Introduction
When everyone begins their journey in the currencies market, forex indicators are the first concept they learn about in technical analysis. The movement of forex prices, like any other financial instrument, is chaotic and random.
Yet, history does repeat itself. Once you look deeper, certain structures emerge over time that traders look to exploit for profit. One way of capitalizing on these patterns is with indicators for forex trading.
Conventional technical tools have their roots dating back to the early to mid-20th century, with pioneers like William Gann, Charles Dow, Richard Wyckoff, Ralph Elliott, and J. Welles Wilder Jr.
In this guide, we look at indicators for forex trading in greater detail.
What are forex indicators?
An indicator is a graphic tool found in charting software designed to provide a specific dynamic about prices, like trend, momentum, volatility, and volume. This tool can be displayed in a bottom window of a chart or superimposed onto it.
Forex indicators consist of pre-programmed formulas which automatically update as new data emerges, meaning no manual intervention is needed.
Think of it like a ruler. Its job is to measure distance more efficiently. An indicator offers traders the same luxury: the ability to quantify a technical component.
Some traders do not use these tools, preferring a cleaner approach that looks purely at price action with candlesticks. This methodology has some benefits, such as a less cluttered chart.
However, there are many elements that the human eye cannot analyse without some tool involved; this is where indicators for forex trading come in.
As you may know, there are tons of these technical tools. Over the years, traders modify existing technical tools, or some create them from scratch. Regardless, one simple tip is not to use too many indicators.
A common mistake, especially for beginners, is to input more than two indicators on their charts. This can lead to conflicting signals and, ultimately, analysis paralysis on whether to buy or sell a particular pair.
More information often doesn’t correlate to better decision-making. Experienced traders understand the value of a minimalistic approach by adopting one or two primary tools. Also, despite the wide array of such tools, most have little differences between them.
Before choosing any technical tool, you should first study the attribute behind its formation. For instance, moving averages (MAs) are the most popular forex trend indicator. –
Yet, it would help if you first learned everything you can about trends and their drivers so you can better implement MAs.
Indicators are also useful for trading chart patterns like head and shoulders, double tops/bottoms, flags, and triangles.
Despite the complex math involved in constructing forex indicators, these tools are not always reliable. You are bound to lose money with them. Therefore, you should only use them as a guide.
Types of indicators for forex trading
As previously mentioned, each indicator provides data on a particular aspect. Therefore, we generally classify them according to four categories (some also include support and resistance, which you can learn more about here).
Let’s look at each of them in more detail.
Trend indicators
Trends form a massive part of the average trader’s forex indicator signals, whether they are a scalper, day trader, swing trader, or position trader. But let’s define a trend. A trend is the predominant direction a market moves over a specific period.
We know prices never move without retracements or pullbacks. While there may be opposing short-lived counter moves in an uptrend, the direction will generally be upwards; the opposite is true for a downtrend.
So, when trading with the trend, we assess which force is more powerful; is it the buying or selling power? Without an indicator, we define a trend based on a series of swing highs and lows.
In a bullish trend, the price will continuously make higher highs and higher lows. With a bearish trend, the market will frequently produce lower lows and lower highs.
Another technique is using a trendline. However, while you may derive some efficiency from these methods, the best trend forex indicators are more advanced. They consider strength over direction according to past open, close, high, and low prices.
As we said, a trend rarely follows a simple high-low structure. Often, you will deal with mini trends or retracements within a bigger trend. The tricky part is that different time frames and settings produce varying interpretations of the general price trajectory.
Yet, the idea is to assess which side the market is strongest over the long term and enter in that direction.
Moving averages
These are the most popular resource for this purpose, often regarded as the best trend indicator for forex. Most graphical tools incorporate moving averages, meaning they are the foundation of technical analysis.
A moving average is a moving line calculated based on a formula accounting for prices (usually the closing) over specific days. In simpler terms, the MA tells you the mean value a market has traded within a particular period.
For instance, a 20-period MA will show the average closing price over the past 20 days. We have several kinds of MAs. However, the most popular are the simple and exponential, with minor differences in output between the two.
A simple MA (SMA) is the most basic type of MA. So a 20-period moving average takes the closing price for each in series, divides it by 20, and calls it a day.
An exponential moving average (EMA) uses a slightly different formula to apply a ‘smoothing factor.’ The aim is to place emphasis on recent prices instead of all values in a series.
Therefore, the EMA is quicker to react to changes, making it preferable for short-term traders. On the other hand, the SMA is slower in reaction, which is a suitable trait for long-term analysis.
