Trading Indicators Explained
Trading indicators use mathematical calculations based on historical price action and volume, which are plotted as lines on a price chart and can help traders identify certain signals and trends within the market.
Trading indicators are very useful for traders. They help answer the following common questions from traders:
What do you do if a currency pair (or any financial asset) is making historical highs or lows, so there is not enough support or resistance or any support or resistance to guide you in making entry and exit decisions?
How do you know you're not buying high or selling low, just before the trend ends? Ideally, in both cases, you should wait for some kind of pullback, but in the process, you risk missing the trend!
If you're in a winning trade and are close to exiting at your planned target, how do you know if the price you're aiming to exit your trade is at the end of the trend, or if you should leave at least part of your position in the hope of making more profits with a trailing stop-loss order?
Analysts agree that using five trading indicators can strike the right balance in providing sufficient information to make informed decisions. Using too many trading indicators may provide more information, but it often paralyzes your technical analysis. Ideally, you'll be better off using three technical trading indicators together and a maximum of seven. Ultimately, it's up to you to make your own choices. You don't have to stick to the same tools all the time; you just need to decide how many you can use on a single chart. Traders who use a long-term trading strategy across larger time frames have more time and can track more trading indicators. They also need to be well-versed in economic events and have a solid understanding of fundamental analysis methods:
1. Economic events relevant to the currencies they trade.
2. Macroeconomic data that drives the global economy and shows risk appetite within markets, as macroeconomic data affects the performance of all markets.
Types of trading indicators
There are distinct categories of trading indicators, including leading and lagging indicators. A leading indicator is a trading signal that predicts future price movements, while a lagging indicator looks at past trends and indicates momentum.
Furthermore, there are five main types of trading indicators: trend indicators, momentum indicators, volatility indicators, support and resistance indicators, and volume indicators. They are grouped based on their function, which helps reveal the average future price of a currency pair and provides a clearer picture of support and resistance levels.
1. Trend indicators
Trend-following trading indicators were created to help traders trade currency pairs that are trending up or down. We've all heard the phrase "the trend is your friend"—currency trading indicators can help identify the direction of a trend and tell us if there is a clear trend. Here's a list of the best trend indicators and the best trend strength indicators:
Moving Average
The Moving Average (MA) is a technical trading indicator that measures the average price of a currency pair over a period of time. Moving averages help provide a clear indication on the chart of the direction in which the pair is moving—up, down, or sideways. There are a variety of moving averages to choose from, the most common being the Simple Moving Average (SMA) and the Exponential Moving Average (EMA).
Ichimoku indicator
The Ichimoku Kinko Hyo indicator is a complex-looking trend indicator that is simpler than it appears. This Japanese trading indicator was created as a standalone indicator to show current trends, plot support and resistance lines, and signal trend reversals.
Average Directional Index (ADX)
The Average Direction Index (ADX) won't tell you whether the price is trending up or down, but it is the best indicator for determining the trend because it will tell you if the price is trading within a range. This makes it an ideal candidate for either a range or trend strategy by ensuring you are trading based on current market conditions.
Parabolic SAR Indicator
The Parabolic SAR indicator refers to a trading system based on price and time. Wilder called this the "parabolic time/price system." SAR stands for "stop and reverse," and is the actual indicator used in the system. The Parabolic SAR tracks the price as the trend extends over time. The indicator moves below the price when it is in an uptrend and above it when it is in a downtrend. In this regard, this trading indicator may stop and reverse when the price reverses and breaks out to the upside or slides to the downside.
2. Momentum indicators
The main problem that traders and investors face is that they only get paid when they are correct about their future predictions, yet most of the popular trading indicators we have covered so far lag further than the leading indicators.
Lagging indicators tell us about the past, and from that information, all we can do at best is form some hypotheses about the future.
What should a trader do? Use momentum indicators and trade momentum! They are leading indicators, but why?
1. The momentum indicator can tell you whether a trend is strengthening or weakening.
2. The momentum indicator can tell you whether a financial asset is overbought or oversold in current market conditions. Therefore, momentum indicators indicate the possibility of an imminent trend reversal.
Knowing these changes can help you anticipate reversals, which can lead to more profitable trades for traders. That's why it's ranked as one of the most powerful trading indicators and the best day trading indicator used by experienced traders.
Momentum indicators can give you additional clues about the most likely probabilities. There are many momentum indicators, but for now, we'll present just a few of the most effective and easiest to use.
Stochastic indicator
The Stochastic Oscillator provides traders with a different way to calculate price volatility by tracking the current price's volatility from the lowest high to the lowest low over a set period. This distance is then divided by the difference between the highest highs and lowest lows over the same time period. The resulting line, %K, is then used to create a moving average, %D, which is positioned directly above %K.
