is an RSI Buy signal?
A move below 30 is considered a buy signal. This is a sign that an asset has been resold and will likely rebound. However, the speed of the rebound will depend on whether the asset is in a significant downward trend. You should wait for a signal to buy in this instance.
The pros and cons of using Relative Strength Index, (RSI).
Pros
Key reversal levels can be found
It is more efficient to use it in a non-trending environment
Simple to understand and easy to implement
This can be used for finding momentum loss
Cons
In a trending zone, may provide false signals
Completely ignores volume during key reversals
RSI is not recommended as a single trading signal. This is due to the possibility of error depending upon the context of the overall chart. Make an informed decision by considering the formation and patterns of candlesticks, price trends, and other data.
4. Moving Average Convergence Diversity (MACD).
Moving average convergence divergence, also known as MACD, is a trend-following momentum indicator that displays how one security’s moving average compares to another. MACD is displayed on a trading graph with many lines:
The MACD is the result of subtracting an exponential moving average (EMA), between 26 and 12 periods.
The MACD’s 9-day EMA is the result of the signal line.
If plotted on the chart, the signal lines can trigger a buy/sell signal. The principle is to sell or short the MACD if it crosses below the signal line, and buy or wait if it moves above.
MACD is widely used to interpret crossovers and divergences as well as rapid rises/falls. It is also used to show traders when conditions are either too good or too bad.
How it works
MACD will provide more than technical signals to sell or buy.
Based on the speed of a crossover, the market may be either too hot or too cold.
If the price’s bullish, bearish or strong movement is occurring.
Changes in the trend direction or severity of a price will result.
The recent momentum of a price may cause a change in its trend.
MACD basically helps traders identify when to enter, exit, and add to their position.
MACD is primarily an indicator that is slow because it relies on historical price action data. This means that it must “lag” price. MACD histograms are used by some traders to predict changes in a trend. This is why it’s considered a leading indicator.
Divergence refers to when the indicator is making lower lows than the price. If the opposite happens, bearish diversgence will occur.
Moving Average Convergence Divergence (MACD), pros and cons
Pros
Clear signal to know when to buy (crossover), or sell (divergence).
Useful as both a trend- and momentum indicator
When used with other technical indicators, it enhances the clarity of analysis
Cons
Can provide reversal signal that doesn’t result in significant reversal, but will cause a sideways movement or temporary pause
May not provide a more accurate analysis of a particular trend
MACDs can give trade signals very often at close price ranges. This can lead to small losses several times in succession.
5. Average Directional Movement Index, (ADX).
Average Directional Movement Index is a technical indicator used to determine a trend’s overall strength. The ADX indicator is calculated using the DX component.
ADX is a component to the Directional Movement System J. Welles Wilder Jr. also designed. The system uses positive and negative directional movements indicators (DMI+ and DMI-) to indicate whether prices are moving in positive or negatively.
How it works
DX measures the market’s trendsiness. It can range from 0 up to 100. The market’s direction is more directional if it has a higher value than 100. If DX’s value increases, and DMI+/DMI- spreads increase, then the trend is strong.
A strong trend is indicated by an ADX of 25
A trend is indicated by an ADX of less than 20
An ADX drop from high levels could indicate a trend ending. To confirm that positions can be closed, additional research is necessary.
ADX drops indicate that the current market trend is weakening. Avoid trading trend systems because the trend is changing.
ADX may rise by as much as 4 to 5 units following a long period of being low. This could signal that there is an opportunity to trade the current trend.
The market is showing a strengthening trend if ADX is increasing.
If a trend follows a constant slope, ADX’s value tends to plateau.
Pros and cons of using Average Directional Motion (ADX)
Pros
Can you quantify the strength of an emerging trend?
Effectively filters trades if there are accumulation periods
Forex trending conditions can be identified
This works best for day trading or swing trading
Can be used to indicate the strength of bears and bulls simultaneously
Cons
Lagging indicator following price movement
Use of shorter time frames can give false signals
For a complete analysis of price action, you will need to use other indicators.
It doesn’t necessarily mean that the asset prices will change simultaneously when ADX moves up and down. This is because both the uptrend ADX as well as the downtrend ADX signify strength in either an upward or downward direction.
Forex trading is easier when you can use all or some of the indicators. These indicators can be used to your advantage if you have clear rules.
