Technical: Indicators

TOPIC TEN

Interpreting charts are considered one of the key drivers when choosing entry and exit points of a trade. But do the fancy indicators actually give an accurate outcome? Let's explore moving averages, RSI and oscillators, MACD, Bollinger bands and Ichimoku clouds.

AN INTRO TO FOREX

Topic One

IMPACTS OF LEVERAGE/MARGIN

Topic Five

USING STOP-LOSSES

Topic Nine

FUNDAMENTAL ANALYSIS

Topic Thirteen

MARKET STRUCTURE & LANGUAGE

Topic Two

STOCKS & COMMODITIES

Topic Six

TECHNICAL: INDICATORS

Topic Ten

KEEPING TRADING JOURNALS

Topic Fourteen

PIPS, LOTS & CROSS CURRENCIES

Topic Three

BATTLING THE PSYCHOLOGY

Topic Seven

TECHNICAL: SUPPORT & RESISTANCE

Topic Eleven

GOAL SETTING

Topic Fifteen

READING CHARTS

Topic Four

ESSENTIALS OF RISK MANAGEMENT

Topic Eight

TECHNICAL: FIBONACCI RETRACEMENTS

Topic Twelve

GETTING STARTED

Topic Sixteen

Whether identifying patters or just enjoying fancy charting and flashing prices, technical indicators make forex trading to the untrained eye look impressive. The key question is, do they actually work and is it easy to use them?

The number of different indicators and pattern recognition tools available these days is staggering. While indicators can be helpful and there are traders that have come up with strategies to make certain ones work, many are not consistent.

Sometimes back testing might show if an indicator works better, however it may just be under the current environment for that certain currency pair under that specific time frame. Let's look at some of the most popular indicators and what they are designed to do.

Moving Averages (MA)

Moving averages smooth out price data and create a trend indicator while reducing excessive fluctuations. They don't necessarily predict market direction. Moving averages are based on past price lags behind current price levels. Several other indicators stem from moving averages.

Simple vs exponential

The most common type is called the Simple Moving Average (SMA) and is used for general market direction as well as potential support or resistance levels. It is calculated by taking the average price (usually closing price) over a selected ‘period’. Traders can select what period to apply to the SMA. Charting defaults often show 10, 20 and 50 level period.

Longer periods create a smoother SMA (such as 100 or 200). The Exponential Moving Average (EMA) differs slightly to the SMA. It reduces lag and applies more weight on recent prices (more sensitive to price changes and hugs the actual price).

Moving Averages (MA)

Longer and shorter time periods

The higher the number of periods used in either SMA or EMA, the smoother the line will be and further away from the actual price (greater lag). Longer periods won't react as quickly as a short term MA and requires longer to change direction. A chart showing daily prices, a 10 period MA averages 10 days. A chart showing hourly prices, a 10 period MA will be the average price across the 10 hours and so on.

Relative Strength Index (RSI) & Oscillators

The Relative Strength Index (RSI) is a tool measuring speed and change of price movements (classified as a momentum oscillator). It shows whether the price has become too high or too low (overbought or oversold) based on current trends.

The RSI has two levels of ‘extremes,’ the upper and lower ends of the value scale (from 0 to 100). The most common levels the bounds classifying whether price is overbought or oversold is 70% or 80% on the upper end and 30% or 20% on the lower end. As the value of the oscillator approaches and crosses the upper extreme (e.g. 80%), the asset is considered to be overbought and the price too high. Similarly, if the lower band (e.g. 20%) is crossed the price is considered too low and is oversold.

The typical default period used to determine the RSI value is 14 (e.g. a daily chart will assess 14 days). If more sensitivity is needed then the periods can be lowered. A 7 period RSI has a higher probability of reaching the bands for overbought and oversold than say a 25 level RSI.

RSI / Oscillators

Price levels can go well into overbought/sold territory before dropping. Reversals in price can take time to develop. Levels can change from overbought to oversold relatively quickly.

RSI has been found to work best using overbought and oversold levels when the market price is moving sideways within a range as shown above.

Stochastic oscillator and Williams %R

The two closest indicators to the RSI are the stochastic oscillator and the Williams %R, both showing potential overbought and oversold market areas. The stochastic oscillator is a momentum indicator comparing the closing prices to the range of those prices over a selected period. Signals form when price crosses above or below a short term moving average. Using the 0-100 range, oversold and overbought are shown by crossing into the upper and lower extreme bounds.

The inverse of the stochastic oscillator is the Williams %R (Williams Percentage Range). Similarly to the stochastic oscillator, the Williams %R uses the close price to compare against high/low ranges of the price in a given period. While the %R looks at the close in relation to the period highest high, the stochastic is calculated by the relationship of the close and the lowest low.

