GET Financial Education Series - Forex
Technical Analysis: Technical Indicators – Lesson 7
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Charts always have a story to tell. However, from time to time those charts
may be speaking a language you do not understand and you may need some help
from an interpreter. Technical indicators are the interpreters of the Forex
market. They look at price information and translate it into simple, easy-to-read
signals that can help you determine when to buy and when to sell a currency
pair.
Technical indicators are based on mathematical equations that produce a
value that is then plotted on your chart. For example, a moving average
calculates the average price of a currency pair in the past and plots a
point on your chart. As your currency chart moves forward, the moving average
plots new points based on the updated price information it has. Ultimately,
the moving average gives you a smooth indication of which direction the
currency pair is moving.
Each technical indicator provides unique information. You will find you
will naturally gravitate toward specific technical indicators based on your
trading personality, but it is important to become familiar with all of
the technical indicators at your disposal.
You should also be aware of the one weakness associated with technical
indicators: Because technical indicators look at historical price data,
they are not guaranteed to know anything definite about the future.
Technical indicators are divided into the following categories:
- Trending Indicators
- Oscillating Indicators
- Volume Indicators
Trending Indicators
Trending indicators, as their name suggests, identify and follow the trend
of a currency pair. Forex traders make most of their money when currency
pairs are trending. It is therefore crucial for you to be able to determine
when a currency pair is trending and when it is consolidating. If you can
enter your trades shortly after a trend begins and exit shortly after the
trend ends, you will be quite successful.
Let's take a look at the following trending indicators:
Moving Average
Moving averages are the most basic trending indicator. They show you
what direction a currency pair is going and where potential levels of
support and resistance may be moving averages themselves can serve as
both support and resistance.
As we discuss moving averages, we will look at the following three topics:
- How moving averages are constructed
- Moving average trading signal
- Strengths of moving averages
How a Moving Average is Constructed
Moving averages are constructed by finding the average closing price
of a currency pair at any given time and then plotting these points on
a price chart. The result gives you a smooth line that follows the price
movement of the currency pair.
You can adjust the volatility of a moving average by adjusting the time
frame the indicator looks at to obtain the average price. Moving averages
that look at fewer time periods to determine an average are more volatile.
Moving averages that look at more time periods to determine an average
are less volatile.
Moving Average Trading Signal
Moving averages provide useful trading signals for currency pairs that
are trending.
Entry signal
- when an up-trending currency pair bounces back up after hitting an up-trending
moving average, or when a down-trending currency pair bounces back down
after hitting a down-trending moving average.
Exit signal
- when you enter a trade on an up-trending currency pair, set a stop
loss below the moving average. As the moving average rises, move your
stop loss up along with the moving average. If the currency pair ever
breaks far enough below the moving average, your stop loss will take
you out of your trade.
When you enter a trade on a down-trending currency pair, set a stop
loss above the moving average. As the moving average falls, move your
stop loss down along with the moving average. If the currency pair ever
breaks far enough above the moving average, your stop loss will take
you out of your trade.
Strengths of a Moving Average
Moving averages enjoy the following strengths:
- They identify simple trends
- They are flexible enough to work in both short-term and long-term
time frames
Bollinger Bands
Bollinger bands, created by John Bollinger, are a trending indicator
that can show you not only what direction a currency pair is going but
also how volatile the price movement of the currency pair is. Bollinger
bands consist of two bands an upper band and a lower band and a moving
average and are generally plotted on top of the price movement of a chart.
As we discuss Bollinger bands, we will look at the following three topics:
- How Bollinger bands are constructed
- Bollinger band trading signal
- Strengths of Bollinger bands
How Bollinger Bands are Constructed
Bollinger bands are typically based on a 20-period moving average. This
moving average runs through the middle of the two bands. The upper band
is plotted two standard deviations above the 20-period moving average.
The lower band is plotted two standard deviations below the 20-period
moving average.
A standard deviation is a statistical term that measures how far various
closing prices diverge from the average closing price. Therefore 20-period
Bollinger bands tell you how wide, or volatile, the range of closing prices
has been during the past 20 periods. The more volatile the currency pair,
the wider the bands will be. The less volatile the currency pair, the
narrower the bands will be.
Bollinger Band Trading Signal
Bollinger bands provide useful breakout signals for currency pairs that
have been consolidating.
