Top 10 Forex Indicators That Every Trader Should Know

Forex Indicators That Every Trader Should Know
.06 May 2024
author avatar image Andreas Thalassinos
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Table of Contents

Introduction

When trading the forex market, traders usually rely on two major approaches, technical analysis, and fundamental analysis, to identify the potential beginning of a new trend. Technical analysis involves studying the price primarily through the price chart to determine the early stages of the new trend. This approach often uses technical indicators, such as moving averages, oscillators, trend lines, and channels, to help traders identify potential entry and exit points for trades.

On the other hand, fundamental analysis is a method of analyzing the forex market that considers the political, economic, and environmental factors that affect the price of a currency. This method often involves analyzing economic data releases, such as unemployment rates, GDP figures, and inflation data, as well as geopolitical events, such as wars, elections, and natural disasters, in determining the potential direction of a currency’s price movement.

This guide will explore the technical analysis approach and the most popular technical indicators traders use to identify potential trading opportunities. These indicators include the Relative Strength Index (RSI), the Stochastic, Moving Average Convergence Divergence (MACD), Bollinger Bands, the Donchian Channel, Fibonacci retracements, and many more. By understanding how to use these indicators, traders can better understand the forex market and make more informed trading decisions.

The Moving Average (MA)

The moving average is one of the most basic indicators used by traders to analyze the price chart. It is determined by calculating the average price over a specific period, with popular periods including 10, 20, 50, 100, and 200. There are also different calculation methods that traders can use. For example:

  • Simple Moving Average (SMA)
  • Exponential Moving Average (EMA)
  • Linear Weighted Moving Average (LWMA)
  • Smoothed Moving Average
  • Least Squares Moving Average (LSMA)
  • End Point Moving Average (EPMA)
  • Hull Moving Average (HMA)
  • Arnaud Lagoux

The above moving average methods differ in how much weight they assign to the current price. Other than that, they provide buy and sell entries. For example, a buy entry occurs when the price moves above the moving average line, and a sell entry occurs when the price moves below the moving average line.

As simple as that!

It isĀ importantĀ to avoid using a moving average in a range.Ā The moving average indicator isĀ aĀ trend-followingĀ indicator, and utilizing it in a range can lead to losses.Ā To avoid such losses, traders use two moving averages: a short and a long-period moving average.

When the short-term moving average intersects the long-term moving average while the price trades above, it indicates a buy signal. On the other hand, if the short-term moving average falls below the long-term moving average and the price drops below both, it is a signal to sell.

Bollinger Bands

The Bollinger Bands indicator is widely used by traders to measure volatility. It comprises three lines: the upper band, middle band, and lower band. The middle band represents a 20-period simple moving average of the prices. The upper band is positioned two standard deviations above the middle band, while the lower band is positioned two standard deviations below the middle band.

When the upper and lower bands are tight, they suggest low volatility and a trading range. In Bollinger Bands’ language, this is known as a squeeze. If the price breaksĀ outĀ above the squeeze, waiting for confirmation before placing a buy trade is advisable. The confirmation involves placing a buy entry above the high price of the breakout candle.Ā Similarly, suppose the price breaks out below the lower band.Ā 

In that case, it is recommended to place a sell entry below the low price of the breakout candle. In a trading range, a breakout is expected to happen in one of two directions – either above the upper band or below the lower band. Once a breakout occurs, prices will close outside the bands, and a trend will be established. Trading opportunities can arise during both the breakout and the trend.

For instance, if the prices close above the upper band, it may present a potential opportunity to buy by entering above the candlestick’s high price. Conversely, suppose prices close below the lower band. In that case, it may signal an opportunity to sell by entering below the candlestick’s low price.

The Average True Range (ATR)  

The Average True Range (ATR) indicator measures market volatility and signifies potential turning points in the forex market. 

