Achieving success in the foreign exchange (forex) marketplace can be challenging. Nonetheless, traders from around the globe, both experienced and novice, attempt to do exactly that on a daily basis. Given the above-average failure rate of new entrants to the market, one has to wonder how long-run profitability may be attained via forex trading.
Among the many ways that forex participants approach the market is through the application of technical analysis. By definition, technical analysis is the study of past and present price action for the accurate prediction of future market behaviour. The premier tools for the practice of technical analysis are known as indicators.
Indicators come in all shapes and sizes, and each helps the user place evolving price action into a manageable context. While there are many indicators to choose from, all are used to either identify market state or recognise potential trading opportunities. Through the integration of indicators, one can develop a collection of powerful forex trading strategies.
One of the key benefits to utilising technical indicators is the freedom and flexibility afforded to the trader. Indicators are versatile in that they may be implemented in isolation or within the structure of a broader strategic framework. In each instance, their proper use promotes disciplined and consistent trading in live forex conditions.
Selecting The Best Indicators For Active Forex Trading
Upon adopting a trading approach rooted in technical analysis, the question of which indicator(s) to use becomes pressing. In order to find suitable candidates, it is important to first determine one's available resources, trading aptitude and goals. Through conducting a detailed personal inventory, the best forex indicators for the job will begin to emerge. At the end of the day, your ideal trading indicators will complement both your assets and objectives.
In practice, technical indicators may be applied to price action in a variety of ways. Two of the most common methodologies are oscillators and support and resistance levels. Each has a specific set of functions and benefits for the active forex trader:
An oscillator is an indicator that gravitates between two levels on a price chart. Oscillators are designed to show when a security is overbought or oversold. They are frequently used as a barometer to measure pricing momentum as it relates to trend extension, exhaustion and market reversal.
Oscillators are strategically valuable as they aid the trader in determining market state, as well as providing forex signals for trade in the global currency markets. Examples of popular momentum oscillators are the relative strength index (RSI) and the MACD indicator.
Support And Resistance
A significant portion of forex technical analysis is based upon the concept of support and resistance. Support and resistance levels are distinct areas that restrict price action. A support level is a point on the pricing chart that price does not freely fall beneath. Conversely, a resistance level is a point on the pricing chart that price does not freely drive above.
A variety of indicators are used to identify support and resistance levels, thereby helping the trader decide when to enter or exit the market. Several of the most popular are Fibonacci retracements/extensions, pivot points and the simple moving average (SMA).
Ultimately, the best forex indicators are user-friendly and intuitive. These two attributes assist in the crafting of informed trading decisions and add strategic value to the comprehensive trading plan.
Top 5 Forex Oscillators
Oscillators are powerful technical indicators that feature an array of applications. Whether you are trend following, trading reversals, or implementing a reversion-to-the-mean strategy, oscillators can be a valuable addition to the forex trader's toolbelt. Below are five time-tested offerings that may be found in the public domain.
Developed in the late 1950s by market technician George Lane, the Stochastic oscillator is designed to identify when a security is overbought or oversold. To do so, it compares a security's periodic closing price to its price range for a specific period of time.
The driving force behind the Stochastic Oscillator, also referred to simply as Stochastics, are the probabilities involved with random distribution. Typically symbolized by %K, it is essentially a comparison of evolving price action to a relative mean value. It's derived by the following formula:
%K = ((Closing Price - Range Low) / (Range High - Range Low)) * 100
Stochastics are exceedingly popular among forex traders as they offer a means of quickly ascertaining whether a currency pair is overbought or oversold. They are plotted as two lines on a pricing chart: the current or slow stochastic (%K) and the fast stochastic (%D), which is a specified periodic moving average. Values are interpreted on a 0-100 scale, with 0 indicating oversold conditions and 100 overbought. In the event that a product's price movement approaches either extreme, a trade setup may come to pass. As price approaches 0, buy signals may be in the offing; as price rallies toward 100, sell signals may come into view.
In addition to the 0-100 scale, the potential divergence/convergence, or crossover of the %K and %D, also render varying degrees of importance. These occurrences may be interpreted as signals of a pending shift in price action. The versatility of Stochastics make it a go-to methodology for many veteran and novice traders alike.
Relative Strength Index (RSI)
The Relative Strength Index (RSI) is a momentum oscillator used by market technicians to gauge the strength of evolving price action. Developed in the late 1970s by J. Welles Wilder Jr., RSI has become an exceedingly popular indicator among technical forex traders.
Calculating RSI is a multi-step process and involves measuring relative strength through the comparison of average price gains and losses. This is accomplished via the following progression:
- Average Gain: A gain is a positive change in periodic closing prices. To calculate the average gain, all periodic gains are added and then divided by the period itself (Total Gain / Period).
- Average Loss: A loss is a negative change in periodic closing prices. To calculate the average loss, all periodic losses are added and then divided by the period itself (Total Losses / Period).
