Introducing Technical Indicators
Whilst trends and retracement levels offer a preliminary measure for subsequent market movements, price charts offer far greater value to those that realise their potential. Technical indicators are the tools for unlocking this value. The product of a range of mathematical equations, technical indicators are plotted against charts using price information. The resultant data points produce a range of signals which enable traders to forecast subsequent price movements.Whilst technical indicators each offer their own benefits, each shares a common weakness. The information derived from technical indicators is based upon historic market movements, hence insights gleaned will not necessarily reflect a currency pair’s subsequent direction. Despite this limitation, technical indicators remain a valuable tool for any successful foreign exchange trading strategy.
Technical Indicators can be both Trending and Oscillating in nature.
Trending Indicators
Trending indicators identify and follow trends in a given currency pair, providing confirmation that a pair is trending. Trending indicators include Moving Averages and Bollinger Bands.Moving Average Indicators
Using a currency pair’s average closing price as the basis of their construction, Moving Average Indicators deliver information into both market movements and Support and Resistance.Trading Opportunity: Producing a smooth line which follows price movement, the Moving Average Indicator raises both entry and exit signals for a trending currency pair as the price thereof moves through the moving average; specifically, when an upward trending pair bounces back up having hit an upward trending moving average or when a downward trending pair bounces back down after hitting a downward trending moving average.
Investment Protection: The trader may control volatility by, firstly, modifying the time frame examined and, secondly, by employing an appropriate stop loss. For an upward trending currency pair, a stop loss may be deployed below the moving average. Conversely, for a downward trending currency pair, a stop loss may be deployed above the moving average. As the indicator rises and falls, the trader can ensure that any unexpected break below or above the moving average will see the trader’s position closed, thereby protecting their investment.
Bollinger Bands
In addition to covering currency pair movement, Bollinger Bands illustrate levels of volatility. Extending the insights gleaned through the Moving Average Indicator, Bollinger Bands employ both an upper and lower band to illustrate levels of divergence. Plotted against a 20 period moving average; a level which runs through the centre of the bands; Bollinger Bands use standard deviation to illustrate divergence from the average closing price.Both the upper and lower bands comprising the Bollinger Bands are plotted using standard deviation; specifically, the upper band if plotted two standard deviations above the 20 period moving average whilst the lower band is plotted two standard deviations below the 20 period moving average. As the width between the bands increases, so too does volatility in the pair’s closing price.
Investment Protection: In addition to illustrating levels of volatility, an increase in the distance between bands following a period of consolidation can raise an entry signal. Following a break out, the bands will see a subsequent narrowing. A trailing stop loss may be employed by the trader to ensure that any reversal in the trend would see the position closed.
Oscillating Indicators
Unlike trending indicators, Oscillating Indicators move back and forth as the price of a given currency price rises and falls. These indicators offer traders an insight into the strength of an enveloping trend, with movement higher or lower highlighting whether a currency pair is overbought or oversold respectively. This information; when incorporated into a trading strategy; can provide an indication of whether a reversal in the pair’s price may soon follow. Oscillating Indicators include the Commodity Channel Index; the MACD; and the Slow Stochastic Indicator.The Commodity Channel Index
Highlighting whether market sentiment is either Bullish or Bearish, the Commodity Channel Index; or CCI; is constructed using the average value of past price movements. By cycling progressively back and forth across 100, 0 and -100 levels, the CCI illustrates the extent to which price movements have fluctuated from the average. As prices rise or fall, the CCI will move higher or lower respectively, with the speed of any such movement illustrating levels of volatility.Trading Opportunity: As per previous indicators, the CCI raises trade signals as momentum becomes exhausted; specifically, a buy signal is raised as the CCI falls below -100 before moving back above -100, whilst a sell signal is raised as the CCI rises above 100 before moving back below 100. Such movements imply that a shift in market sentiment may be imminent.
Investment Protection: The trader may control volatility by by employing an appropriate stop loss. A stop loss may be deployed below the nearest level of Support where a buy signal has been identified. Conversely, a stop loss may be deployed above the nearest level of Resistance where a sell signal has been identified. As the indicator rises and falls, the trader can ensure that any unexpected break below or above the CCI will see the trader’s position closed, thereby protecting their investment.
Moving Average Convergence Divergence
Illustrating shifts in market sentiment, the Moving Average Convergence Divergence indicator; or MACD; offers an indication of whether a market is becoming overextended. Constructed using a series of moving averages; these typically being the pair’s 12 and 26 period exponential moving average; the MACD is often plotted below price movements on a chart.Examining the distance between the two moving average lines, the MACD is considered positive where the 12 period moving average is above the 26 period moving average. Conversely, the MACD is considered negative where the 12 period moving average is below the 26 period moving average. These moving averages are accompanied by a third moving average; a 9 period moving average referred to as the trigger.
Trading Opportunity: The MACD raises trade signals either as the MACD moves above the trigger line or as the MACD moves below the trigger line. These moves illustrate a shift in market sentiment from Bearish to Bullish, and from Bullish to Bearish respectively. At the same time, exit signals occur as the MACD moves back below the trigger line in the case of a buy signal, or back above the trigger line following a sell signal. These moves illustrate a return to the earlier market sentiment.
Slow Stochastic
Unlike other Oscillating Indicators, the Slow Stochastic indicator provides evidence of both a shift in market sentiment and of market over extension. Comprising two lines labelled %K; a line highlighting the relationship between the pair’s current closing price and its range of historic closing prices; and %D; a line comprising a moving average of the %K; the Slow Stochastic oscillates within a range of 0 to 100, and is typically plotted below the price chart. As the closing price of the pair approaches the top of the range of historic closing prices, the %K will rise, followed by the %D. Conversely, as the pair approaches the bottom of the range of historical closing prices, the %K will fall, followed by the %D. Importantly, the Slow Stochastic indicator features both an upper reversal zone; the area above 80 on the indicator; and a lower reversal zone; the area below 20 on the indicator.Trading Opportunity: The Slow Stochastic raises trade signals as the currency pair’s price crosses into and out of the upper reversal zone, suggesting that the market is overbought; specifically, a sell signal is raised as the %K moves from above the 80 level to below the 80 level. Conversely, a trade signal is raised as the currency pair’s price crosses into and out of the lower reversal zone, suggesting that the market is oversold; specifically, a buy signal is raised as the %K moves from below the 20 level to above the 20 level. Both of these scenarios imply that a trend reversal may be imminent.
