5/8/2018 4 Types Of Indicators FX Traders Must Know

4 Types Of Indicators FX Traders Must Know

By Troy Segal | Updated April 9, 2018 — 8:30 AM EDT SHARE

Many forex traders spend their time looking for that perfect moment to enter the markets or a
telltale sign that screams "buy" or "sell." And while the search can be fascinating, the result is always
the same. The truth is, there is no one way to trade the forex markets. As a result, traders must learn
that there are a variety of indicators that can help to determine the best time to buy or sell a forex
cross rate.

Here are four di erent market indicators that most successful forex traders rely upon.

Indicator No.1: A Trend-Following Tool

It is possible to make money using a countertrend approach to trading. However, for most traders
the easier approach is to recognize the direction of the major trend and attempt to profit by trading
in the trend's direction. This is where trend-following tools come into play. Many people try to use
them as separate trading system; while this is possible, the real purpose of a trend-following tool is
to suggest whether you should be looking to enter a long position or a short position. So let's
consider one of the simplest trend-following methods – the moving average crossover.

A simple moving average represents the average closing price over a certain number of days. To
elaborate, let's look at two simple examples – one longer term, one shorter term. (For related
information on moving averages, see Exploring The Exponentially Weighted Moving Average.)

Figure 1 displays the 50-day/200-day moving average crossover for the euro/yen cross. The theory
here is that the trend is favorable when the 50-day moving average is above the 200-day average and
unfavorable when the 50-day is below the 200-day. As the chart shows, this combination does a
good job of identifying the major trend of the market – at least most of the time. However, no matter
what moving-average combination you choose to use, there will be whipsaws.

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Figure 1: The euro/yen with 50-day and 200-day moving averages

Source: ProfitSource

Figure 2 shows a di erent combination – the 10-day/30-day crossover. The advantage of this
combination is that it will react more quickly to changes in price trends than the previous pair. The
disadvantage is that it will also be more susceptible to whipsaws than the longer term 50-day/200-
day crossover.

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Figure 2: The euro/yen with 10-day and 30-day moving averages integrity
Source: ProfitSource

Many investors will proclaim a particular combination to be the best, but the reality is, there is
no "best" moving average combination. In the end, forex traders will benefit most by deciding
what combination (or combinations) fits best with their time frames. From there, the trend – as
shown by these indicators – should be used to tell traders if they should trade long or trade
short; it should not be relied on to time entries and exits. (For additional information, check out
Forex: Should You Be Trading Trend Or Range?)

Indicator No.2: A Trend-Confirmation Tool TRADE NOW

Now we have a trend-following tool to tell us whether the major trend of a given currency pair is
up or down. But how reliable is that indicator? As mentioned earlier, trend-following tools are Leveraged trading is high risk.
Losses can exceed investment.
prone to being whipsawed. So it would be nice to have a way to gauge whether the current
trend-following indicator is correct or not. For this, we will employ a trend-confirmation tool.
Much like a trend-following tool, a trend-confirmation tool may or may not be intended to
generate specific buy and sell signals. Instead, we are looking to see if the trend-following tool Trading Center
and the trend-confirmation tool agree.

In essence, if both the trend-following tool and the trend-confirmation tool are bullish, then a
trader can more confidently consider taking a long trade in the currency pair in question.
Likewise, if both are bearish, then the trader can focus on finding an opportunity to sell short the
pair in question.

One of the most popular – and useful – trend confirmation tools is known as the moving average
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convergence divergence (MACD). This indicator first measures the di erence between two
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exponentially smoothed moving averages. This di erence is then smoothed and compared to a Ameritrade.
moving average of its own. When the current smoothed average is above its own moving
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On the flip side, when the current smoothed average is below its moving average, then the
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Figure 3: Euro/yen cross with 50-day and 200-day moving averages and MACD indicator
Source: ProfitSource

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In essence, when the trend-following moving average combination is bearish (short-term average
below long-term average) and the MACD histogram is negative, then we have a confirmed
downtrend. When both are positive, then we have a confirmed uptrend.

At the bottom of Figure 4 we see another trend-confirmation tool that might be considered in
addition to (or in place of) MACD. It is the rate of change indicator (ROC). As displayed in Figure 4, the
red line measures today's closing price divided by the closing price 28 trading days ago. Readings
above 1.00 indicate that the price is higher today than it was 28 days ago and vice versa. The blue
line represents a 28-day moving average of the daily ROC readings. Here, if the red line is above the
blue line, then the ROC is confirming an uptrend. If the red line is below the blue line, then we have a
confirmed downtrend. (For more on the ROC indicator, refer to Measure Momentum Change With
ROC.)

