One of the most controversial topics among forex traders concern indicators. Traders tend to be unequivocal about what works best, and what doesn’t. As trading styles and strategies differ, so do the experiences and biases of traders. Suffice it to say, what works for one trader may not work for another. In addition, each trader relies on their own subset of information to make decisions. Often, these are a mixture of signals and interpretations that indicators may or may not be providing.
When novice traders start actively trading forex, they often have charts strewn with many indicators, including ones that are duplicative. As they gain experience, these traders will subtract indicators, perhaps using only one oscillator and one or two moving averages. Indeed, many of the most experienced and successful traders use just a few indicators. Their charts can seem bare to the average trader.
With the possible exception of Japanese candlesticks, almost all indicators are lagging to some degree. Most indicators are mathematical formulas based upon historical or moving averages. They point to what has happened or is happening within a specific period, and its relation to what happened in earlier periods. As past performance is not necessarily indicative of future results, so it is with forex indicators. They are however, useful tools to gauge markets, as well as the potential actions of other traders. They can be viewed as snapshots of price activity, and measurements that many traders react to, with some degree of predictability.
The main function of indicators is not to predict future price action, but to measure the odds of successful trade entries and exits. They are best used in combination with each other, separated by type. Here are a few of the top indicators in alphabetical order, as well as a brief definition:
Bollinger Band Review
Most price activity occur within or near the standard deviation. Bollinger Bands quantify these areas from the simple moving average based upon a certain number of periods.
Candlesticks Indicator
The Japanese method of viewing price action as opposed to bar charts. At a glance, candlesticks illuminate a significant amount of information regarding price activity, momentum, sentiment and market volatility.
Elliot Wave Indicator
A measurement based upon the theory that markets move in cycles or waves-five waves up and three waves down-similar to the rhythms found in nature.
Fibonacci Review
Developed by a 13th century Italian mathematician, this indicator is based upon cycles and ratios found in nature. In trading, it is used as a leading indicator to show probable levels of support and resistance, as well as trends and retracement.
MACD Indicator
Moving Average Convergence Divergence is probably the most popular indicator employed by professional traders. It is used to identify or confirm trends by measuring differences in historical moving averages with current prices.
Moving Average Indicator
Another key indicator for traders, particularly the 200 day MVA. A simple moving average is the sum of the closing prices for a particular currency pair, divided by the number of periods. These are plotted as lines on charts. Other moving averages are the Exponential Moving Average (with greater emphasis on recent price action to negate some of the lagging effect of prices) and the Weighted Moving Average.
Parabolic SAR Review
More of a stop placement tool than an indicator of possible direction or trend, the parabolic refers to shape of the dots the indicator places on the charts, while the SAR refers to “stop and reverse.”
RSI Review
The Relative Strength Indicator is an oscillator that measures a currency’s current price relative to past performance.
Stochastic
Another popular oscillator that indicates the momentum of a currency pair as well as positive and negative divergence.
Support and Resistance (as well as Pivot Levels)
Support is a price level where a currency pair has difficulty falling below and resistance where it has trouble going above.
According to several online broker surveys, the majority of traders favor Moving Averages, MACD and Fibonacci. This by itself, tends to make these indicators “stronger” as much of trading is based upon beliefs and supposition. In addition, many trading algorithms are programmed with the information derived from these indicators further enhancing assumptions based upon their data.
Some traders prefer use other Western and Japanese indicators in the belief that these are more reliable, or give insights the “herd” may be ignoring. These indicators use similar data as the more popular ones, but decipher, translate and display it differently. These include:
ATR
Average True Range is a moving average calculated using high prices, low prices and closing prices of a currency pair, over a 14 day period. Often used to measure volatility as well as strength of price action. While it can be useful in determining if a market is trending, it does indicate the direction of the trend.
CCI
Commodity Channel Index is similar to the RSI. It measures prices relative with moving average to help identify market cycles.
Heiken Ashi
Another variation on standard Japanese candlesticks, these are displayed as averages. The visual representation of clusters of candlesticks helps identifying trend direction easier.
Ichimoku Kinko Hyo
Despite the vast space it occupies, one of the clearest indicators on a chart, where a currency pair’s trend, momentum, support and resistance levels can be seen with one look. The main body of this indicator is illustrated by a “cloud” where price action-particularly breakouts-can be quickly ascertained.
Conclusion
Each indicator highlights a particular aspect of market activity. An oscillator like RSI or Stochastic for example, can help a trader determine if a currency pair may be overbought or oversold. Moving averages can help indicate trends and reversals. MACD can be used to confirm those trends, indicating possible convergence and divergence.
Indicators are best used in conjunction with each other as part of a comprehensive trading system. Traders should experiment to see which works best, instead of relying on the advice and experience of others. There is no right or wrong in trading, only the bottom line.
