October 16, 2017
Let’s take a look at the most popular technical indicators in the forex market. We will explain what each indicator measures, how it can be applied in trading a provide examples of trades based on the indicators.
How to Use Bollinger Bands
Bollinger Bands are used to measure the price volatility of a currency pair. This indicator plots two bands, an upper and a lower band, which are two standard deviations away from a simple moving average. Simply said, in a volatile market the bands widen, and when market conditions are calm the bands will come close to each other. Traders usually look for two conditions when using Bollinger Bands, the “squeeze” and the “breakout”.
A Bollinger Band breakout, which can be seen at point (1), is simply a candlestick closing outside the upper or lower band. This situation is very rare, as 90-95% of all price action takes place inside the bands. A breakout implies that recent price action is heavily dominated by either buyers or sellers, and that the price may proceed in the direction of the breakout. Indeed, that’s what we see on the chart. Another breakout can be seen at point (2).
How to Use the MACD Indicator
The Moving Average Convergence-Divergence, or MACD, is another popular indicator in the forex market. It’s primarily used to identify trends in their early stages of development. The MACD consists of three moving averages, with the third being a moving average of the difference between the first two moving averages. Although this may seem complicated, it actually isn’t. Let’s see how the MACD indicator looks like on a chart.
The usual settings for the MACD are 13 periods and 26 periods for the faster and slower moving averages, and a 9-period MA of the difference between the first two MAs which acts as a signal line. The histogram (green) simply represents the distance between the signal line (red) and the line which represents the difference between the faster and slower moving averages (grey).
Let’s stop with the theory for a second, and explain how the MACD is used. A simple crossover of the two plotted lines signals that the previous trend may end, and that a new trend is on its way. The signal line (red) crossing from below indicates a potential uptrend, while the signal line crossing the second line from above indicates a potential downtrend.
How to Use Parabolic SAR
Beside identifying trends in their early stage and entering trades, it’s equally important to know when a trend might end. A perfect entry without a perfect exit has little value to the trader. That’s where Parabolic SAR (Stop And Reversal) comes into play. This is a very simple indicator, which plots lines (or dots) above or below the price on the chart. An example is given in the next chart.
This indicator creates trading signals that are simple to use. If the PSAR line is below the price, it’s a signal to BUY. And if the PSAR line is above the price, it’s a signal to SELL. The green arrows show how GBP/USD reacted with the PSAR above and below the price.
How to Use Stochastic
Another popular technical indicator in forex is the Stochastic indicator. This indicator is popularly used to identify oversold and overbought market conditions. The Stochastic is presented in a range between 0 and 100. Generally, if the Stochastic lines break above 80, it represents an overbought market condition with the possibility that the price will drop. Similarly, a break below 20 indicates an oversold market condition, and traders should be aware that the price may rise very soon. This means, a Stochastic over 80 gives a SELL signal, while a Stochastic below 20 gives a BUY signal.
The chart above shows two trade entries based on the Stochastics. At point (1), the Stochastic breaks below 20 and gives a buy signal, while at point (2) the Stochastic breaks above 80 and gives a sell signal.
How to Use RSI
The Relative Strength Index, or RSI, is an indicator very similar to the Stochastic. Beside its use to identify overbought and oversold conditions, the RSI is also used to confirm up- and downtrends. The RSI is presented on a scale between 0 and 100, where a reading above 70 indicates overbought conditions, while a reading below 30 indicates oversold conditions.
The chart above shows trade signals based on the RSI indicator. Points (1) and (2) indicate overbought market conditions and a potential to open a short position, while point (3) indicates an oversold area and gives a signal for a long position. Beside overbought and oversold areas, a reading of the RSI above 50 confirms a forming uptrend, while a reading below 50 confirms a downtrend in it’s early stage.
How to Use ADX
The Average Directional Index, or ADX, is an indicator primarily used to gauge the strength of the current trend. Unlike Stochastics, it doesn’t return information on whether the trend is bullish or bearish. The ADX can receive a value between 0 and 100, with readings above 50 indicating a strong trend, and reading below 20 indicating a weak trend. Because of that, the ADX is widely used to determine whether the market is trading sideways or about to start a new trend.
The chart above shows both market conditions and their respective ADX readings. The ranging market shows an ADX reading below 20, while the trending market shows a reading above 50.
