Using trading indicators is part of any technical trader’s strategy. Here are the most popular trading indicators and how to combine them.
One of the hardest, most time-consuming aspects of forex trading, shares trading, or cryptocurrency trading is figuring out what trading style(s) and time frame(s) suit you best. From the technical analysis perspective, that means finding the right toolbox of trading indicators you habitually use and learn very well.
What are Trading Indicators
Trading indicators use mathematical calculations based on historical price action and volume, which are plotted as lines on a price chart and can help traders identify certain signals and trends within the market.
Trading indicators are useful in helping to answer the following common trader dilemmas:
- What do you do if a currency pair (or any asset) is making historic highs or lows, so there isn’t enough, or any, support or resistance to guide you in making entry and exit decisions?
- How do you know you’re not buying at the top, or selling short at the bottom, just before the trend ends? Ideally, in either case, you’d wait for a pullback of some kind, but meanwhile, you risk missing out on the Trend!
- If you’re in a winning trade and it approaches your planned exit, how do you know if you should take your planned exit, or leave at least some of the position in hopes of letting profits run with a trailing stop?
The consensus is that about five trading indicators should be the right balance between enough information to make informed decisions and not too much so that you suffer from information overload, aka paralysis by analysis. Practically, an accurate combination of technical trading indicators can mean anywhere from three to seven; it’s ultimately your choice. You don’t have to stick with the same tools all the time; just limit the number you’re watching at any given time. Those trading longer time frames have more time and can afford to look at more indicators. They also need to be better informed about the long-term fundamentals of both:
- The underlying economies of the currencies they trade.
- The big macroeconomic drivers of the global economy drive risk appetite and influence all markets all the time.
Types of trading indicators
There are distinct categories of trading indicators, including leading indicators and lagging indicators. A leading indicator is a forecast signal that predicts future price movements, while a lagging indicator looks at past trends and indicates momentum.
Furthermore, there are five main types of trading indicators: Trend Following, Momentum, Volatility, Support/Resistance, and Volume. They are grouped based on their function, which ranges from revealing the average price of a currency pair over time to providing a clearer picture of support and resistance levels.
Our award-winning online trading platform comes with a wide range of technical indicators for both short and long-term trades. Browse some common technical trading indicators, both leading and lagging, that can help to identify momentum and bullish and bearish trends within the financial markets.
1. Trend Indicators
Trend following indicators were created to help traders trade currency pairs that are trending up or trending down. We have all heard the phrase ‘the trend is your friend’ – these indicators can help point out the direction of the trend and can tell us if a trend exists.
A Moving Average (MA) is a technical tool that averages a currency pair’s price over a period of time. The smoothing effect this has on the chart helps give a clearer indication of what direction the pair is moving – either up, down, or sideways. There is a variety of moving averages to choose from, with Simple Moving Averages (SMA) and Exponential Moving Averages (EMA) being the most popular.
Ichimoku Kinko Hyo is a complicated-looking trend assistant that is simpler than it appears. This Japanese indicator was created to be a standalone indicator that shows current trends, displays support/resistance levels, and indicates when a trend has reversed.
The Average Direction Index (ADX) won’t tell you whether the price is trending up or down, but it will tell you if the price is trending or is ranging. This makes it the perfect filter for either a range or trend strategy by making sure you are trading based on current market conditions.
The Parabolic SAR refers to a price-and-time-based trading system. Wilder called this the “Parabolic Time/Price System.” SAR stands for “stop and reverse,” which is the actual indicator used in the system. SAR trails price as the trend extends over time. The indicator is below prices as they're rising and above prices as they're falling. In this regard, the indicator stops and reverses when the price trend reverses and breaks above or below the indicator.
2. Momentum Indicators
The basic problem traders and investors face is that we get paid for being right about what happens in the future, yet most of the popular trading indicators we have covered thus far are more lagging than leading indicators.
They tell us about the past, and from that information, all we can do at best is to form some hypotheses about the future.
What is a trader to do? Use momentum indicators. They are leading indicators because:
- They can tell you whether a trend is strengthening or weakening.
- They can tell you if an asset is overbought or oversold relative to past activity over a given period, and so indicate if the trend is more likely to reverse direction.
Knowing these can help you forecast changes and be more profitable.
Momentum indicators can give you additional clues to put the odds of being correct even more in your favor. There are many momentum indicators, but for now, we will introduce just a few of the most effective and easiest ones to use.
Stochastic Oscillator offers traders a different approach to calculate price oscillations by tracking how far the current price is from the lowest low of the last X number of periods. This distance is then divided by the difference between the high and low prices during the same number of periods. The line created, %K is then used to create a moving average, %D, that is placed directly on top of the %K.
The Moving Average Convergence/Divergence (MACD) tracks the difference between two EMA lines, the 12 EMA and 26 EMA. The difference between the two EMAs is then drawn on a sub-chart (called the MACD line) with a 9 EMA drawn directly on top of it (called the Signal line). Traders then look to buy when the MACD line crosses above the signal line and look to sell when the MACD line crosses below the signal line as seen here. There are also opportunities to trade divergence between the MACD and price.