Regardless of the type, moving averages work in the same way. You determine the trade direction based on whether the price is above or below the MA. When above, this suggests an uptrend; when below, this signals a downtrend.
Here is an image below of the 25-MA on the euro’s 1HR chart.
It is not necessary to use more than one MA. The common exception is the crossover strategy, which helps spot trend changes and offers entry/exit triggers.
With this system, traders use a higher-period and a lower-period moving average. When one intersects with the other, it suggests a reversal. We have circled the crossover points on the NZD/USD 1HR chart below.
MACD
Experts regard the moving average convergence divergence (MACD) as a trend-following momentum tool. It is quite versatile, as traders can use MACD for entry triggers, momentum, and divergence. This tool consists of two MAs: the MACD and signal lines.
The first line is calculated by subtracting two EMAs. By default, the periods are 26 and 12. The signal line is a 9 EMA represented as histogram bars.
There are several ways of interpreting the MACD. Firstly, anything above the 0 level suggests bullishness, while anything below it suggests bearishness. We analyze trend changes based on the intersection between the MACD and signal line.
When the MACD line crosses above the signal line, it’s a buy signal; when it crosses below the signal line, it’s a sell signal.
Lastly, we have divergence, an event where the high-low structure of price doesn’t correlate with the indicator. This is a staple of momentum tools and is one of the first signs of a potential reversal.
Earlier, we spoke of an uptrend consisting of higher highs and higher lows. However, when the indicator prints a higher high and a lower high, we have a bearish divergence. The opposite is for downtrends; lower lows, lower highs (price); lower lows, higher lows (indicator).
The chart below has the MACD on the 4HR chart of EUR/JPY. We have also marked an instance of bearish divergence.
Momentum indicators
While forex trend indicators are helpful, they don’t provide any guidance on force or strength. Why is this important? As a trader, figuring out the direction is one thing. However, it’s no use if the price is unlikely to move a great distance to net you profits; this is where momentum comes in.
Momentum refers to the acceleration rate of a market. Similar to physics, traders study the quantity of motion for prices. We want to enter when everything picks up steam without stalling. We also refer to momentum forex indicators as oscillators because they swing back and forth between two fixed extremes.
One key component with momentum is the concept of overbought and oversold. There are two ways of interpreting this notion.
Overbought reflects peak bullishness, with the potential for the price to keep increasing. On the other hand, oversold suggests extreme bearishness, with the likelihood for the market to move lower.
However, either instance can also signal a pullback to the other side, which may be short-lived or be a fully-fledged reversal. As stated previously, momentum tools also show divergence.
We have several tools for studying momentum, the most popular of which are the Relative Strength Index (RSI) and stochastics.
Relative Strength Index
The late J. Welles Wilder Jr. (1935-2021) created the RSI and a few other popular indicators for forex trading, first referenced in his seminal 1978 book, New Concepts in Technical Trading Systems.
The RSI’s purpose is to depict the momentum strength using a 14-day moving average computed on a 0-100 line graph.
When the RSI is below 30, it implies oversold conditions, while we consider it overbought when the RSI is above 30. We have placed the RSI on the euro daily chart along with an example of bullish divergence.
Stochastics
The stochastics or stochastic oscillator is the creation of George Lane in the late 50s. It is among the most well-known forex trade indicators. Stochastics consist of two moving averages on a line graph; a higher-period MA called the %K line, and a lower-period MA called the %D line.
Like the RSI, it is range-bound between 0 and 100 levels, with oversold below the 20 level, while overbought is above the 80 level.
Stochastics can also present divergences. However, traders also use it for entry and exit signals by observing crossovers of the %K and %D line.
Below is a chart with this oscillator on the AUD/USD daily chart.
Volatility indicators
When we talk of volatility, we seek to measure the depth of price changes (over a specific period. The higher the volatility, the greater distance an FX pair can cover in either direction.
Conversely, lower volatility for a market means that it will have a shorter reach in the same period. Non-USD pairs are generally more volatile than USD-based markets like EUR/USD and NZD/USD.
However, higher volatility comes with a slight increase in trading costs. Understanding this market aspect helps forecast how far prices can travel in a set time.
Average True Range
The Average True Range (ATR) is another of J. Welles Wilder Jr’s creations, also introduced in the same 1978 book mentioned before. It’s nothing more than a simple 14-day MA plotted on a line graph.
