Forex Indicators - An Introduction
Many traders spend time searching when is the perfect time to enter the markets or a significant indication that denominates buying or selling currencies. In fact, there is not only a single way or method to trade forex. Therefore, traders must learn about the different indicators that help to define the most suitable time to buy or sell currencies.
Forex indicators are the technical indicators that are used to forecast future price movements or changes on the forex market based on a rigorous mathematical formula. The technical indicators can help to determine how the price changes and the traders can make entry and exit decisions more effectively. The most dependable trading strategies will generally depend upon various technical indicators. Most successful traders effectively utilize technical indicators as their prime tool to analyze price fluctuations.
Types of Forex Indicators
There are several indicators available in the forex. Every indicator will fall under any of these categories based on the purpose.
1. Leading Forex indicators
A leading indicator is technical in forex that provides early alerts and trade signals of the expected price movement. It attempts to capture the price movement by granting importance to the most recent price movement. They usually define a momentum, just like a momentum oscillator.
2. Lagging Forex Indicators
These types of indicators are also known as trend-following indicators. They often use a more extended time period than that of leading indicators for calculations; however, it can be prominently helpful in assessing market trends. The main purpose of the lagging indicators is that it helps to remove the market noise derived in the price and provides more insights into the trend. A notable downside is the indicator is only reliable after the trend has already started.
3. Confirming Indicators
Confirming Indicators, as the name itself suggests, can be used to confirm or validate the price analysis. That is, it confirms the accurate reading of price movements observing the volume. An increase in volume supports a price action. The confirming indicator includes the volume along with the price in order to provide a confirmation to the traders that the uptrend or downtrend is confirmed not only based on the price but also based on the volume. Confirming Indicators work well in conjunction with Leading and Lagging Indicators to get a more accurate assessment of market movements.
Best Technical Indicators to Trade Forex
As mentioned above, the technical indicators are categorized based on the purpose. Therefore, a trader will require a combination of various indicators for a trade. Let us see some of the best and most popular indicators to trade forex.
1. Moving Average
Moving Average (MA) is a lagging indicator and an important analytical tool that serves to identify and follow price trends. It determines the average value of a price in a selected period of time, as well as the potential for a change or movement in the current trend. They do not prognosticate the price direction, but instead, they determine the current direction, even if there are delays based on past prices. Despite this, the moving averages serve to smooth out price movement and sieve out the noise.
The Moving Average indicator is the most widely used technical forex indicator, and they are of two types: Simple Moving Average (SMA) and the Exponential Moving Average (EMA).
Simple Moving Average (SMA)
A simple moving average (SMA) is a technical indicator, arithmetic moving average calculation, which is calculated by summing recent closing prices and then dividing it by the number of time periods. That is,
SMA = (Price1+ Price2+ … + Pricen)/n
where, Pricen is the closing price at the time period “n,” and n is the total number of time periods.
For example, let us assume the daily closing prices in a week as 21, 22, 23, 24, 25, 26, and 27.
Then, for the 1st day of the 5-day SMA can be calculated as
SMA = (21 + 22 + 23 + 24 + 25) / 5
SMA = 23
And for the 2nd day of the 5-day SMA can be calculated as
SMA = (22 + 23 + 24 + 25 + 26) / 5
SMA = 24
Similarly, the 3rd day of the 5-day SMA can be calculated as
SMA = (23 + 24 + 25 + 26 + 27) / 5
SMA = 25
Exponential Moving Average (EMA)
An exponential moving average (EMA) is a moving average that is used to identify and measure trend direction over a time period. The EMA is almost similar to SMA as both of the moving averages measure the trend directions. However, while SMA calculates the average of recent closing prices, EMA places more weight on the more current data.
Calculating EMA involves 3 steps
Step 1: Calculate the SMA over a particular time period
Step 2: Calculate the multiplier for weighting the EMA (by using the formula [2/(selected time period + 1)]).
For example, for a 20-day moving average, multiplier can be calculated as [2/(20+1)]= 0.0952.
Step 3: Calculate the current EMA
That is,
EMA = (Pricec - EMAy ) x multiplier + EMAy
where Pricec is the closing price, and EMAy is the previous day’s EMA.
For example, consider a 4-day EMA with prices of 21, 22, 24, and 27. The last value, 27, implies to the most recent price.
The multiplier here can be calculated as (2/(4+1)), which equals to 0.4
Using the calculation, the current EMA value of 24 = [(27- 24) x 0.4 + 24] which equals to 25.2
Both these indicators are interpreted in the same method and are generally used to smooth out price movements. When the price value of a currency pair is rising above the moving average, a trend can be considered as bullish, or else the trend can be considered bearish.
2. Bollinger Bands
Bollinger Bands is a technical indicator that is used to measure the degree of variation of a trading price (volatility). Three bands define it - a middle band, which is a simple moving average (generally 20-day SMA, but can be modified) and two outer bands. The SMA works as a foundation for the other two bands. The upper and lower bands are generally set to two standard deviations aside from the SMA, and they measure the volatility by examining the correlation between the bands and price. Calculating Bollinger bands can be using
Middle Band = 20-day simple moving average (SMA)
Upper Band = 20-day SMA + (20-day standard deviation of price x 2)
Lower Band = 20-day SMA - (20-day standard deviation of price x 2)
The currency pair will become more overbought when the price reaches closer to the upper band. By this time, the buyers would have already made money on the increase in the price and closed their trades to make profits. The overbought pair stops then bends down. Consequently, when the price rises above the upper band, it can be considered as a selling signal, whereas a drop downwards the lower band can be regarded as a buying signal.
The bands expand on increasing volatility and narrow down on decreasing volatility. Bollinger Bands work better when the market is not trending.
3. Moving Average Convergence/Divergence (MACD)
The MACD (Moving Average Convergence/Divergence) is a trading indicator that is used to identify the possible entry and exit points on comparing the short and long term price trends. MACD is based on moving averages, and as that is in the name, convergence refers that the two moving averages are coming together, and divergence refers that the two moving averages are drifting apart.
MACD is calculated by defining the difference of a currency pair’s 26-day exponential moving average and the 12-day exponential moving average. That is,
MACD=12-day EMA − 26-day EMA
The result of this calculation will be a 9-day EMA, which is called as the MACD Signal Line.
A potential buy signal will be generated when the short term 12-day EMA crosses over the long term 26-day EMA and is considered that the MACD is above the zero line. Similarly, a potential sell signal will be generated when the short term 12-day EMA is below the long term 26-day EMA and considered below zero line.
Both convergence and divergence are acquired from MACD Histogram. MACD Histogram is calculated by finding the difference between MACD and MACD Signal Line. It interprets that it is likely possible to buy when the MACD-histogram rises above the signal line and is possible to sell when the MACD-histogram drops below the signal line.
Divergence occurs when the MACD is moving faster in the direction of the current market trend. If the MACD increases and price decreases, it means that the indicator does not confirm the price, bullish divergence occurs. Contrarily, if the price increases and MACD decreases, a bullish divergence occurs.
MACD is a versatile indicator that can be used in both trending and non-trending markets. It can be the most active part of your trading platform, as it measures both trend and momentum.
Conclusion
Every trader will require technical indicators to establish a successful trade. Most of the trading platforms will have a set of built-in trading indicators. Even though any indicator can assure a 100% success rate, it will have its own advantages. Different indicators can help traders in different ways. Therefore, it is advisable to use multiple indicators in a trade.