MACD indicator
The Moving Average Convergence/Divergence (MACD) indicator is rated as the best indicator for providing buy and sell signals. The MACD tracks the difference between two moving averages: the 12-day exponential moving average (EMA) and the 26-day EMA. The difference between the two EMAs is then plotted on a sub-chart (called the MACD line), with a 9-day EMA plotted directly above it (called the signal line). Traders then look to buy when the MACD line crosses above the signal line and look to sell when the MACD line crosses below the signal line, as shown here. There are also opportunities to trade the differences that occur between the MACD movement and the price movement.
Relative Strength Index (RSI)
The Relative Strength Index (RSI) is one of the most commonly used oscillators. A major component of the RSI formula is the ratio of the average gain to the average loss over the past 14 days. The RSI ranges from 0 to 100, with overbought levels occurring above 70 and oversold levels occurring below 30. Traders will look to short when the signal line crosses above 70 and buy when the signal line crosses below 30.
3. Volatility indicators
The volatility index measures the magnitude of the ups and downs of a particular financial asset. When a currency price fluctuates significantly up and down, it is said to have high volatility. A currency pair that doesn't fluctuate much is said to have low volatility. It's important to note a currency pair's volatility before opening a trade, so we can take this into account by choosing our trade size and stop-loss and take-profit levels using the volume index.
Bollinger Bands Indicator
The Bollinger Bands indicator creates three straight lines on the chart. The "middle band" is a 20-day simple moving average, with the "upper band" and "lower band" plotted two standard deviations above and below the 20-day simple moving average. This means that the more volatile a pair is, the wider the outer bands become. This makes Bollinger Bands a viable option for any currency pair, regardless of its behavior. This makes Bollinger Bands one of the best and most widely used volume indicators among the trading community.
Average True Range Indicator (ATR)
The Average True Range (ATR) indicator tells us the average distance between high and low prices over a specified number of time periods represented by Japanese candlesticks (usually measuring the average price of the last 14 candles). This indicator is expressed in pips, and the higher the ATR, the more volatile the pair, and vice versa. This makes this volume indicator an excellent and ideal tool for measuring the volatility of forex pairs.
Standard Deviation Indicator
The standard deviation indicator is an indicator that helps traders measure the magnitude of price movements. Therefore, the standard deviation indicator enables traders to determine how volatility will affect the price in the future. It cannot predict whether the price will rise or fall; it only tells us that the price will be affected by volatility.
The standard deviation indicator compares current price movements to historical price movements. Many traders believe that large price movements are followed by small price movements, and that small price movements are followed by large price movements.
4. Support and resistance indicators
Support and resistance are key to technical analysis. Support and resistance refer to price levels that act as barriers to a financial asset's price moving in a specific direction. Traders are always looking for an indicator that plots support and resistance lines. Below, we present a list of the best trading indicators that plot support and resistance lines.
Pivot Points
Pivot points are among the most widely used lines in all markets, including stocks, commodities, and forex. They are created using a formula consisting of previous periods' high, low, and closing prices. Traders use these lines as potential support and resistance levels—levels that the price may struggle to break through.
Trendlines and Channels
Trendlines and channels are lines formed above and below recent price action, showing the highs and lows of prices over an extended period. These lines can act as support or resistance if the price meets them again.
Fibonacci levels
Fibonacci retracement levels are an indicator that can identify the degree to which a market is moving against its current trend. A retracement occurs when the market experiences a temporary decline—also known as a pullback.
Traders who believe the market is about to make a new move often use Fibonacci levels to confirm this. The Fibonacci indicator helps identify potential support and resistance levels, which can signal an uptrend or a downtrend. Because traders can identify support and resistance levels using this indicator, which draws support and resistance lines, it can help them determine where to place stop-loss and take-profit orders, or when to open and close their positions.
5. Volume indicators
Volume indicators are used to confirm the strength of trends, which may warn of a price reversal. Some of the more complex trading indicators that compare volume and price movements are the Rate of Change (Volume), Balance Volume, Force Index, Accumulation Distribution, Chaikin Oscillator, Money Flow Index, and Chaikin Money Flow.
Other technical trading indicators
Elliott Waves, Gann Angles, and the DiNapoli Indicator study trading volume and are among the most powerful entry and exit indicators for timing trades.
How to use trading indicators:
For example, your typical set of technical trading indicators might include:
1. A set of moving averages for 10, 20, 50, 100, and 200 days: Again, these moving averages act as support and resistance points as well as momentum indicators if they cross or form price ranges.
2. Trend lines and channel lines show the trend and provide support and resistance points.
3. Double Bollinger Bands and MACD show changes in momentum.
Fibonacci levels for current trends on each given timeframe indicate potential support and resistance points. You'll need to redraw them for each timeframe you examine, as initial trends can vary significantly across different timeframes.
How many indicators should a trader use?
In keeping with the idea that simplicity is best, there are four easy indicators you should familiarize yourself with and can use one or two at a time to determine your trade entry and exit points: the moving average, the relative strength index (RSI), and the slow and fast stochastic oscillator.