Entry signal
- when the bands widen and begin moving in opposite directions after a
period of consolidation, you can enter the trade in the direction the
price was moving when the bands began to widen.
Exit signal
- at some point after the breakout occurs, the bands will begin to move
back toward each other (see Point B on Figure 4). When this happens, set
a trailing stop loss to take you out of the trade if the trend reverses
(see Point C on Figure 4).
Strengths of Bollinger Bands
Bollinger bands enjoy the following strengths:
- They help you identify the trend
- They identify current market volatility
Oscillating Indicators
Oscillating indicators, as their name suggests, are indicators that move
back and forth as currency pairs rise and fall. Oscillating indicators can
help you determine how strong the current trend of a currency pair is and
when that trend is in danger of losing momentum and turning around.
When an oscillating indicator moves too high, the currency pair is considered
to be overbought (too many people have bought the currency pair and there
are not enough buyers left in the market to push the currency pair higher).
This indicates the currency pair is at risk of losing momentum and turning
around to move lower or sideways.
When an oscillating indicator moves too low, the currency pair is considered
to be oversold (too many people have sold the currency pair and there are
not enough sellers left in the market to push the currency pair lower).
This indicates the currency pair is at risk of losing momentum and turning
around to move higher or sideways.
Let's take a look at the following oscillating indicators:
Commodity Channel Index (CCI)
The commodity channel index (CCI) is an oscillating indicator developed
by Donald Lambert that can show you how bullish or bearish traders are
toward a currency pair and how dramatic those sentiments are. You can
see the volatility of a currency pair with the CCI, much like you can
with Bollinger bands.
The CCI is usually plotted below the price movement on a chart.
As we discuss the CCI, we will look at the following three topics:
- How the CCI is constructed
- CCI trading signal
- Strengths of the CCI
How the Commodity Channel Index (CCI) is Constructed
The commodity channel index (CCI) is based on both the average value
of past price movements and how far those price movements have strayed
from the average how volatile the price movements have been.
If the average price of the currency pair is moving higher, the CCI will
also be moving higher. Just how quickly the CCI moves higher depends on
how volatile the currency pair is. If it is more volatile, the CCI will
move higher faster. If it is less volatile, the CCI will move higher slower.
If the average price of the currency pair is moving lower, the CCI will
also be moving lower. Just how quickly the CCI moves lower depends on
how volatile the currency pair is. If it is more volatile, the CCI will
move lower faster. If it is less volatile, the CCI will move lower slower.
The CCI moves back and forth, crossing 100, zero and -100 as it cycles
through its progression.
Commodity Channel Index (CCI) Trading Signal
The commodity channel index (CCI) produces trading signals as it crosses
back and forth above and below both 100 and -100.
Entry signal
- when the CCI rises above 100 and then turns around and crosses back
below 100, you can sell the currency pair knowing that buyers have exhausted
their momentum and the currency pair is likely to decline in the near
future.
When the CCI falls below -100 and then turns around and crosses back
above -100, you can buy the currency pair knowing that sellers have exhausted
their momentum and the currency pair is likely to rise in the near future.
Exit signal
- when the CCI turns around and starts moving higher after you have sold
a currency pair, place your stop loss just above the nearest level of
resistance. If the currency pair turns around and moves above resistance,
your stop loss will take you out of the trade.
When the CCI turns around and starts moving lower after you have bought
a currency pair, place your stop loss just below the nearest level of
support. If the currency pair turns around and moves below support, your
stop loss will take you out of the trade.
Strengths of the Commodity Channel Index (CCI)
The commodity channel index (CCI) enjoys the following strengths:
- It helps you identify volatility in a currency pair
- It helps you identify potential reversal points for a currency pair
- It helps you confirm the strength of current trends
Moving Average Convergence Divergence (MACD)
The moving average convergence divergence (MACD) is an oscillating indicator
developed by Gerald Appel that can show you when trading momentum changes
from being bullish to bearish and from being bearish to bullish. The MACD
can also show you when traders are becoming over-extended, which usually
results in a trend reversal for the currency pair.
The MACD is usually plotted below the price movement on a chart.
As we discuss the MACD, we will look at the following three topics:
- How the MACD is constructed
- MACD trading signal
- Strengths of the MACD
How the Moving Average Convergence Divergence (MACD) is Constructed
The moving average convergence divergence is constructed based on a series
of moving averages and how they relate to one another. The standard MACD
looks at the relationship between a currency pairs 12-period and 26-period
exponential moving average. Specifically, the MACD looks at the distance
between these two moving averages. If the 12-period moving average is
above the 26-period moving average, the MACD line will be positive. If
the 12-period moving average is below the 26-period moving average, the
MACD line will be negative.
