Top 5 Forex Indicators Every Trader Should Know
Trading on the Forex market is not easy. Despite this, many traders are still able to consistently make profitable returns using Forex indicators to implement successful trading strategies
Trading indicators are used under the assumption that the Forex market is not random, as some economic theories contend. In this article, we will discuss the role of trading indicators in the financial markets, introduce you to five of the most important Forex indicators and explain how they can help your trading in 2021!
The Forex markets tend to behave in certain ways under certain conditions. Proponents of technical analysis trade under the assumption that this behaviour repeats itself and thus certain price patterns will occur time and again. Forex indicators are used to help recognise and exploit such patterns as they form.
Five Important Forex Indicators Explained
There are a lot of contenders for the most popular trading indicator. In this section, we will take an in depth look at five of the most important indictors for both beginner and professional traders alike.
Simple Moving Average
A Simple Moving Average (SMA) is a continuously calculated value of the mean average closing price over a specified time period. As implied by the word 'moving', each time the time frame advances, we calculate a new value to reflect the changes in price.
For example, the 20-day moving average is the mean average of the closing prices for the previous 20 days. The value is calculated each day, discarding the oldest figure in favour of the newly available daily closing price.
Why Use the SMA?
The purpose of the SMA is to smooth out price movements in order to better identify the trend. The SMA is a lagging indicator, meaning that it incorporates prices from the past and, therefore, provides a signal after the trend begins. The longer the time period of the SMA, the greater the smoothing and the slower the reaction to changes in the market. For this reason, the SMA, like other lagging indicators, is not the best trading indicator for receiving advanced warning of a movement in the market.
That being said, the SMA is one of the best Forex indicators when it comes to confirming a trend. It often operates as one of multiple SMAs on the same chart with different time periods – one (or more) with a shorter time period and one with a longer time period. Typical values for the shorter SMA might be 10, 15, or 20 and for the longer SMA 50, 100, or 200.
When Does it Signal a Trend?
The SMA signals a new trend may be starting when the short-term average crosses over the long-term average. If the short-term average is moving above the long-term average, this may signal the beginning of an uptrend. If the long-term average is moving above the short-term average, this may signal the beginning of a downtrend. You can experiment with different period lengths to find out what works best for you.
Exponential Moving Average
Whilst similar to the simple moving average, the Exponential Moving Average (EMA) works out the average price over a specified time period but gives a higher weighting to the more recent price values. The amount by which this weighting decreases for each successively older price value is exponential, hence the name. This means that the EMA will respond more quickly to price changes.
Moving Average Strategy
A very simple Forex trading strategy using a combination of two moving averages, is to trade each time the moving averages cross. You buy when the shorter moving average (MA) crosses above the slower MA, and you sell when the shorter MA crosses below the slower MA. With this system, you will always have a position, either long or short for the currency pair being traded.
You then exit your trade when the shorter MA crosses the longer MA. The next step is to place a new trade in the opposite direction to the one you have just exited. By doing this, you are effectively squaring and reversing.
If you do not want to be in the market all the time, this is not going to be the best Forex indicator trading strategy for you. In that case, a combination using a third MA might suit you better.
A triple moving average strategy uses a third MA. The longest time frame acts as a trend filter. When the shortest MA crosses the middle one, you do not always place the trade. The filter says that you can only place long trades when both shorter MAs are above the longest MA. You can only go short when both are below the longest MA.
The Moving Average Convergence Divergence (MACD) Indicator
Moving Average Convergence/Divergence (MACD) is a Forex indicator designed to gauge momentum. Not only does it identify a trend, but it also attempts to measure the strength of the trend. In terms of giving you a feeling for the strength behind the move, it is one of the best indicators for Forex. Calculating the divergence between a faster EMA and a slower EMA is a key concept behind the indicator.
The MACD line is typically calculated by subtracting the 26-day EMA from the 12-day EMA, and then a 9-day EMA of the MACD is plotted as a signal line. When the MACD line crosses below the signal line, it is a sell signal. When it crosses above the signal line, it is a buy signal. You can set all three parameters (26, 12 and 9) as you wish. As with moving averages, experimentation will help you to find the optimal settings that work for you.
The Bollinger Band
Any list of the best Forex indicators needs to include some form of volatility channel - which is another method of identifying a trend. A Bollinger Band is a volatility channel invented by financial analyst John Bollinger, more than 30 years ago and it is still among the most popular trading indicators for Forex.
The Bollinger band uses two parameters:
- The number of days for the moving average
- The number of standard deviations that you want the band placed away from the moving average
The most common values are 2 or 2.5 standard deviations. In statistics, the standard deviation is a measure of how spread apart the values of a data set are. In finance, standard deviation acts as a way of gauging volatility.
A Bollinger band will adjust to market volatility. It widens as volatility increases and narrows as volatility decreases. A long-term trend-following system using Bollinger bands might use two standard deviations and a 350-day moving average. You would initiate a long position if the previous day's close was above the top of the channel, and you might take a short if the previous day's close is lower than the bottom of the band. The exit point would be the point when the previous day's close crosses back through the moving average.
Fibonacci Retracement
The Fibonacci retracement indicator is based on the idea that after an extreme move, a market will have an increased chance of retracing by certain key proportions. Those proportions come from the Fibonacci sequence. This is a sequence of numbers popularised by the Italian mathematician, Fibonacci. The modern sequence begins with 0 and 1. Any subsequent number is the sum of the preceding two numbers in the sequence.
For example: the sequence begins – 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233…
The Fibonacci ratios come from these numbers. The most important ratio is 0.618. This number is calculated by looking at the ratio of one number to the number immediately following it in the sequence. This value tends to move toward 0.618 as you progress through the series. For example, 89/144 = 0.6181 and 144/233 = 0.6180.
Another key ratio is 0.382. This is derived from the ratio of a number to another number two places further on in the sequence. The ratio tends to move toward 0.382 as you progress through the series. For example, 55/144 = 0.3819 and 89/233 = 0.3820.
The last important key ratio is 0.236. This is derived from the ratio of a number to another number three places on in the sequence.
The theory is that after a major price move, subsequent levels of support and resistance will occur close to levels suggested by the Fibonacci ratios. It is a leading Forex indicator and it is used to make predictions of price movements before they occur. This is in contrast to the indicators that use moving averages, and which only show trends once they have begun. There is an element of self-fulfilling prophecy about Fibonacci ratios. Many traders may act on these expectations and, in doing so, influence the market themselves.
Conclusion
The best Forex indicator will be the one that works best for you and your trading style. Whether you consider yourself a day trader or a long-term trader, there will be a technical indicator to suit your needs.
Many traders find it is best to use a combination of Forex indicators - using a primary one to identify a possible opportunity, and another as a filter. The filter would determine whether the overall conditions are suitable to trade. As with most other activities, you will learn how to trade effectively with indicators by practicing.
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This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of, or recommendation for, any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.
