Best technical indicators and how to use them

Author: Martin Moni
Martin Moni
All publications of the author

Forex traders are always trying to gain an edge in the markets, which is essential given the fierce competition among thousands of traders. Despite this need, no one can predict how the markets will shift, but there some tools one can use as a guide – technical indicators.

We have already provided a few custom indicators in the section on Forex strategies, but those were custom indicators which only work on MetaTrader 4 and no other Forex trading platforms. Today, we are going to look at some of the common technical indicators available in all platforms, including web traders, and how you can make use of these tools to your benefit.

There are basically 2 forms or patterns a market can take when looking at real-time Forex charts, an oscillating or a trending pattern. The indicators to be used in either of these conditions will vary, too, to adapt to the market situation.

Oscillating indicators

An oscillating pattern is seen when price changes bounce off support and resistance levels, maintaining a horizontal pattern.

As you can see from the image above, prices have maintained an oscillating pattern, and this situation is often seen on the eve of crucial news releases or when one of the currencies in the pair is not in an active session. In the above image, news about Australia’s private sector credit is about to be announced and the New York session closed a few hours ago so the AUD/USD pair is oscillating.

Indicators most suitable in these situations include:

MACD

The initials MACD stand for moving average convergence divergence, and that’s because it’s created using exponential moving averages (EMAs). To calculate the MACD, you will need to subtract the 26-day EMA from the 12-day EMA to come up with the main indicator. An additional 9-day EMA is then added on top of that indicator, and this becomes the signal line. When that’s done, you will have something like this:

This is the default MACD indicator found in MetaTrader 4, and it is called a MACD histogram. The bars oscillating around the zero (0) mark inform the trader on whether the market has been overbought or oversold. Since the pattern is oscillating, you can place a buy order if the MACD histogram shows an oversold condition close to the support level and vice versa.

However, as you may have noticed from the above image, this indicator is slow because it uses high value parameters like the 9-day, 12-day and 26-day EMAs. As a result, on shorter timeframes like the H1 chart above, you can miss out on some trades or get in a trade late. An advanced version of the MACD is available for download at the end of this post, and it looks something like this:

This modified version shows you the crossovers which allow you to get in on the trades much earlier and catch most of the price change, thus, more profits, even on shorter timeframes. Nevertheless, MACD is still most effective on longer timeframes.

RSI

Standing for relative strength index, the RSI indicator monitors the changes in price movements according to speed. It is one of the most commonly used indicators and can work on any timeframe, simply by observing the level of the RSI ranging between 0 to 100. The average range is between 30 and 70, and any value below 30 is considered oversold and above 70 as overbought. Looking at the image below, you can see how the RSI was able to identify key support and resistance levels when the markets changes direction.

Stochastic oscillator

This indicator is very similar to the RSI because it is also used to identify points at which the market is overbought or oversold. In addition, its values also range from 0 to 100, but in this case the average range is between 20 and 80. Values above 80 represent an overbought market situation while those below 20 show the opposite, oversold.

As you can see, the stochastic oscillator is very similar to the RSI, but it is much more favourable to use in shorter timeframes because it captures even the slightest price changes and maximizes their effect, which is certainly helpful for scalpers hoping to make money from these tiny price changes.

Trending indicators

A trending market is one which is characterized by higher highs and lower lows. I know that may not make a lot of sense, but here’s an illustration:

As you can see, the markets kept moving lower, breaking support levels which later turned into resistance levels as the price kept dropping. Trending markets can be extremely profitable for swing traders who tend to hang on to trades for longer, allowing them to gain from the entire rise or fall of a currency’s strength. From the image above, you can see that in less than 2 weeks, a trader with a short position could have gained more than 2,500 pips, which would be enough to end the year with a big smile. Anyway, let’s look at some of the indicators that can be used to identify these potentially lucrative trends:

Moving averages

The most common indicator for trending markets is the moving average (MA), which is a simple line drawn upon the price chart to indicate price fluctuations. By observing a line, it is much easier to tell the direction of the market as opposed to the random fluctuations generated by candlesticks.

The moving average is calculated by finding the average of closing prices of the underlying security over a defined period in the past. As such, MAs are considered lagging because they use past prices, but they are still very useful.

There are 2 kinds of MAs:

Simple moving average (SMA)

The SMA takes the average closing price of the currency pair and divides it by the determined period. The image below shows 3 SMAs combined:

The red SMA has a period of 10, the blue, 20, and the green, 40. As you can see, the longer the period, the smoother the SMA becomes, although it also becomes slower. To determine entry and exit points, traders look for crossover points where the faster SMA crosses the slower one either upwards or downwards.

When the faster SMA (red) crosses the slower SMA (blue) downwards, this indicates an opportunity to sell and vice versa, just like in the image above. You also need to include a much slower SMA, such as the green one above, to indicate whether the market is bullish or bearish. As long as the market is trending below the slow SMA, you should only consider sell opportunities as this indicates a bearish market and vice versa. If in the above chart we had included a very slow SMA, such as one with a period of 50 or more, you could have seen that the market was bearish all along, and why a long-term trader would have held on to their short position.

Exponential moving average (EMA)

Calculation of the EMA is much like that of the SMA, except that more emphasis is put on closing prices of the most recent time periods. The result is a much more erratic moving average, but one which reflects even minor current price changes.

The image above is of EMAs with periods 10 (red), 20 (blue) and 50 (black). You can see that it presents a much more rugged moving average, but one which catches even the slightest price changes.

 

Because the EMA responds to price changes more erratically, users are prone to falling for fake-outs in cases where the markets are testing pivot points. To balance between the need to catch changes in the trend early against the problem of fake-outs, you should use the combination of a slow SMA and a fast EMA, where one will complement the other.

In the above image, the 10-period EMA is in red and the 40-period SMA in blue; you can now see how much more accurate the trend predictions are after the crossovers. In fact, they are almost prophetic because prices drop whenever the EMA crosses the SMA downwards and vice versa.

Bollinger bands

This indicator is derived from the SMA, and two standard deviations in opposite directions creating a total of 3 lines. It is also used to indicate points at which the market is overbought or oversold, as well as points of potential volatility.

From the image above, you can identify how this indicator is used for both of these purposes:

In areas where there is a squeeze, it shows that there is no volatility in the markets, but also the possibility of high volatility to come

When the price moves close to the upper Bollinger band, it indicates an overbought market and the chance of a profitable short position. On the other hand, if the price is close to the bottom Bollinger band, the market is probably oversold and you should be looking for a long position.

 

On technical indicators

These indicators are very useful to technical analysts, but they are only effective if used together rather than relying on just one indicator. When used in combination, they tend to complement each other and provide more accurate predictions. However, independently, they can be very unreliable since they make use of price action in the past.

 

2-line MACD

For more on technical indicators, here’s a video which explains them in detail:

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