Trend trading makes extensive use of technical analysis, including both chart patterns and technical indicators. Indicators are essentially tools that take price information and apply different mathematical formulas to it in order to then transform it into visual information such as graphs or oscillators which can give traders entry or exit signals. By analysing price data, indicators can provide useful information about the strength of a trend, momentum, potential turning points and possible reversals. It is therefore no surprise that indicators are considered the most important technical analysis tool at the disposal of trend traders.
Indicators can be divided into three different categories with common characteristics. These are Price, Volume and Oscillator indicators. Pricing indicators help you gauge overall price movement trends, volume indicators help gauge market sentiment while oscillator indicators can help you determine the degree by which overall trends are changing.
The truth is, there is no one way to trade the forex markets. As a result, traders must learn that there are a variety of indicators that can help to determine the best time to buy or sell a forex cross rate. Below we will explore some of the most important and most frequently used technical indicators:
There are two types of moving averages – simple and exponential moving averages (SMA and EMA). What’s important to understand here is that moving averages are calculated by dividing the sum of closing prices for a given period of time by the period over which the sum has been calculated. The SMA is calculated just this way, and is therefore considered ‘simple’. Meanwhile, the EMA has a similar method of calculation, except more emphasis is placed on the more recent closing prices, which is why it is called “exponential”.
In the end, it all comes down to what you feel comfortable with and what your trading style is. The EMA can give you numerous early signals, but it can also give you a greater number of false and premature signals. The SMA on the contrary, provides fewer and less frequent signals, but it rarely gives false signals during volatility.
When choosing a specific type of moving average, a trader needs to ask himself which period setting is the right one, in the sense that it can give the most accurate signals. If you are a short-term day trader for example, you need a moving average that is fast and reacts to price changes immediately. When it comes to the period and the length, there are usually 3 main moving average periods: the 9 or 10 day period, the 21 day period and the 50 day period.
Moving Average Convergence Divergence (MACD)
Instead of just sticking to a single moving average, the MACD makes use of 3 EMAs. The first two EMAs are used to create a histogram, while the third generates the signal line. Since the MACD makes use of three different EMAs, it is considered as a much more reliable indicator. A trading signal is generated at the point where the signal line crosses the histogram bars. A cross by the signal line outside the bars to the downside is a bullish signal and vice versa.
What is more, the positioning and height of the histogram bars are used to show the strength of the current trend. The outer bars can radiate from the central line and move either downwards or upwards. Upward movement shows that the trend is bullish and vice versa. Meanwhile, the height of the bars shows how strong the trend is, helping you decide whether or not to enter a trade.
Relative strength index (RSI)
Calculated by measuring how fast the price reacts, the RSI indicator is important in determining whether market trends may be close to a reversal. If there is a sudden buying trend in a particular currency for example, then the RSI indicator will respond by moving quickly upwards. It works on the principle that market prices always correct themselves to reflect the actual value of an asset. Therefore, after a quick movement of the RSI upwards, it indicates that market prices may come back down, reversing the prevailing uptrend. To assess the likelihood of an upcoming reversal, the RSI is measured in values ranging from 0 to 100. Readings closer to zero indicate a possible reversal to the upside while readings closer to 100 indicate the opposite.
On-Balance Volume (OBV)
Volume itself is a valuable indicator. The OBV takes a lot of volume information and compiles it into a one-line signal. The OBV indicator measures cumulative buying/selling pressure by adding the volume on up days and subtracting volume on down days. Ideally, volume should confirm trends. A rising price should be accompanied by a rising OBV; a falling price should be accompanied by a falling OBV. It is also important to note that if the OBV is rising and price isn’t, the price is likely to follow the OBV and start rising. If the price is rising and the OBV is flat or falling, the price may be nearing a peak.
The Bollinger Bands indicator was developed by the famous technical trader John Bollinger and is plotted two standard deviations away from a simple moving average. The price of the stock is bracketed by an upper and lower band along with a 21-day simple moving average. The bands automatically widen when volatility increases and narrow when volatility decreases. Bollinger Bands are used to predict possible future turning points.
It is important to note that Bollinger Bands, with the correct settings, contain more than 90% of price action; which fluctuates between the two bands. When the bands contract, and come close together, this is referred to as a squeeze. A squeeze signals low market volatility and is considered to be a potential signal for future increased volatility.
Many traders believe the closer the prices move to the upper band, the more overbought the market, while the closer the prices move to the lower band, the more oversold the market. Bollinger Bands are therefore used to identify reversal points and predicting changes in price direction.
No indicator is absolute
Indicators can simplify price information, as well as provide trend trade signals or warn of reversals. Indicators can be used on all time frames, and have variables that can be adjusted to suit each trader’s specific preferences. However, it is important to remember that no indicator is nor should be considered absolute. When it comes to trend trading it is always a good idea to use multiple indicators in order to verify the onset of a trend.