- Relative Strength (RS): Relative Strength is derived by dividing the average gain by the average loss (Average Gain / Average Loss).
Once RS is determined, the RSI calculation may then be completed:
RSI = 100 - [100/(1+RS)]
Similar to Stochastics, RSI evaluates price on a scale of 0-100. Its primary goal is to determine whether a market is overbought or oversold and if conditions are poised for an immediate change. As a general rule, the closer RSI gravitates toward 0, the more oversold a market may be. Conversely, values approaching 100 are viewed as overbought.
The RSI may be applied to any security on any time frame. Its effectiveness in identifying the exhaustion of market trends and possible reversals makes the RSI a favoured indicator among forex traders.
Moving Average Convergence Divergence (MACD)
Invented by Gerald Appel in the late 1970s, the Moving Average Convergence Divergence (MACD) is favoured by forex traders. Like other momentum oscillators, it can be a challenge to derive manually in live-market conditions. Fortunately for active forex traders, modern software platforms offer automated functionality on any time frame.
Essentially, the MACD is a comparison of two exponential moving averages (EMA), typically with periods of 26 and 12. Through observing whether these EMAs are tightening, widening or crossing over, technicians are able to make judgements on the future course of price action. In this way, market trends, reversals or rotations may be projected.
The calculation for MACD is as follows:
MACD = [(26 Period EMA) - (12 Period EMA)]
MACD is applied as a chart overlay in conjunction with a Signal Line. The Signal Line is a periodic EMA of the MACD itself; frequently a nine-period EMA. Histograms are also employed to express the degree of variance between the MACD and Signal Line.
Forex traders are fond of the MACD because of its usability. It is a visual indicator, with divergence, convergence and crossovers being easily recognised. Due to this attribute, the MACD is easily integrated into any trading system with other forex tools and analytical devices.
Commodity Channel Index (CCI)
The Commodity Channel Index (CCI) was created and promoted by mathematician Donald Lambert in the early 1980s. It was initially developed for trading commodities futures contracts, but it has been adapted to the forex, CFD and equities markets.
Like other oscillators, the CCI places market behaviour into context by comparing the current price to a baseline value. In the case of the CCI, the moving average serves as a basis for evaluation.
Given the following building blocks, the CCI may be constructed:
Typical Price: ⅓(High + Low + Close)
MA: Moving Average, N periods of typical prices
MD: Mean Deviation, N periods of typical prices
The CCI formula is as follows:
CCI = [(Typical Price - (MA)) / (.015 * MD)]
In contrast to several of the other oscillators, CCI is viewed with respect to a channel existing between +100 and -100. Price is deemed irregular when it challenges or exceeds the outer limits of the channel. This is unique from the standard 0-100 scale as the boundaries are not finite. The CCI moves with the market, suggesting that price has a tendency of returning to an adapting mean value.
While the difference between CCI and other momentum oscillators appears negligible, the channel concept dictates unique strategic decisions. Nonetheless, CCI is an easy-to-use indicator and the core concepts of overbought or oversold still apply.
The Parabolic Stop And Reverse, also known as Parabolic SAR or PSAR, is used to identify trend direction as well as potential reversal points. Designed by J. Welles Wilder Jr., the Parabolic SAR is an unconventional oscillator. Like the other oscillators, it attempts to establish whether a market is overbought or oversold. However, it does not employ any sort of standardised scale; simply a series of strategically placed "dots."
The PSAR is constructed by periodically placing a dot above or below a prevailing trend on the pricing chart. For an uptrend, dots are placed below price; for downtrends, dots are placed above. The product is a visual representation of the prevailing trend, pullbacks and potential reversal points. Accordingly, the PSAR is most commonly applied as an overlay on open high low close (OHLC) and Japanese candlestick charts.
Forex traders often integrate the PSAR into trend following and reversal strategies. While choppy and range-bound markets can pose challenges to its effectiveness, the visual simplicity boosts the PSAR's appeal to many forex traders.
Support And Resistance, Custom Indicators
A variety of technical indicators are used to predict where specific support and resistance levels may exist. Upon doing so, areas of support and resistance are frequently combined with other trading indicators to build a robust, comprehensive trading system.
Introduced to the world of finance in 1983 by John Bollinger, Bollinger Bands (BBs) are a technical indicator designed to measure a security's pricing volatility. Although not intended for defining market entry/exit points in isolation of other market factors, BBs do provide a detailed look at the volatility of a security.
Bollinger Bands feature three distinct parts: an upper band, midpoint and lower band. Each is represented by a line on the pricing chart, tracing the outer constraints and center of price action. The visual result is a flowing channel with a rigid midpoint. BBs may be applied to OHLC and Japanese candlestick charts on any time frame.
At their core, BBs exist as a set of moving averages that take into account a defined standard deviation. The BB calculations are mathematically involved and typically completed automatically via the forex trading platform. To customise a BB study, you may modify period, standard deviation and type of moving average.