The MACD line is accompanied by a trigger line. This line is a 9-period
exponential moving average of the MACD line.
Moving Average Convergence Divergence (MACD) Trading Signal
The moving average convergence divergence (MACD) produces trading signals
as it crosses back and forth above and below the trigger line.
Entry signal
- when the MACD crosses above the trigger line, you can buy the currency
pair knowing that momentum has shifted from being bearish to being bullish.
When the MACD crosses below the trigger line, you can sell the currency
pair knowing that momentum has shifted from being bullish to being bearish.
Exit signal
- when the MACD crosses back below the trigger line when you have bought
the currency pair, you can sell the currency pair back knowing that momentum
has shifted back from being bullish to being bearish.
When the MACD crosses back above the trigger line when you have sold
the currency pair, you can buy the currency pair back knowing that momentum
has shifted back from being bearish to being bullish.
Strengths of the Moving Average Convergence Divergence (MACD)
The moving average convergence divergence (MACD) enjoys the following
strengths:
- It helps you identify when the momentum of a currency pair changes
- It helps you confirm the strength of current trends
Slow Stochastic
The slow stochastic is an oscillating indicator developed by George Lane
that can show you when investor sentiment changes from being bullish to
bearish and from being bearish to bullish. The slow stochastic can also
show you when traders are becoming over-extended, which usually results
in a trend reversal for the currency pair.
The slow stochastic is usually plotted below the price movement on a
chart.
As we discuss the slow stochastic, we will look at the following three
topics:
- How the slow stochastic is constructed
- Slow stochastic trading signal
- Strengths of the slow stochastic
How the Slow Stochastic is Constructed
The slow stochastic consists of two lines %K and %D that oscillate in
a range between 0 and 100. %K is constructed based on where the current
closing price of a currency pair is in relation to the range of closing
prices for that same currency in the past. %D is a moving average of %K.
If the closing price of the currency pair is near the top of the range
of past closing prices, the %K line (followed by the %D line) will move
higher.
If the closing price of the currency pair is near the bottom of the range
of past closing prices, the %K line (followed by the %D line) will move
lower.
For example, if the EUR/USD has closed in between 1.4200 and 1.4300 on
each of the past 14 trading periods and it closes at 1.4295 (near the
high of the range), %K will move toward the top of the indicator's range.
Slow Stochastic Trading Signal
The slow stochastic produces trading signals as it crosses in and out
of its upper and lower reversal zones. The upper reversal zone is the
area of the indicator that is above 80. The lower reversal zone is the
area of the indicator that is below 20. When %K is above 80, it shows
the currency pair may be overbought and may be reversing trend shortly.
When %K is below 20, it shows the currency pair may be oversold and may
be reversing trend shortly.
Entry signal
- when %K crosses from above 80 to below 80, you can sell the currency
pair knowing that investor sentiment toward the currency pair has shifted
from being bullish to being bearish.
When %K crosses from below 20 to above 20, you can buy the currency pair
knowing that investor sentiment toward the currency pair has shifted from
being bearish to being bullish.
Exit signal
- when %K reverses direction after having crossed either above 20 or below
80 and crosses over %D, you can exit your trade knowing that investor
sentiment is changing direction again.
Strengths of the Slow Stochastic
The slow stochastic enjoys the following strengths:
Volume Indicators
Since currencies are traded on the inter-bank market and not on a central
exchange, volume data for currency transactions is not available. Without
volume data, you cannot construct volume indicators. Therefore, we do not
use volume indicators in Forex trading.
You will learn more about volume indicators as you diversify your investing
into stocks, CFDs and futures.
Regional material
Scandinavia
Many Nordics trade equities and CFD counterparts. Using the trading volume
of equities, price movements can often be predicted through momentum analysis
before prices change.
Eastern Europe
Mostly use MACD for FX trends and bollinger bands for sideways movements.
North America
Fundamentals mix very well with a combination of indicators such as RSI,
MA, and MACD.
Southern Europe
Across all different markets and instruments, MAs are used to a great
extent to identify trends, while RSI and Stochastic oscillators are used
for momentum and sideways movements in the market.
Moving Average
