A basic guide to choosing technical indicators
(Basically this article for FX Traders but similar principles applicable for Futures Traders too)
Navigating your way through the forex market is a bit like trying to find your way out of a deep, dark cave with only a flicker of a match. To get out of the cave you need a torch, and luckily for the retail trader there are figurative torches in the foreign exchange markets too.One such beacon is technical analysis, which can make life a lot easier. Moving averages, relative strength indicators, Bollinger Bands, Fibonacci retracements, MACD’s and Ichimoku Cloud charts are just some of the technical indicators that are widely used in the forex markets as buy and sell signals.
The Simple Moving Average
These are probably the most commonly watched indicators of all, and they are the basis for a lot of the other technical measures such as Bollinger banks and Ichimoku cloud charts. They are basically price averages over a number of days or hours. Typically investors look at moving averages in periods ranging from 21 (days/ hours), 50, 100 and 200. They are useful because they give traders the general direction of a currency pair and can act as both support and resistance levels.
The chart below (1) shows AUDUSD. It is currently above its 100, 200, 50 and 21-day moving averages, which suggests a strong uptrend in the Aussie dollar. In this case the moving averages are now support levels that could protect the Aussie if it was to take a tumble.
The Bollinger Band is also based on moving averages, but it is slightly more sophisticated. These bands take into account the highs and lows of price, and use standard deviation to show how far a price is from its mean. They are super useful if you want to see if a currency pair is over-extended either on the up or down side. So if a price reaches the lower end of the band this is considered a buy signal and a sell signal if it touches the upper band.
This is the moving average convergence/ divergence indicator originally formulated in the 1970′s. It’s main benefit to traders is that it tracks the medium-term trend for an asset class. It is calculated by subtracting the 26-day moving average from the 12-day moving average. The calculation uses closing prices if you are looking at a daily chart and,essentially, shows you how the trend changes over time. However, what makes a MACD really useful is the inclusion of a 9-day moving average of the MACD itself- called the signal line (blue line in chart), which is plotted on top of the MACD and can be used to show changes in trend.
Traders can read the MACD indicator in three ways. Firstly, if the MACD line (pink line) crosses above the signal line (blue line) this is considered a bullish signal – as it suggests that on a longer-term basis the trend is higher. The opposite is also true – so if the MACD crosses below the signal line this indicates bearish price action ahead.
Secondly, if the price of the asset diverges from its MACD this suggests a trend is weak or coming to its end, and is a warning sign that traders should prepare for a change.
Thirdly, the MACD can also indicate overbought and oversold conditions. This is especially useful when measured against the Relative Strength Indicator (RSI). If the MACD looks stretched on the upside and the RSI is above 80 (between 20 and 80 are normal conditions for the RSI) then the asset can be considered to be overbought. Likewise, the opposite is also true, so when the MACD looks stretched on the downside and the RSI is below 20 then this indicates oversold conditions and traders should be on the look out for a reversal.
Technical indicators don’t predict price action with 100 per cent accuracy and are more of an art than a science, but they are an invaluable tool for forex traders. They also go some way to leveling the playing field a bit for small retail traders and behemoth institutional machines since they are relatively easy to get access to and are fairly straight-forward to understand. Technical analysis is knowledge, and for traders of any size knowledge is power.
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