As a general rule, a wide distance between outer bands signals high volatility. Conversely, tight bands suggest that price action is becoming compressed in the vicinity of a periodic average price.
Even though Bollinger Bands are trademarked, they are public domain trading indicators. Forex traders frequently implement BBs as a supplemental indicator because they excel in discerning market state.
Pivot points, or simply pivots, establish areas of support and resistance by examining the periodic highs, lows, and closing values of a security. They are a powerful tool for quantifying normal trading ranges, market direction and abnormal price action as it occurs.
In practice, there are a multitude of ways to calculate pivots. One common method begins with taking the simple average of a periodic high, low and closing value, then applying it to a periodic trading range. The pivot value is calculated via the following formula:
Pivot = (High + Low + Close) / 3
Upon the pivot being derived, it is then used in developing four levels of support and resistance:
Resistance1 = (Pivot * 2) - Low
Resistance2 = Pivot + (High - Low)
Support1 = (Pivot * 2) - High
Support2 = Pivot - (High - Low)
Pivot points are used in a variety of ways, primarily to indicate the presence of a trending or range bound market. A general rule is that when price is above resistance levels, a bullish trend is present; if below support levels, a bearish trend is present. In the event price falls between support and resistance, tight or range bound conditions are present. Regardless of market state, pivot points may be used to generate buy and sell signals.
Pivots are a straightforward means of quickly establishing a set of support and resistance levels. Forex market participants regularly utilise them in breakout, trend and rotational trading strategies.
Average True Range (ATR)
Average True Range (ATR) is a technical indicator that focuses on the current pricing volatility facing a security. Akin to Bollinger Bands, ATR places ongoing pricing fluctuations into context by scrutinising periodic trading ranges.
The primary element of the ATR indicator is range, which is the distance between a periodic high and low of a security. It is computed as follows:
Range = Periodic High - Periodic Low
Range is a flexible calculation in that it may be applied on any period, including intraday, day or multi-day durations. For ATR, True Range (TR) is used instead of normal range to maximise the accuracy of the indicator. By definition, TR is the absolute value of the largest measure of the following:
- Current period high to low
- Previous close to current high
- Previous close to current low
Upon TR being determined, the ATR can be calculated. The process is mathematically involved; at its core, it is an exponential moving average of select TR values. To keep the ATR current, the exponential moving average is used in favour of a simple moving average. Fortunately for active forex traders, the ATR indicator may be calculated automatically by the software trading platform.
The primary purpose of ATR is to identify market volatility. It is not concerned with the direction of price action, only its momentum. High ATR readings indicate an active market, while low ATRs suggest consolidation. While ATRs do not specifically establish support and resistance levels, they are frequently used to confirm the validity of such price points.
The development of Donchian Channels is credited to fund manager Richard Donchian in the late 1940s. Like Bollinger Bands and the ATR, Donchian Channels aim to quantify market volatility through establishing the upper and lower extremes of price action.
Due to their usability, Donchian Channels are a favoured indicator among forex traders. They're typically applied automatically via a forex trading platform, but Donchian Channels may be easily computed manually. The key element of the indicator is period. Once an ideal period is decided upon, the calculation is simple. The following is a set of Donchian Channels for an 18-period duration:
Upper Band = 18 period high
Lower Band = 18 period low
Middle Band = (18 period high + 18 period low) / 2
Through focusing on the market behaviour evident between a periodic high and low, Donchian Channels are able to quickly identify normal and abnormal price action. Further, the upper/lower bands may be viewed as support and resistance levels because they have previously inhibited price.
The appeal of Donchian Channels is simplicity. The indicator is easy to decipher visually on OHLC, line, or candlestick charts and the calculation is intuitive. These two attributes make Donchian Channels an attractive indicator for trend, reversal and breakout traders.
One of the biggest benefits of trading forex in the modern era is the ability to personalise the market experience. Advancing technology has brought the creation of custom charts, indicators and strategies online to the retail trader.
For droves of forex participants, building custom indicators is a preferred means of technical trading. A custom indicator is conceptualised and crafted by the individual trader. Aside from personal preference, it is subject to no predefined constraints and may be applied in any manner deemed appropriate.
Given the robust functionality of modern forex trading platforms such as Trading Station or MetaTrader 4 (MT4), traders have the freedom to construct technical indicators based on nearly any criteria. The only thing limiting the custom forex indicator and associated forex trading strategies is the trader's imagination.
The Bottom Line
At first, technical trading can seem abstract and intimidating. However, through due diligence, the study of price action and application of forex trading indicators can become second nature.
Whether you're a trend, reversal or breakout trader, there are many forex indicators to choose from in the public and private domains. To sum them up, the best ones are easy to use and will add value to a comprehensive trading strategy.
FXCM Research Team
FXCM Research Team consists of a number of FXCM's Market and Product Specialists.
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