Technical indicators are a crucial part of forex trading. Traders use them to identify signals and combine them with market analysis to place better trades. Stay with us as we explain what a technical indicator is and which are the most commonly used ones in the forex universe.
- Technical indicators are calculations designed to predict or assist in predicting the direction of a currency pair's price movement.
- Indicators are used in technical analysis.
- There are overlay indicators and oscillators.
- Based on what information they display, we distinguish trend, momentum, volatility and volume indicators.
- Relying on single technical indicators by themselves is a mistake in technical analysis
- The top three most popular indicators in forex are Moving Averages, RSI and MACD.
What is a technical indicator?
A technical indicator is a mathematical calculation designed to predict the direction of an asset or market by using historical data. The resulting value of the calculation is used to forecast in which direction prices will go.
Technical indicators are typically displayed on a chart and are read and interpreted relative to the price of an asset, i.e. the exchange rate of a currency pair. Forex traders who build their strategies on technical analysis rely heavily on technical indicators.
Categories of technical indicators
Depending on how they are displayed on a chart, we speak of two main types of indicators:
- overlay indicators
Overlay indicators, as the name suggests, are plotted onto a price chart, essentially on top of the price of a currency pair. Moving averages are the most common type of overlay indicators.
An oscillator, such as the MACD, oscillates between two extreme values and builds a trend indicator that fluctuates within these bounds. Oscillators can be plotted above or below a price chart.
Although there is no universally accepted categorization of technical indicators, most sources refer to the following main types:
- trend indicators
- momentum indicators
- volatility indicators
- volume indicators.
A trend indicator attempts to provide an objective overview of the general direction of a trend. Forex traders use trend indicators such as moving averages, to identify currency pairs that are trending up or trending down. In addition to the direction of a trend, these indicators can also help decide the strength of the given trend.
Momentum indicators are used to determine the strength or weakness of a currency pair's price by analyzing the speed of price changes. Momentum indicators, such as the MACD, are also helpful in determining turning points in price development.
A volatility indicator measures how far an asset derives from its mean price, sometimes also displaying in which direction. The Average True Range (ATR) is a widely popular volatility indicator.
Volume indicators are self-explanatory; they measure and display the trading volume of a particular asset in a given trading period. The Volume Oscillator (OV) is a widely used volume indicator.
What you need to know before using technical indicators
Forex traders who follow technical analysis hardly ever rely on a single technical indicator to make trading decisions. Instead, they use a combination of indicators and data yielded by these indicators to build a strategy. Why?
It’s simple: no indicator can predict exactly future prices and they also tend to produce fake signals. However, when many indicators pinpoint in the same direction, you may have a more reliable set of data to work with.
Combining several indicators is helpful but try not to go overboard. Using too many indicators will lead to too many signals, which will get you confused.
The best approach is to select a few indicators you want to use in your strategy and combine the information gleaned from them with fundamental analysis.
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Top 3 most useful technical indicators in forex
Moving averages (MA)
Moving averages are probably the most common indicators among forex traders. Moving averages ( MA) are trend indicators. Generally speaking, they help smooth out price data by generating a constantly updating average.
Traders can set the trading intervals used as the basis of calculation (i.e. days, hours, or even minutes). For example, a 50 MA displays a dynamic average of the last 50 days on the daily chart or the last 50 hours on the hourly chart.
Moving averages are overlay indicators displayed as a line on the price chart.
There are two main types of moving averages:
- Simple Moving Averages (SMA) and
- Exponential Moving Averages (EMA).
The SMA weighs each interval equally, so it makes a basic average calculation while in the EMA, more recent data carries a bigger weight. People tend to use the EMA more often, as it is considered more accurate.
Some traders use moving averages to identify the overall trend, some consider them as support/resistance levels, while others rely on them for buy/sell signals when different moving averages cross each other.
Relative Strength Index (RSI)
The RSI measures the strength or weakness of a currency pair by comparing price increases and price decreases over a given period. The RSI is an oscillator that moves on a scale of 0 to 100 and it is displayed beneath or next to the price chart.
It is a momentum indicator that changes nearly as fast as the price itself and it tends to give fake signals, so combine this useful tool with other analyses.
The RSI is mostly known for determining overbought or oversold conditions. Traditionally, a reading above 70 on the RSI is considered overbought and a value below 30 is oversold.
As it is a momentum indicator, the RSI can also identify standard and hidden divergences. A divergence is when the price of a currency pair moves in the opposite direction of a momentum indicator, such as RSI.
The RSI is kind of a 2-in-1 indicator, displaying both momentum data and value data of a given asset.
Moving Average Convergence Divergence (MACD)
The MACD is a momentum indicator that oscillates without boundaries. It consists of an MACD line and a signal line complemented with a histogram which shows the difference between the MACD and the signal line. The signal line is the simple moving average of the MACD line. The MACD is based on two moving averages.
As the MACD is a momentum indicator and it can be a helpful tool for identifying divergences. The histogram is the part you want to look at when you look for divergences. As for buy and sell signals, the MACD has multiple crossings, each giving a signal.
Zero crossing refers to when the MACD line crosses the zero-line, and the MACD crossover is when the MACD line crosses the signal lines. Each of these scenarios may be interpreted as a respective buy or sell signal. If you want to look more closely at MACD strategies and signals, check out this in-depth guide to using the MACD indicator.
What is the most accurate indicator for forex?
There is no technical indicator that is 100% foolproof. Nevertheless, most traders swear by moving averages as one of the most reliable and accurate technical indicators. Moving averages give an overview of general trends and their versatile nature makes them a really good addition to any strategy based on technical analysis.
What are the 4 types of technical indicators?
There four main types of indicators are:
- volume and
- volatility indicators.
An indicator can display various types of data, and some will show trend and momentum data at the same time.
Do successful traders use indicators?
Technical analysis with indicators involved is a crucial part of a good strategy, but alone it won’t do much good in the long-term, due to frequent fake signals and lagging. Combine indicators with fundamental analysis (i.e. use an economic calendar) to build a valuable strategy.
What indicator is best for the 1-hour chart?
Momentum indicators, such as the MACD, are the most relevant on the 1-hour chart. These types of indicators react faster to market movements, thus keeping up with a rather small time frame chart like the 1-hour one.