The result is a pip measurement for an FX pair on a specific pair. For example, if the ATR reads 50 on a 4HR chart, you can expect the price to travel around this range in the next four hours.
The ATR tends to be the least utilized in forex trade indicators as it doesn’t offer trading signals. Still, it is beneficial for stop loss and profit target placement.
If you know the ATR, you attempt to have a wider stop loss than that figure to avoid unnecessary stop-outs. Similarly, you can align the ATR readings based on your ideal profit target by seeing how many hours or days it may take.
Here is an image of the ATR on the 30-minute chart of EUR/JPY.
Bollinger Bands
Bollinger Bands are one of the most versatile forex trade indicators, created by John Bollinger. Traders use this copyrighted technical tool to observe oversold/overbought conditions, measure volatility, and identify trends.
Bollinger Bands consist of a 20-day moving average (middle band) floating between two standard deviations (the lower and upper band).
- When the price is above the middle band, it shows an uptrend; when below, it reflects a downtrend.
- An overbought signal is generated when the market pushes outside the upper band, while an oversold signal happens when it challenges the lower band.
Chartists also look at the structure of the bands. When they contract or ‘squeeze,’ it suggests a ranging or quiet market. On the other hand, you can expect the price to pick up steam when the bands begin expanding.
Here’s a picture of this tool below on the GBP/USD 1HR chart.
Volume indicators
Let’s now look at forex volume indicators. Volume is simply the number of units or quantity that is being traded in a given period. With an actively traded market, we say it has high volume; the opposite is true for a thinly traded market.
We also interpret volume by forecasting the number of buyers and sellers. In an uptrend, there are more buy orders than sell orders. For the price to change direction, more sell orders must come in, or more buyers need to close their positions. Of course, the opposite is valid for a downtrend.
Yet, forex volume indicators are the least reliable in technical analysis tools. The FX market is decentralized, meaning that investors are clueless about the true number of people trading a pair at any time.
The closest to real volume is with sentiment tools or client positioning data given by a handful of brokers. Still, this information is only limited to the clients of that company rather than the entire market.
So, traditional volume-based tools depict volume based on past prices rather than on the actual quantity of buyers and sellers.
Accumulation/distribution index
The accumulation/distribution (A/D) index helps traders assess the supply and demand of price. It shows how much of a market is accumulated (bought) or distributed (sold) using money flow.
This refers to averaging all the prices (high, low, close, and open) and multiplying them by the daily volume.
One of the A/D index’s primary functions is to present divergence between volume and price data. So, if the market is rising, but the indicator is falling, that would suggest there isn’t enough accumulation, and downward pressure may be on the cards.
On the other hand, when the price is decreasing while the A/D is rising, it implies upward momentum may be forthcoming. Here’s a picture of this tool on the 1HR GBP/JPY chart.
Money Flow Index
Compared to the A/D indicator, the MFI (Money Flow Index) is the most dynamic in volume indicators for forex trading. Many chartists called the MFI a ‘volume-weighted RSI’ because it visually looks similar to the RSI.
It has the same function as a typical oscillator using a line graph bouncing between 0 and 100. We consider anything above 80 overbought, while readings below 20 reflect oversold. Likewise, you can also trade divergences with the MFI.
Here’s an image of the MFI below on the EUR/GBP 4HR chart.
Which are the best indicators for forex trading?
As with any technical tool, what works for one trader may not tickle another’s fancy. Some traders may not care much about trends and, therefore, won’t use moving averages.
You may prefer to only look at momentum or combine several indicators at once. The point is that everyone is different based on what matters most to them when analysing charts.
Another frequently-referenced question with this topic is whether indicators work. We should appreciate they only provide data, all of which is lagging.
This means they offer delayed feedback by giving you a trigger to trade once the price has already moved in your preferred direction.
Many traders struggling with technical tools use them as something that provides signals, but this isn’t recommended. You cannot rely on a moving average crossover or divergence alone as a trigger to trade a forex pair; it’s quite risky.
As a trader, you analyse a market holistically, accounting for several factors instead of one aspect. You seek to connect the dots, understanding the ‘story’ of price to form a meaningful trade idea. So, indicators do work when you consider other elements.
Conclusion
In the last decade, there has emerged a distinction between two camps: those using indicators and others trading price action. The debate is ongoing as traders seek to decide the better option to increase the equity curve.
Whether you prefer price or indicators, you shouldn’t use these tools in isolation. Otherwise, trading success would be much easier. It’s best to stick with one or two indicators and fully understand the element they measure to become a better analyst.
