First things first, what do we mean when we say forex indicator? Well, when people talk about forex indicators, all they really mean is an occurrence which, they believe, is indicating that they should buy/sell/trade a currency.
This occurrence could be anything; it could be some financial/economic news, a bigtime investor could say/do something which leads them to believe something significant is around the corner, or they could just be reading the data presented on a currency’s graph and think they see an indicator in the curvature of the line.
All things can be read as indicators but what are the most reliable indicators when it comes to forex trading? Obviously, all trading is carried out on a speculative basis, i.e., nobody knows exactly what’s going to happen to any market/stock/currency – that’s just the nature of the beast. However, this guide will strive to identify the most reliable, or most consistently genuine indicators of forex activity.
Although, in principle, anything could be read as a trading indicator, when people talk about forex indicators, in the context of technical analysis, an indicator is a mathematical calculation based on a currency's price and/or volume. The result is used to predict future prices. Common technical analysis indicators are the moving average convergence-divergence (MACD) indicator and the relative strength index (RSI).
1. Moving average convergence divergence (MACD)
The moving average convergence divergence, or MACD, is one of many trend-following forex indicators which numerous trading websites (including this one!) have ranked highly on their respective lists of top forex indicators. But, how does it work?
Well, first let’s very briefly run through what a trend-following forex indicator is. A trend-following forex indicator is a tool – usually a formula or algorithm – which analyses the behaviour of a forex currency and, in doing so, helps traders predict how the currency might perform in future. This is all you need to know about trend-following forex indicators for now.
So, what is the MACD? Well, the MACD is calculated by subtracting the 26-day exponential moving average (EMA) from the 12-day EMA. A nine-day EMA of the MACD, called the ‘signal line’, is then plotted on top of the MACD, functioning as a trigger for buy and sell signals. The MACD is interpreted in three main ways:
1. Crossovers: When the MACD falls below the signal line, this suggests the beginning of a bearish (negative) trend and, as such, this may be an indicator to sell
2. Divergence: When the currency price (obviously this will depend on what currency pair is being utilised) diverges from the MACD, it may indicate the end of the current trend.
3. Dramatic rise: When the MACD rises dramatically (the shorter-term moving average pulls away from the longer-term moving average) it may indicate that a currency has been overbought and will soon correct to normal levels
2. Relative strength index (RSI)
The RSI is a momentum indicator which is used by forex traders to identify when a currency pair has been overbought or oversold.
Here’s the mathematical formula used to determine the RSI:
RSI = 100 - 100 / (1 + RS)
RS = Average gain of up periods during the specified time frame / Average loss of down periods during the specified time frame
Although the RSI method wasn’t created with the forex market in mind, the formula can of course be adapted and has been known to be an effective indicator of when a currency pair has been overbought or oversold.
The RSI is best used alongside other indicators so it’s a good idea to only initiate a trade looking to profit from a retracement if one of the following conditions also applies:
1. An MACD divergence has occurred (see above for more details on this)
2. The average directional index (ADX) has turned in the direction of a possible retracement
Please note: The average directional index (ADX) is an indicator used in technical analysis as an objective value for the strength of a trend. ADX is non-directional, so it quantifies a trend's strength regardless of whether it is up or down. We won’t worry about how it’s calculated for now but feel free to look it up if you’re curious…
3. The Bollinger Bands
Bollinger Bands, which is a registered trademark of famous technical trader John Bollinger, are another ingenious way to track the behaviour of forex currencies and execute trades accordingly. Bollinger bands are plotted two standard deviations away from a simple moving average, which we learnt about earlier (see MACD which is based on simple moving averages).
Bollinger bands consist of three lines, one which sits above the currency price, one which sits below, and one which reflects the 21-day simple moving average; these lines form a band around the price graph line (hence the name). Standard deviation measure volatility so the wider apart the bands are, the less volatile the market is, and vice versa.
Bollinger Bands are incredibly popular among technical trading analysts, many of whom believe that the closer the prices rise toward the upper band, the more overbought the market is, and the closer the prices fall toward the lower band, the more oversold the market is. John Bollinger has a set of 22 rules to follow when using the bands as an indicator.
Please bear in mind, Bollinger Bands, like all forex indicators, are intended to be using in conjunction with other indicators to create a well-rounded indication of things to come. Of course, even when used in this manner, indicators are seldom a sure thing so always exercise caution when reading forex indicators.
To summarise, forex indicators are a fantastic tool which forex traders can and should use to gain a better understanding of currency trends. They can help traders determine when best to buy/sell to make the most profit.
However, as always, be careful not to rely on indicators too heavily and, of course, never invest (or hedge/margin) more than you’re prepared to lose.