When the ATR expands, market volatility increases, with the range of each candlestick getting larger. If the market reverses and there is an increase in ATR, that indicates strength behind the new trend. It’s important to note that ATR is not directional, so an expanding ATR can indicate buying or selling pressure. High ATR values are usually the result of a sharp advance or decline in the market and are unlikely to be sustained for extended periods of time.

A low ATR value indicates a period of time where the price range is small, and there is less market activity. This typically occurs when the market moves sideways, resulting in lower volatility. An extended period of low ATR values may indicate that the market is consolidating, which increases the likelihood of a continuation move or reversal.

The Average True Range (ATR) is a valuable tool for identifying stop or entry triggers and signalling changes in volatility. Unlike fixed dollar-point or percentage stops, which do not account for volatility, the ATR stop adjusts to sudden price movements or consolidation areas, which can cause an unusual price movement in either direction. To capture these abnormal price movements, use a multiple of ATR, such as 1.5.

How to calculate the Average True Range (ATR)

The Average True Range calculation formula is as follows: 

ATR = (Previous ATR * (n – 1) + TR) / n

where n represents the number of periods and TR represents the True Range. To calculate the True Range for today, find the greatest value among the following three options:

  • Today’s high minus today’s low
  • The absolute value of today’s high minus yesterday’s close
  • The absolute value of today’s low minus yesterday’s close

Moving Average Convergence/Divergence or MACD

The MACD (Moving Average Convergence/Divergence) is a widely used technical tool in forex trading. It involves two moving averages – a short and a long-period exponential moving average. The MACD is calculated by subtracting the 26-period EMA from the 12-period EMA. 

A MACD value above the zero baseline indicates an uptrend, which is a buy opportunity. Conversely, when the MACD falls below the zero baseline, it suggests a downtrend, which is a sell opportunity. 

The Signal line is another important indicator, calculated as the 9-period simple moving average of the MACD. It provides faster signals, and when the MACD rises above it, it indicates positive momentum, with the bulls in control. On the other hand, when the MACD falls below the Signal line, it suggests negative momentum, with the bears in control. 

It is important to note that faster signals provided by the Signal line may also result in more false signals.

Fibonacci

During the Middle Ages, Leonardo Fibonacci, an Italian mathematician from Pisa, introduced a sequence of figures known as the Fibonacci numbers in his book, “Liber Abaci” or ‘Book of Calculation’. Each number in the Fibonacci sequence is calculated by adding together the two previous numbers:

1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, …

The Fibonacci sequence is important in finance as traders use it to calculate support and resistance levels.

How to use Fibonacci Retracement in forex trading

One significant aspect of this tool is the tendency for the ratio of any number to the next in the sequence to be approximately 0.618.

89/144=0.618

Furthermore, the ratio of any number in the sequence to the number two places ahead is always 0.382.

55/144=0.382

Similarly, the ratio of any number to the number three places ahead tends to be 0.236. 

34/144=0.236

Traders use Fibonacci ratios, also known as retracement levels, in trading. When prices approach these levels, traders wait for a reversal signal before opening a position based on their strategy. The 0.618 level is the most commonly used of the three levels.

How to use Fibonacci Extensions in forex trading

The ratio of a number in the sequence to the next lower number will result in the golden ratio, which is approximately equal to 1.618.

144/89=1.618

Furthermore, it is worth noting that when a number in the sequence is divided by the number that precedes it in two places, the resulting ratio equals 2.618.

144/55=2.618

Additionally, dividing a number by another number located three places earlier in the sequence will result in a quotient of 4.236.

144/34=4.236

These ratios are also known as Fibonacci extensions.

Fibonacci extensions are useful tools for estimating potential price targets and profits in forex trading. For instance, by attaching the Fibonacci retracement tool to the top of the swing and dragging it down to the bottom of the swing, three potential price targets can be calculated: 1.618, 2.618, and 4.236. These levels could be potential upside targets.