The Relative Strength Index (RSI) is the most popular oscillator to use. A big component of its formula is the ratio between the average gain and average loss over the last 14 periods. The RSI is bound between 0 – 100 and is considered overbought above 70 and oversold when below 30. Traders look to sell when 70 is crossed from above and look to buy when 30 is crossed from below.
The Commodity Channel Index (CCI) is different from many oscillators in that there is no limit to how high or how low it can go. It uses 0 as a centerline with overbought and oversold levels starting at +100 and -100. Traders look to sell breaks below +100 and buy breaks above -100.
3. Volatility Indicators
Volatility measures how large the upswings and downswings are for a particular asset. When a currency’s price fluctuates wildly up and down it is said to have high volatility. Whereas a currency pair that does not fluctuate as much is said to have low volatility. It’s important to note how volatile a currency pair is before opening a trade, so we can take that into consideration by picking our trade size and stop and limit levels.
Bollinger Bands Indicator
Bollinger Bands print three lines directly on top of the chart. The middle ‘band’ is a 20-period simple moving average with an upper and low ‘band’ that are drawn two standard deviations above and below the 20 MA. This means the more volatile the pair is, the wider the outer bands will become, giving the Bollinger Bands the ability to be used universally across currency pairs no matter how they behave.
The Average True Range (ATR) tells us about the average distance between the high and low prices over the last set number of bars (typically 14). This indicator is presented in pips where the higher the ATR gets, the more volatile the pair, and vice versa. This makes it a perfect excellent tool to measure FX volatility (see also the Currency Strenght Meter Indicator).
Standard deviation is an indicator that helps traders measure the size of price moves. Consequently, they can identify how likely volatility is to affect the price in the future. It cannot predict whether the price will go up or down, only that it will be affected by volatility.
Standard deviation compares current price movements to historical price movements. Many traders believe that big price moves follow small price moves, and small price moves follow big price moves.
4. Support/Resistance Indicators
Support and resistance are key to technical analysis. The concept refers to the price levels that form barriers to an asset price being pushed in a given direction.
Pivot Points are one of the most widely used in all markets including equities, commodities, and Forex. They are created using a formula composed of high, low, and close prices for the previous period. Traders use these lines as potential support and resistance levels, levels that price might have a challenging time breaking through.
Trendlines and Channels
Trendlines and channels are lines above and below recent price action that show the high and low prices over an extended period. These lines can then act as support or resistance if the price meets them again.
Fibonacci retracement is an indicator that can pinpoint the degree to which a market will move against its current trend. A retracement is when the market experiences a temporary dip – it is also known as a pullback.
Traders who think the market is about to make a move often use Fibonacci retracement to confirm this. This is because it helps to identify possible levels of support and resistance, which could indicate an upward or downward trend. Because traders can identify levels of support and resistance with this indicator, it can help them decide where to apply stops and limits, or when to open and close their positions.
5. Volume indicators
Volume indicators are used to confirm the strength of trends. Lack of confirmation may warn of a reversal. Some of the more sophisticated indicators that compare volume and price movements are Rate of Change (Volume), On Balance Volume, Force Index, Accumulation Distribution, Chaikin Oscillator, Money Flow Index, Chaikin Money Flow.
Other trading indicators
Elliott Waves, Gann, DiNapoli, and similar studies are timing or cycle indicators.
How to use Trading Indicators
For example, your typical technical tool kit might include, in addition to an awareness of any obvious support/resistance points:
- A set of moving averages of 10, 20, 50, 100, and 200 periods: Again, these serve as both support/resistance points as well as momentum indicators if they show crossing or layering.
- Trend lines and channels lines show the trend and provide support/resistance points.
- Double Bollinger Bands and MACD show changes in momentum.
- Fibonacci retracements of the most current trends in each given time frame suggest possible support/resistance points. You’d need to redraw these for each time frame that you examine, as the primary trends may differ dramatically in different time frames.
If you spot any Western-style chart pattern forming, note the implied support/resistance levels of double top and bottom, head and shoulder, cup and handle, and triangles. Japanese candlestick patterns provide shorter-term signals of trend continuation or reversal.
What you need to know before using trading indicators
The first rule of using trading indicators is that you should never use an indicator in isolation or use too many indicators at once. Focus on a few that you think are best suited to what you’re trying to achieve. You should also use technical indicators alongside your own assessment of the movements of an asset’s price over time (the ‘price action’).
It’s important to remember that you must confirm a signal in some way. If you are getting a ‘buy’ signal from an indicator and a ‘sell’ signal from the price action, you need to use different indicators, or different time frames until your signals are confirmed.
Another thing to keep in mind is that you must never lose sight of your trading strategy. Your rules for trading should always be implemented when using indicators.
To practice using trading indicators, try CAPEX’s demo account.
Or, if you are ready to start trading, open a live account.
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