Note in Figure 4 that the sharp price declines experienced by the euro/yen cross from mid-January
to mid-February, late April through May and during the second half of August were each
accompanied by:

The 50-day moving average below the 200-day moving average

A negative MACD histogram

A bearish configuration for the ROC indicator (red line below blue)

Figure 4: Euro/yen cross with MACD and rate-of-change trend confirmation indicators
Source: ProfitSource.com

Indicator No. 3: An Overbought/Oversold Tool

A er opting to follow the direction of the major trend,
a trader must decide whether he or she is more
comfortable jumping in as soon as a clear trend is
established or a er a pullback occurs. In other words,
if the trend is determined to be bullish, the choice
becomes whether to buy into strength or buy into
weakness. If you decide to get in as quickly as
possible, you can consider entering a trade as soon as
an uptrend or downtrend is confirmed. On the other
hand, you could wait for a pullback within the larger
overall primary trend in the hope that this o ers a
lower risk opportunity. For this, a trader will rely on
an overbought/oversold indicator.

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There are many indicators that can fit this bill. However, one that is useful from a trading standpoint
is the three-day relative strength index, or three-day RSI for short. This indicator calculates the
cumulative sum of up days and down days over the window period and calculates a value that can
range from zero to 100. If all of the price action is to the upside, the indicator will approach 100; if all
of the price action is to the downside, then the indicator will approach zero. A reading of 50 is
considered neutral. (More on the RSI can be found in Relative Strength Index Helps Make The Right
Decisions.)

Figure 5 displays the three-day RSI for the euro/yen cross. Generally speaking, a trader looking to
enter on pullbacks would consider going long if the 50-day moving average is above the 200-day and
the three-day RSI drops below a certain trigger level, such as 20, which would indicate an oversold
position. Conversely, the trader might consider entering a short position if the 50-day is below the
200-day and the three-day RSI rises above a certain level, such as 80, which would indicate an
overbought position. Di erent traders may prefer using di erent trigger levels.

Figure 5: Euro/yen cross with three-day RSI overbought/oversold indicator

Source: ProfitSource

Indicator No.4: A Profit-Taking Tool

The last type of indicator that a forex trader needs is something to help determine when to take a
profit on a winning trade. Here too, there are many choices available. In fact, the three-day RSI can
also fit into this category. In other words, a trader holding a long position might consider taking
some profits if the three-day RSI rises to a high level of 80 or more. Conversely, a trader holding a
short position might consider taking some profit if the three-day RSI declines to a low level, such as
20 or less.

Another useful profit-taking tool is a popular indicator known as Bollinger Bands®. This tool takes
the standard deviation of price-data changes over a period, and then adds and subtracts it from the
average closing price over that same time frame,  to create trading "bands." While many traders
attempt to use Bollinger Bands® to time the entry of trades, they may be even more useful as a
profit-taking tool.

Figure 6 displays the euro/yen cross with 20-day Bollinger Bands® overlaying the daily price data. A
trader holding a long position might consider taking some profits if the price reaches the upper
band, and a trader holding a short position might consider taking some profits if the price reaches
the lower band. (Refer to The Basics Of Bollinger Bands® for more information.)

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Figure 6: Euro/Yen cross with Bollinger Bands®
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Source: ProfitSource

A final profit-taking tool would be a "trailing stop." Trailing stops are typically used as a method to
give a trade the potential to let profits run, while also attempting to avoid losing any accumulated
profit. There are many ways to arrive at a trailing stop. Figure 7 illustrates just one of these ways.

The trade shown in Figure 7 assumes that a short trade was entered in the forex market for the
euro/yen on January 1, 2010. Each day the average true range over the past three trading days is
multiplied by five and used to calculate a trailing stop price that can only move sideways or lower
(for a short trade), or sideways or higher (for a long trade).

Figure 7: Euro/yen cross with a trailing stop

The Bottom Line

If you are hesitant to get into the forex market and are waiting for an obvious entry point, you may
find yourself sitting on the sidelines for a long while. By learning a variety of forex indicators, you can
determine suitable strategies for choosing profitable times to back a given currency pair. Also,
continued monitoring of these indicators will give strong signals that can point you toward a buy or
sell signal. As with any investment, strong analysis will minimize potential risks.

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