On the other hand, by applying the Fibonacci tool on a downward swing, you can calculate three possible profit targets. Similarly, you need to attach the Fibonacci tool to the swing bottom and drag it to the swing top to determine the corresponding price targets, which are 1.618, 2.618, and 4.236.

Relative Strength Index (RSI)

According to the bibliography, the Relative Strength Index (RSI) is the most famous and widely used indicator among traders. It is a bounded oscillator that moves between 0 and 100. The baseline for this indicator is set at 50, which indicates the direction of the market. 

When the RSI rises above 50, it signals an uptrend, while falling below 50 signals a downtrend. The RSI also provides extreme levels that indicate an overbought and oversold zone. Specifically, when prices move above the 70 extreme levels, it means an overbought area. Although the uptrend may persist, a drop below 70 signals a sell opportunity. 

Similarly, when prices move below the 30 extreme level, it indicates an oversold area. Although the downtrend may continue, a rise above the 30 level signals a buying opportunity.

Pivot Point

Pivot points are widely used by traders to identify the direction of a market, predict possible reversal points, and determine potential support and resistance levels. This tool is particularly popular among novice traders, as it involves simple mathematical formulas. Pivot points use the previous session’s open, high, low, and close prices to calculate the current period’s direction, as well as future support and resistance levels.

What is the formula of the standard Pivot Point technique

In order to identify possible turning points, pivot point calculation uses the formula below: 

  • Resistance 3 = High + 2*(PP ā€“ Low)
  • Resistance 2 = PP + High ā€“ Low
  • Resistance 1 = 2*PP ā€“ Low
  •  Pivot Point(PP) = (High + Low + Close) / 3
  •  Support 1 = 2*PP ā€“ High
  •  Support 2 = PP ā€“ (High ā€“ Low)
  •  Support 3 = Low ā€“ 2*(High-PP)

The concept behind pivot point analysis is that when prices rise above the defined pivot point, it indicates a bullish market direction, and the upward trend is likely to continue. Conversely, when prices fall below the pivot point, it signals a bearish market direction, and prices will move downward.

How to apply the Pivot Points in Forex trading

Traders who open long positions above the pivot point may encounter resistance at R1 (resistance level 1), which presents an opportunity for day traders to lock in potential profits. A significant upward movement beyond R1 could open up further opportunities for profit at higher resistance levels (R2 and R3). To avoid losses in the event of unexpected volatility, it is recommended to use a protective stop-loss below the pivot point.

Short positions opened below the pivot point can potentially encounter support at S1 (support level 1), which may allow day traders to lock in potential profits. Suppose there is a strong downward surge below S1. In that case, traders may find additional profit opportunities at lower support levels, such as S2 and S3. To avoid further losses due to unexpected volatility, placing a protective stop-loss order above the pivot point is recommended.

Sideways movements in the market are limited between the pivot point and R1. These levels can be potential buying and selling opportunities for range traders because prices tend to bounce off the pivot point and rebound back from R1. 

If the prices break out above R1, they may move towards R2. At the same time, the pivot point will act as support. On the other hand, if prices break below the pivot point, they may continue to fall towards S1, and the pivot point will now act as a resistance level.

If prices are below the pivot point, they may find support at S1 and bounce back towards the pivot point. Similarly, when prices are between the pivot point and S1, it is considered a range, and traders look for opportunities to buy when prices bounce off S1 and sell when prices bounce off the pivot point.

Five techniques are used for pivot point calculation, with the Standard technique being the most popular. The other four techniques are Fibonacci’s, DeMark’s, Woodie’s, and Camarilla’s.

Most pivot point calculation techniques use the previous period’s high, low, and close prices, except for the DeMark formula. The DeMark formula uses the relationship between the open and close price to define one of the three formulas that calculate X in the appropriate pivot point calculation. Additionally, Camarilla incorporates the current period’s open price in the pivot point calculation. 

The weight assigned to each pivot point level varies across pivot point calculation techniques. These levels are the pivot point, support and resistance, and the distance between each pivot point.

