Technical Indicators in Forex Trading

Technical Indicators in Forex Trading

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Many of the common charts encountered in the toolkit of Forex traders are composed of a graphed series of technical indicators. So, in order to understand those charts, the student of Forex investing will do well to study those indicators.

Fortunately, it isn’t necessary to know exactly how to calculate them in order to use them. Software will do that for you. But, it’s helpful to have some idea of how they are arrived at, and what they mean, in order to evaluate their worth as trading tools.

Keep in mind, however, that none of the indicators – taken alone – tell the whole story. Nor do all of them together make one certain. Indicators are just that, they indicate. They do not predict with certainty. No mathematical tool used in Forex trading will do that. Beware of hyped promises.

Following are some of the more commonly used.

–  Moving Average

Just as prices can be charted so can average prices. And, like the prices themselves, the averages change over time. The two most commonly calculated are the SMA (Simple Moving Average) and EMA (Exponential Moving Average).

The SMA is the average of prices taken at specified intervals, say an hour or a day. Each price is weighted equally in calculating the average. The more complicated EMA weights some prices more than others, on the premise that some are more relevant. Recent prices are considered more telling than those further back, hence these are weighted more in the calculation. For example, a 10-day EMA calculation will weight the last days more heavily than the first days.

Many software tools will indicate a buy signal when the current price rises above its moving average, since this suggests a rising market. A sell signal may be triggered when the price falls below the moving average.

– Bollinger Bands

Just as in futures and options trading, Bollinger Bands are a commonly used indicator. While their calculation involves some heavy-duty mathematics, their interpretation is considerably easier.

The bands are calculated as standard deviations above and below a simple moving average. The width of the bands will vary depending on volatility. As volatility rises, they become wider. As volatility decreases they narrow. Prices tend to stay within the upper and lower bands, with sharp price changes tending to occur after the bands tighten. If prices move outside the bands, the current trend will tend to continue.

A sell signal is suggested when the current price is above the moving average, close to the upper band. A buy signal is indicated when it moves to the lower band.

– RSI

The RSI, or Relative Strength Index, is a value between 0 and 100. A number above 70 usually suggests that a currency is overbought and therefore due for a price reversal. A value below 30 indicates a currency is oversold.

As a price is making a new high, but the RSI fails to surpass its previous high, the trend is said to ‘diverge’. This often indicates an impending reversal of the trend. When the RSI dips below a recent bottom, it is said to have executed a ‘failure swing’. That move is seen as tending to confirm the impending price reversal.
There are several other common indicators, including MACD (Moving Average Convergence/Divergence), Momentum, OBV (On Balance Volume), Money Flow Index, Parabolic SAR, Stochastic Oscillators and dozens even more esoteric.

All these were developed as statistical tools to help predict prices and trends. But keep in mind that, though some technical analysts claim to eschew looking for causes, all of them are based on assumptions when used as technical indicators.

As with any tool, they should form part of a strategy for trading. They should not be used as a substitute for studying the market and using proper risk management.