When you begin to trade Forex, it's important to remember that looking for the best Forex technical indicator is futile - there is no holy grail in Forex. To succeed in Forex you will have to follow the same route as every other trader and learn the trade. Learn the logic behind the most popular indicators, work out their strengths and weaknesses, and most importantly learn how technical indicators can fit together organically and help you in your trading journey.
Any technical indicator is a mathematical tool that analyses one of the five following figures: open price, high, low, closing price and volume. As a result of the calculation, technical indicators are plotted graphically as chart patterns. Sometimes they overlay the price chart and sometimes they are drawn in a separate window. There are literally thousands of indicators out there and anybody with coding skills can write their own, but keep in mind that there is only so much information that will actually be of use to you.
Another thing to keep in mind is that the majority of technical indicators were developed for the stock market and daily charts, because back in the day of their creation, 24 hours was about as often as trading charts were updated. That was about 30 years before the internet.
In this article we will explore some of the most popular indicators. Their focus is trend, momentum, volume and volatility.
Average directional movement index (ADX)
ADX indicator is a Forex technical analysis indicator of the trend strength and it is built upon EMAs of the two other indicators: +DI and -DI.
The DI's are a calculation of how a current day's highs, lows and closing are related to the previous day's highs, lows and closing, divided by the average true range. In essence, +DI says how strong the bull is today, compared to yesterday, while -DI says how strong the bear is today, compared to yesterday. ADX takes the values of +DI and -DI, and tells us who is stronger today compared to yesterday - the bull or the bear.
Graphically speaking, ADX with +DI and -Di look like three lines entangled with each other, moving on the scale of 0 to 100. If ADX is below 20, the trend (whether bullish or bearish) is weak. The threshold of 40 indicates a trend strength and everything above 50 is a strong trend. If +DI is above -DI, the bull is overpowering the bear. The curvature of lines also has value, showing how fast the rate of change is. ADX is a lagging indicator commonly used to evaluate the strength of a trend.
Aroon is a Forex trading technical indicator that measures if there is a trend, how it's developing and how strong is it. Aroon indicators play with the idea that the trend can be measured by evaluating how recent the previous highest highs and lowest lows were. The recentness of the higher highest is reflected in Aroon's bullish line, while the recentness of the lower lows is reflected in Aroon's bearish line. The lines are further oscillated from 0 to 100. For example, when the bullish line is pressed to the top of the scale around the 100 mark and the bearish line is barely above the bottom at 0 - higher highs are often, while lower lows are seldom - we have a strong bullish trend. Crossovers indicate trend direction change. Aroon is also a lagging indicator and is often used to confirm whether a trend has stayed intact.
Moving average convergence/divergence (MACD)
MACD is meant to reveal changes in the strength, direction, momentum, and duration of a trend. It is built upon moving averages of 12 and 26 periods, but with some interesting alterations.
There are two things you can conclude from this alone. Using moving averages is similar to using a lagging indicator; 12 and 26 sound a lot like a trading fortnight and a trading month, thus the indicator is meant to be used on daily charts.
Regardless of the alterations, the indicator consists of the MACD line - the difference between the 12 EMA and 26 EMA, the signal line - the same MACD line smoothed by a nine period SMA, and the histogram, which is the difference between MACD and signal. The bars along the 0 axis - the histogram - are often used to identify divergences. A divergence occurs when the price makes a higher high or a lower low that is not supported by the histogram, also making a higher high or a lower low, accordingly. A divergence hints at the change in the price direction.
Relative strength index (RSI)
Relative strength index (RSI) is the first in the group of momentum indicators next to Williams % range and Stochastic, that serves the same basic purpose, but through slightly varying methods. Momentum indicators are used to signal if an instrument is being overbought or oversold, by measuring the velocity and the magnitude of price movements. Momentum is nothing more than the rate of price change.
RSI compares closing prices of the current and previous candles for the up and down trends, turns the outcome into EMA (or in some cases into SMA) and then calculates how uptrend EMA relates to the downtrend EMA, when oscillated on a 1 to 100 scale. The bigger the difference between today and yesterday - the stronger the momentum. Thus if every future close is higher than the previous, the RSI will be oscillating upward and as soon as it reaches the 80 threshold - the overbought area - it will constitute a sell signal. Conversely for the buy signal. RSI is no stranger to the concept of divergence. If the price makes a higher high, while the RSI only makes a lower high, a bearish signal is generated and vice versa.
Don't let the word oscillator confuse you. Every technical indicator that jumps up and down in a set scale is oscillated. That's how even the trend indicators may be oscillators by their characteristics. As mentioned above Stochastic, much like other volume indicators, helps identify overbought and oversold areas through measuring momentum. In the case of Stochastic, it is done by evaluating how close the closing price was to the price range. In an uptrend the price should be closing near the highs of the trading range, and during a downtrend it should be near the lows. Stochastic is similarly plotted in a 0 to 100 corridor, with basically the same 80/20 overbought/oversold thresholds.
Just to mention briefly, Williams % range compares today's closing price to the highest price in the past and in relation to the average of high and low in the past. In all other respects, it functions like RSI and Stochastic.
Just like all previously described Forex technical indicators, volatility-based indicators monitor changes in the market price and compare them to historical values.
Average true range (ATR)
The range is simply today's high minus today's low. True range extends it to yesterday's closing price if it was outside of today's range. Average True Range Indicator is then an EMA of the true range.
ATR is the greater of the following:Current high less the current low The absolute value of the current high less than the previous close The absolute value of the current low less than the previous close
The bigger the price difference between one of the above, the higher the ATR goes, and the higher the volatility on the market. This can be helpful to know when adjusting your trading stops for example.
Bollinger bands are another volatility indicator that uses an SMA or an EMA and envelopes it by two standard deviation lines. This creates a dynamic corridor for the price to bounce in. Following Mr. Bollinger's idea, prices are high when near the upper deviation line and low when at the lower deviation line, which hints at a turnaround.
Measuring total market volume of the Forex spot market is impossible at the rate and depth required by traders, unlike, say in stocks, commodities, or even Forex futures. The problem is that Forex spot is traded over-the-counter, which means there is no single clearing location to recalculate volumes. The volume that is available at your platform is derived from your broker's own data stream. Those numbers don't even remotely begin to report the total worldwide volume.
Nonetheless, there are traders that involve volume indicators in their Forex trading, and some of them might even be successful at it. In this article, however, we shall only introduce the one that is most known.
On-balance volume (OBV)
OBV is used to measure increases or decreases in the volume of a traded instrument relative to its price. This follows the idea that volume precedes price and can be used to confirm price moves.
Mechanically speaking, total daily volume is assigned a positive number if it increased compared to the previous day. Similarly, a negative value is assigned if total volume decreased since the previous day. When prices go strongly in one direction, so should OBV. A divergence between the price and OBV would indicate a weakness in the market move.
Undoubtedly, there are many more technical indicators that will be of interest, but on researching them you will inevitably see similarities between them and the Forex technical indicators explained in this article. This is a good thing, because it means that you are considering not only the mechanical execution of the trading signals they generate, but also understanding the logic they use and how it applies to the market.
Read more about Forex indicators by following this link.