Types of Technical Indicators
So let's say you've got a forex chart set up. You've figured out what time frame you want to trade on and whether you want to use line, bar, or candlestick charts. Now it's time to choose some indicators to put on your chart.
So what is an indicator? An indicator is a piece of software that tells you information about the behavior of price over time.
There are literally hundreds of indicators you can use to get more information about the price. But we'll only talk about a few of the most popular ones in this article.
An “oscillator” is an indicator that moves between two values, hence the name “oscillator”.
Oscillators are used to predict a trend before it occurs. So they are “leading indicators” in the sense that they try to tell you what is going to happen in the future rather than confirming what has already happened.
RSI is short for “relative strength index”. It's calculated by comparing the average gain over a certain time period with the average loss over the same time period. It has values between zero and 100.
If RSI falls below 100, the currency is considered to be “oversold”. This means that it has moved down so quickly that the move is probably unsustainable, and you can expect it to move back up soon.
If RSI rises above 70, the currency is considered to be “overbought”. In this case, it has moved up too quickly and will probably fall soon.
Here's an example of RSI.
Stochastic is calculated by comparing the most recent closing price with the high and low over a previous time period. Its value ranges from zero to 100.
When stochastic is above 80, the currency is considered to be overbought. When stochastic is below 20, the currency is considered to be oversold.
Here's an example of stochastic.
Parabolic SAR is calculated using a very complex equation with a lot of if/then statements in it.
But the result is a very simple line of dots that indicates whether the currency is in an uptrend or downtrend.
If the dots are above the price, this is a sell signal. If the dots are below the price, this is a buy signal.
This indicator is also very useful for figuring out where to place a stop.
Oscillators can be very useful for determining when a trend is going to reverse. But they sometimes give false signals. So be sure not to rely on just one of them.
It's best to combine two or three of them together and to use some lagging indicators to confirm their signals as well.
Trend Following Indicators
Trend following indicators don't tell you in advance when a trend is going to reverse. Instead, they are “lagging indicators”. They tell you when a trend has already reversed.
At first glance, this might not sound very useful.
But if you've already got a signal telling you that a trend is about to reverse and then you see a trend following indicator confirming that reversal, this can spell the difference between having the confidence to make a trade and sitting it out.
Here's some of the most popular trend-following indicators.
Moving averages are lines composed of the averages of previous prices over time.
The key to using moving averages as a trend-following indicator is to set up several of them based on different time periods.
The ones based on shorter time periods are considered to be “faster”, and the ones based on longer time periods are considered to be “slower”.
When the faster MA crosses the slower one, this confirms that the previous trend has reversed.
For example, a lot of swing traders like to use a 10-day and 21-day moving average. When they see the 10 cross the 21 from below it, this indicates that the currency has gone into an uptrend. When they see the 10 cross the 21 from above it, this indicates the currency has gone into a downtrend.
Here's an example:
As you can see from this chart of USD/CAD, you would have missed a big move up if you had waited for an MA crossover in Dec. 2016 before buying the pair. But at least you would have caught the end of the move. And by waiting until the crossover to buy, you would have increased the probability of having a winning trade.
MACD (Moving Average Convergence Divergence)
MACD is actually both an oscillator and a trend-following indicator.
It's calculated by subtracting one moving average from another one and then constructing a “signal line” that is a moving average of MACD itself.
When MACD is above zero, it's a sign that the currency is in an uptrend. When it's below zero, it's a sign that the currency is in a downtrend.
Here's an example:
Volatility indicators are used to figure out how much a currency is changing over a time period. The most popular of these is Average True Range or ATR.
ATR appears as a line in a separate window. When this line is high, it means the price is moving all over the place. When this line is low, it means the price is moving calmly within a narrow range.
If a currency has high volatility, it has greater potential for profit or loss.
In a case like that, you don't want to place your take-profit point too close to your entry or else you will probably miss out on gains.
On the other hand, a currency with low volatility may not offer as much profit but does allow you to place your stop closer to your entry-point. So it can be less risky.
Either way, knowing the volatility of a currency can help you to make better trading decisions.
Volume is a measurement of the amount of trading going on with a particular currency pair.
When price is rising and volume is rising with it, this is a sign that the rally is gaining momentum.
But if the volume slows down and the price is still rising, this is a sign that it may be about to crash.
The Fibonnaci indicator is named after the mathematician Leonardo Pisano Fibonacci. Fibonacci discovered that there were a series of ratios that seemed to occur over and over again throughout nature.
It turns out that these “Fibonacci ratios” occur in forex trading as well, and they can be used to find entry points for trades.
Traders call these ratios “Fibonacci retracement points”. Here's an example of how to use them.
In order to create Fibonacci retracement points on a chart, you click and drag the Fibonacci tool from the latest peak of price to the latest trough.
The price tends to stop at the various “retracement” lines.
In the case of this monthly USD/CAD chart, the price first stopped at the 38.2% retracement level. It then fell and came back up to break through a few months later. But once it broke through, it stopped at the 50% retracement level.
It then fell back below 38.2% before making a run at the 50% level again. It has recently started to poke above the 50% level. If it continues to go up, it will likely stall at the 61.8% level.
This can help a lot to determine where to enter and exit trades.
All of these indicators, whether they be oscillators, trend-following indicators, volume, volatility or Fibonacci can be useful in different circumstances. It is up to you to decide which of them is the most useful for your particular trading style.
But hopefully this information has made it a little easier to decide on.
Now that you know how to use indicators, let's talk about how to execute a trade.