The Stochastic momentum oscillator

The Stochastics is an interesting momentum oscillator that works well in both sideways and trending markets. The main idea behind Stochastics is that during an upward move, prices tend to close near the upper end of the price range, defined as the area between the highest and lowest prices of the previous candlesticks. Similarly, during a downward move, prices tend to close near the lower end of the range. 

The Stochastics consists of two lines: the %K and the %D. The %K is the more sensitive of the two lines, and it calculates the percentage between 0 and 100% of the location of the current closing price to the price range. The Stochastic oscillator provides two horizontal lines representing extreme readings and overbought and oversold prices. These lines are the 80 and 20 levels, respectively. A reading above 80 indicates overbought prices, while a reading below 20 indicates oversold prices.

The %D is the slower line, a smoothed version of the %K line. Usually, it is a 3-period simple average of the %K. A Buy signal is triggered in the oversold area below 20 when %K crosses above %D. Conversely, a Sell signal is triggered above 80 when the %K line crosses below the %D line. Depending on the trader, certain filtering may be added. For example, some traders may wait for the %K line to fall below 80 or move above 20 for a signal, while others may wait for the slower %D line to move above the 20 area to buy and fall below the 80 overbought area to sell.

Finally, a word of caution. Always rely on the price and then confirm with the oscillator.

Donchian Channels

Donchian Channels are a technical indicator that measures volatility and identifies bullish and bearish extremes.

These formulas can be used to calculate the upper and lower channels, as well as the middle line, at any point on the chart.

  • Upper=HighestHigh(š‘)
  • Lower=LowestLow(š‘)
  • Middle=Upper+Lower2

The Donchian channel is an indicator used to measure market volatility. It widens when prices fluctuate and narrows when they remain stable. This tool’s primary use is to provide signals for establishing long and short positions. If a currency pair is trading above its highest n-period high, then a long position is established. On the other hand, if it’s trading below its lowest n-period low, then a short position is established.

Parabolic SAR

The Parabolic SAR, also known as the “stop and reverse system” or PSAR, is a technical indicator that helps traders determine the direction of a financial instrument’s price movement and signals when the direction changes. 

The Parabolic SAR appears as a series of dots above or below the price bars. A dot below the price is a bullish signal, while a dot above the price indicates that the bears are in control and the momentum is likely to remain downward. When the dots flip, it indicates a potential change in price direction. For example, if the dots are above the price and then flip below it, it could signal a further rise in price.

As the price of a forex pair increases, the dots also rise, slowly at first, then catching up with speed and following the trend. The SAR catches up to the price as the trend develops, with the dots moving faster.

The PSAR is an interesting indicator that keeps traders in the market either with a buy or sell position.

In conclusion, the Parabolic SAR is a useful tool for capturing profits during a trend. However, in choppy or sideways markets, it can produce many false signals.

FAQS

What is the Relative Strength Index (RSI)?

The RSI is a commonly used forex indicator that visualizes overbought or oversold market conditions.Ā 

What are the roles of buyers and traders in Moving Average?

When the price is above the moving average, buyers control it. When it is below the moving average, sellers control it.

What is Fibonacci?

Many forex traders use this tool to determine potential areas of profit and reversals.Ā 
Fibonacci retracement ratios such as 0.236, 0.382, and 0.618 provide entry opportunities into the market during a correction.
Fibonacci extensions estimate potential profit targets based on the ratios 1.618 (the golden ratio), 2.618, and 4.236.

author avatar image
Andreas Thalassinos

Experienced educator with a demonstrated history of working in the financial services industry. Skilled in Technical Analysis, Market Risk, Asset Management, Stock Market, and Trading Systems. Strong professional with a MSTA by Society of Technical Analysts (UK), CFTe and MFTA focused in Master of Financial Technical Analysis from International Federation of Technical Analysts (USA).

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