Ichimoku Kinko Hyo
Ichimoku Kinko Hyo is an effective indicator used primarily on JPY pairs. It translates from Japanese as “a glance at a chart in equilibrium”, and indicates future support and resistance areas as well as future price movement. Let’s take a look at how Ichimoku Kinko Hyo looks like on a chart.
Well, this looks a little bit more complicated than the previous indicators. Let’s explain first what all these lines mean.
Kijun Sen (blue line): This is also called the standard or base line, and it averages the highest high and the lowest low for the past 26 periods.
Tenkan Sen (red line): Or turning line. This line averages the highest high and lowest low for the past 9 periods, and is essentially a faster version of the blue line.
Chikou Span (green line): This is also called the lagging line, because it plots today’s closing price 26 periods behind.
Senkou Span (orange lines): The first Senkou line averages the standard line and turning line and plots 26 periods ahead.
The second Senkou line averages the highest high and the lowest low for the past 52 periods and, just like the first Senkou line, plots 26 period ahead.
Now, let’s explain the signals that these lines create:
- The Senkou lines act as support lines if the price is above the lines (like in our example), or as resistance lines if the price is below the Senkou lines.
- The standard line is an indicator of future price movement. If the price remains above the standard line it gives a bullish signal, while a price below the standard line gives a bearish signal.
- A cross of the Chikou line below the price creates a sell signal, while a cross above the price creates a buy signal.
Trading with Multiple Chart Indicators
As traders, we can’t rely on a single indicator to give perfect trade signals. No mentioned indicator is able to do that. Rather, traders combine more indicators and wait for their signals to line up to enter trades with a higher success rate.
One of the indicators commonly used together are the Bollinger Bands and the Stochastic.
The chart above shows how a combination of signals from both the Bollinger Bands and Stochastic can create nice trade setups. At point (1), a Bollinger Bands breakout signals a BUY, but when looking closer at the Stochastics that is in the overbought area, entering a long position doesn’t look like a smart move anymore. Indeed, the price fell inside the bands again.
Point (2) shows a bearish Bollinger Band breakout accompanied with an overbought Stochastics. Opening a short position at this place will be turn into a profitable trade.
What is the Best Technical Indicator in Forex
Although there are dozens of technical indicators available to the trader, it’s difficult to pick the best. Technical indicators in their very nature rely on past price action and lag the current market situation more or less. Traders who wish to use technical indicators in their trading strategy should therefore test which particular indicator works best for them. For some it might be MACD, while others may swear on the Bollinger Bands. However, technical indicators should never be used on their own, but in combination with other means of analysis or just as a confirmation to enter a trade. For example, Stochastics can nicely be used to prevent entering short positions when the market is oversold, or long positions when the market is overbought.
Summary: Popular Chart Indicators
In this article we gave a brief overview of the most popular chart indicators available in forex trading. Keep in mind there many more indicators, but we picked the one we consider the most useful in the forex market.
Here is a quick overview of the indicators we covered:
- Bollinger Bands are used to measure price volatility, and their most popular strategies include the “squeeze” and the “breakout”
- The MACD indicator is used to identify trends in their early stages
- Parabolic SAR is used to identify possible trend reversals (Stop And Reversal – SAR), and for spotting profitable exit points.
- Stochastic indicator measures overbought and oversold market conditions. A reading above 80 gives a SELL signal, and a reading below 20 a BUY signal.
- The Relative Strenght Index or RSI, is also used to identify overbought and oversold market conditions. A reading above 70 gives a SELL signal, and a reading below 30 a BUY signal. A reading above or below 50 can also be used to confirm an early up- or downtrend, respectively.
- The ADX indicator gauges the strength of the current trend. It’s primarily used to identify sideways markets (reading below 20), and trending markets (reading above 50).
- Ichimoku Kinko Hyo gives information about possible future price movements. The Senkou lines act as support and resistance lines, and the Kijun Sen and Chikou lines give signals for long and short positions. This indicator returns best result on JPY pairs.
As technical indicators are lagging, I encourage traders to also apply other types of analysis and combine them with technical indicators. That’s when the best trading results are achieved.
Test Your Knowledge: Technical Indicators
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Question 1 of 3
Which of the following is NOT a type of indicator:Correct
Question 2 of 3
The Stochastic indicator is popularly used to:Correct
Question 3 of 3
The ADX is widely used to determine whether the market is trading sideways or about to start a new trend.Correct