The closing price is stacked up against the highest price (Williams %R) and the lowest price (stochastics oscillator) over a recent period. This indicator is commonly used to pick up market reversals yet to occur as well as seeing if a price is heading towards an overbought or oversold range.

MACD

MACD (Moving Average Convergence/Divergence)

The MACD (pronounced Mac-D) is a well know indicator and also an oscillator used to determine the direction and momentum of the market. Moving averages are used to calculate the MACD by determining differences (convergences and divergence) between shorter and longer term moving averages.

The MACD value fluctuates above and below a 'zero line (centre-line)'. Traders use patterns such as cross overs, converging and diverging movements. The three most common default values used to determine the MACD are 12, 26 and 9. These were originally designed to use on ‘daily’ charts and depict two weeks (12), one month (26) and one and a half weeks (9 days), but can be applied on all time frames.

There are 3 key items to look at with this indicator;

The MACD line (the difference between the longer term moving average ‘26’ and the short term ‘12’)
The signal line (uses a 9-period moving average to show quick direction changes)
A histogram representing the difference between the MACD and signal lines.

The histogram is positive (above the zero line) when the MACD is ‘above’ the signal and negative (below the zero line) when MACD is ‘below’ signal line.

MACD is positive (12 MA crosses above the 26 MA):

Momentum to the upside is likely picking up speed. Shorter term MA is diverging away from the longer term MA. MACD will stay positive as long as upward trend continues.

MACD is negative (12 MA crosses below the 26 MA):

The market is presenting a growing downward momentum.

Given the signal is a 9 MA and the MACD is a relationship between the 12 and 26, a cross-over of the MACD ‘above’ the signal indicates a bullish or rising market. Alternatively crossing ‘below’ the signal implies a bearish/falling market. The histogram shows how bullish/bearish the signal is.

Bollinger Bands

MACD is above zero line: Indicates price momentum is towards the upside

MACD is below zero line: Indicates price momentum is towards the downside

MACD crosses above signal line: Indicates bullish/rising market prices

MACD crosses below signal line: Indicates bearish/falling market prices

Bollinger Bands

Bollinger Bands, developed by John Bollinger, are popular indicators which use a moving average to calculate the standard deviation (SD) (measure of volatility around the average) and determine whether the market is calm or active. A larger dispersion/SD means more volatility is present.

Given Bollinger Bands show an adjusting upper and lower band on either side of the moving average, it creates a range based on volatility. More volatility will widen the bands and consolidation in the market (little volatility), will see the bands close in and much narrower.

The bands are most commonly defaulted at a multiplier of 2 SD away from the middle SMA and 20 periods. The creator believed almost 90% of all price movements should be contained within the limits of the bands. Therefore when prices reach outside the bands, it is a considered a signal the price will reverse back in. A price near the bands indicates overbought (resistance) or oversold (support).

Longer time frames compared to shorter time frames and a ranging markets compared to trending markets are deemed to be more credible for this indicator.

When a consolidation in price occurs, an increased chance for a breakout either to upside or downside is likely. Tightening Bollinger Bands can therefore indicate that there is potential for this breakout and volatility is about to increase.

Ichimoku Kinko Hyo

Ichimoku clouds were developed by Goichi Hosoda (also known as Ichimoku Sanjin) from Japan. Its appearance is easily one of the most advanced and complex looking indicators. Moving average trend indications identify potential support, resistance, momentum and trends while incorporating ‘cloud’ formations on the charts.

Note: several charts use different colours for each line while many use the below as default – be sure to check however it is easy to identify each once interpretation of the indicator is known.

Tenkan-sen line (typically red)

Averages the highest high and the highest low from the last 9 periods (most sensitive and hugs price movement more)
Indicator of market trend direction and known as the turning/conversion line

Kijun-sen line (typically blue)

Averages the highest high and the highest low from the last 26 periods (not as responsive to price changes)
Indicator of future price movement and known as the standard/base line

Chikou Span (typically green)

Replicates actual closing prices, plotted 26 periods back
Known as the lagging span

The clouds (Kumo) are formed by the crossing of the two Senkou span A & B lines which form its outlines.

Senkou span A

Averages Tenkan-sen and Kijun-sen lines,
Forms one side of the Kumo cloud and known as the leading span 1
Used as support/resistance point depending if price is above/below the cloud respectively

Senkou span B

Averages the highest high and lowest low from the last 52 periods, plotted 26 periods ahead
Forms the other side of the Kumo cloud and known as the leading span 2
Used as support/resistance point depending if price is above/below the cloud respectively

Kumo cloud

Space between Senkou span A and B
Most noticeable feature of the indicator