Many forex traders squander time looking for the best time to enter the market or a telltale “buy” or “sell” indicator. The hunt may be thrilling, but the end result is always the same. The truth is that there is no such thing as a one-size-fits-all strategy for trading the foreign exchange markets. As a result, traders should familiarize themselves with the numerous indicators that can help them choose the best time to buy or sell a currency cross rate.
Four primary market indicators are used by the most successful forex traders.
FX Traders Should Be Aware of the Different Types of Indicators
The First Indicator: A Trend-Following Tool
It is possible to profit from a countertrend trading strategy. For the most traders, however, the simplest way is to recognize the big trend’s direction and seek to benefit by trading in that direction. This is where trend-following software can help. While it is possible to use a trend-following tool as a standalone trading strategy, the true function of a trend-following tool is to indicate whether you should be seeking to enter a long or short position. Let’s take a look for one of the most basic trend-following techniques: the moving average crossover.
The average closing price over a certain number of days is represented by a simple moving average. Let’s look at two simple examples, one long term and the other short term. The euro/yen cross’s 50-day/200-day moving average crossing is seen in the chart below. The premise is that when the 50-day moving average (in yellow) is above the 200-day moving average (in blue), the trend is positive, and when the 50-day is below the 200-day, the trend is unfavorable. This combination, as seen in the figure, performs a decent job of pinpointing the market’s major trend—at least most of the time. There will, however, be whipsaws regardless of any moving-average combination you select.
An alternative combination is shown in the chart below: the 10-day/30-day crossover. This combination has the advantage of reacting to changes in price trends faster than the prior pair. It has the disadvantage of being more sensitive to whipsaws than the longer-term 50-day/200-day crossover.
Most investors may claim that a certain combination is the best, but the truth is that there is no such thing as a “best” moving average combination. Finally, forex traders will gain the most by determining which combination (or combinations) best suit their time frames. The trend, as demonstrated by these indicators, should then be utilized to determine whether traders should go long or short; it should not be used to timing entry and exits.
The Second Indicator: A Tool for Confirming Trends
We now have trend-following technology that can tell us whether the major trend of a currency pair is up or down. But, how reliable is that metric? As previously indicated, trend-following tools are prone to being whipsawed. As a result, it would be advantageous to have a technique to decide whether or not the current trend-following indicator is correct. This will be done with the help of a trend-confirmation tool. Like a trend-following tool, a trend-confirmation tool may or may not be designed to make specific buy and sell recommendations. Rather, we want to see if the trend-following and trend-confirmation techniques are in agreement.
In other words, a trader can be more confident in beginning a long position in a currency pair if both the trend-following and trend-confirmation tools are positive. If both are bearish, the trader can focus on finding a means to sell the currency pair in question short. One of the most popular—and useful—trend confirmation tools is the moving average convergence divergence (MACD). This indicator’s basic metric is the difference between two exponentially smoothed moving averages. The difference is then smoothed before being compared to its own moving average.
The histogram at the bottom of the chart is positive, suggesting that the current smoothed average is above its own moving average, confirming an uptrend. The histogram at the bottom of the chart is negative when the current smoothed average is below the moving average, suggesting a downtrend.
In other words, you have a confirmed downtrend when the trend-following moving average combination is bearish (short-term average below long-term average) and the MACD histogram is negative. You have a verified rise when both are positive. Another trend-confirmation technique that might be used in addition to (or instead of) MACD can be found at the bottom of the chart below. It’s a measure of how much something has changed throughout time (ROC). The orange-colored line in the chart below represents today’s closing price divided by the closing price 28 trading days ago.
The price is higher today than it was 28 days ago if the reading is above 1.00, and vice versa if the reading is below 1.00. A 28-day moving average of daily ROC readings is represented by the blue line. The ROC is confirming an uptrend if the red line is above the blue line. We have a verified downtrend if the red line is below the blue line. Note that the euro/yen cross’s strong price decreases from mid-January to mid-February, late April through May, and the second half of August were all accompanied by:
• A 50-day moving average that is lower than the 200-day moving average.
• A MACD histogram that is negative
The ROC indicator is in a bearish situation (red line below blue)
The Third Indicator: An Overbought/Oversold Tool
A trader must decide whether they are more comfortable stepping in as soon as a clear trend is developed or after a retreat happens after electing to follow the direction of the big trend. In other words, if the trend is bullish, the choice is whether to buy into strength or weakness. If you want to get in as soon as possible, consider entering a trade once an uptrend or decline has been verified. You could, on the other hand, wait for a pullback within the wider overall primary trend in the hopes of finding a lower-risk opportunity. A trader will use an overbought/oversold indicator to do this.
There are numerous indications that can be used to meet this requirement. The three-day relative strength index, or three-day RSI for short, is one that is valuable from a trading aspect. This indicator creates a value that can vary from zero to 100 by adding up the number of up days and down days over the window period. The indication will approach 100 if all of the price activity is to the upside; if all of the price action is to the downside, the indicator will approach zero. A score of 50 is regarded as neutral.
The euro/yen cross’s three-day RSI is seen in the chart below. In general, a trader wanting to enter on pullbacks should consider going long if the 50-day moving average is above the 200-day and the three-day RSI falls below a specified threshold level, like 20, indicating an oversold position. In contrast, if the 50-day is below the 200-day and the three-day RSI rises beyond a given level, such as 80, the trader may consider opening a short position, indicating an overbought situation. Varying traders may opt to use different levels of triggers.
The Forth Indicator: A Profit-Taking Tool
The final type of indicator required by a forex trader is one that assists in selecting when to terminate a profitable trade. There are also additional solutions available here. In reality, the three-day RSI fits into this category. In other words, if the three-day RSI goes to 80 or above, a trader with a long position may want to consider taking profits.
If the three-day RSI falls to a low level, such as 20 or less, a trader with a short position might consider taking a profit.
A popular indicator called as Bollinger Bands is another effective profit-taking tool. This program creates trading “bands” by adding and subtracting the standard deviation of price-data changes over a period from the average closing price over the same time frame. While many traders use Bollinger Bands to gauge trade entry, they can also be used to take profits.
The euro/yen cross is shown in the chart below, with 20-day Bollinger Bands overlaying the daily price data. If the price reaches the top band, a trader holding a long position may consider taking profits, while a trader holding a short position may consider taking profits if the price reaches the lower band.
A “trailing stop” is a last profit-taking tool. Trailing stops are commonly employed to provide a trade the ability to let profits run while also aiming to avoid losing any profits that have accumulated. A trailing halt can be reached in several ways. One of these methods is depicted in the graph below.
The deal depicted below assumes that on January 1, 2010, a short trade in the euro/yen FX market was entered. Each day, the average actual range over the previous three trading days is multiplied by five, and a trailing stop price is calculated that can only move sideways or lower (for a short trade), or sideways or higher (for a long trade) (for a long trade).