ForexBall Education: Classic Forex Indicators

Author Anil Panchal Category Technical Analysis 03 Jun 2015 Updated at 09:03 CET
The Forex market, the largest financial market and the most volatile one, needs precise technical analysis in order to efficiently capture the market movement. Technical Analysis, the process of forecasting future events based on historical data, depends heavily on the charts and various technical indicators to reward a successful trading journey. These indicators provide a unique outlook on the strength and the direction of the price movement over specific periods of time. The following article describes various classical technical indicators that traders extensively use in their analysis and/or trading and a trading strategy based on the blend of these classical forex indicators.

Technical indicators broadly serve three purposes: to alert (or to signal a probable trade), to confirm (a trend or an entry), and to predict (to define the Stop-loss and the Target point). In short, indicators signify the price movement, and, therefore, it is important to understand them,  to know what they do and how they show and predict the price movement in the market. You should start by learning the difference between two different types of indicators: Leading and Lagging indicators.
 
Leading indicators
Leading indicators, also known as Momentum Oscillators, are designed to lead price movements. The benefit of using Leading indicators is that they generate early signals for entry and exit, which provides more opportunities to trade. These indicators help to identify oversold and overbought conditions during a down-trending and an up-trending market respectively. Some of the popular Leading indicators include:
 
Commodity Channel Index (CCI): The Commodity Channel Index (CCI) is a leading indicator that signals the strength of the trend and probable reversing points of the prevailing trend. Therefore, it signals the cyclicality of a trend. The normal range for CCI is between -100 and +100. Hence, a 100+ level CCI or a level below -100 signals probable reversal of the prevailing trend.


As we can notice on the above chart, a sustained fall below the 100 level led to a sharp decline in the gold daily chart forming a bottom, while a reversal from the -100 level supported gold to rise once again.

Relative Strength Index (RSI): RSI, used by many momentum traders, signals the strength of the current movement. The price is considered overbought – and chances of a pullback are high – when the RSI lies above 70. It is considered oversold when the RSI rates below 30, indicating a probable turn in prices.
 
 
As we can see from the chart above a turnaround from 30 level in RSI on the daily chart of EURUSD in the later part of July gave rise to the reversal of the pair towards the 1.3070 level from near 1.2020 levels.
 
Stochastic Oscillator: It’s an oscillator based on simple and exponential moving averages, which helps determine peaks and troughs of the current price movement. It tells us when the market is overbought or oversold. Hence, whenever the %K line crosses over the %D line it indicates an upward price movement and vise versa while the strength of the move is known where exactly both the lines are trading. Generally a trade above 80 indicates an overbought market signaling a price correction, while a level below 20 would indicate a price reversal. Look at the D1 chart of EURUSD below that aptly describes the effectiveness of the stochastic indicator.


 
Let's now look at the Lagging indicators.
 
Lagging indicators are used to determine a trend and they would rather follow a trend  than predict a reversal. These indicators work well when prices move in relatively long trends. They do not warn you about the upcoming changes in prices, but they simply tell you if the prices are rising or falling. These trend-following indicators usually make you buy and sell late. However, in exchange of missing the early opportunities, these indicators greatly reduce your risks by keeping you on the right side of the market. MACD and Momentum are amongst the Lagging or "trend-following" indicators.

Moving Averages Convergence and Divergence (MACD): While the Moving Average and the Relative Strength Index are both lagging indicators which are based purely on historical data, the MACD is a mixed indicator. That means it is based on lagging and leading indicators, which is more useful. The MACD is a momentum indicator defining the strength of the momentum, i.e. whether the current upward or downward trend is getting stronger or weaker. The MACD is comprised of two parts: a histogram – which is a bar chart showing the difference between the two EMAs (Exponential Moving Averages) of two different time periods – and a signal line – which is an SMA (Simple Moving Average) of the MACD for a specified period.


On the EURUSD daily chart above you can see that a cross under the MACD and Signal line resulted into generating a buy signal while a cross over indicated reversal of existing buy trend.
 
Momentum: Momentum is a simple technical analysis indicator which shows the difference between today's closing price and the closing price N days ago. Hence, it signals the current trend as compared to the prior N days’ movement. One can conduct technical analysis on the indicator window itself, as when the indicator bottoms and turns up it signals the buy trade, and when the indicator peaks and turns down it signals the sell trade. As the market peaks, the Momentum indicator will climb sharply and then fall off — diverging from the continued upward or sideways movement of the price. Similarly, at the market bottom, Momentum will drop sharply and then begin to climb well ahead of prices. Both of these situations result in divergences between the indicator and prices. On the Gold daily chart below you can see how Momentum indicators helped to generate sell trades.

 
After describing various leading and lagging technical indicators, it’s now time to shift towards “Moving Averages”, one of the basic technical indicators every chartist comes across. It is a smooth line indicating the average of closing prices for a specified period. Some trader still argues if it’s a “leading indicator” or a “lagging indicator”, but as the moving average doesn’t predict future trend makes it seems to be a “lagging indicator”. There are four types of moving averages Simple, Exponential, Smoothed and Weighted.

1.    Simple Moving Average (SMA): Simple Moving Average (SMA) is the average or mean price over a certain period of time and is calculated by taking the arithmetic mean of a given set of values and hence equal weight-age is given to each price. It is the easiest to plot, but also the most prone to distortion.
 
2.    Exponential Moving Average (EMA): The usefulness of the SMA is limited because each point in the data series is weighted the same, regardless of where it occurs in the sequence. The most recent data is more significant than the older data and should have a greater influence on the final result. To overcome this argument, the usage of EMA that place greater weigh to recent prices in an attempt to make it more responsive to new information, started gaining pace.
 
3.    Smoothed Moving Average (SMMA): Even though it gives more weight to the recent times, EMA creates more noise which makes it less preferable for longer term analysis. Smoothed Moving Average, is a blend between a Simple Moving Average and an Exponential Moving Average. It is calculated according to this formula:

SMMA = (SUM1 – SMMA1+CLOSE)/ N
SUM1 – The total sum of closing prices for N periods;
SMMA1 – The smoothed moving average of the first bar;
SMMA – The smoothed moving average of the current bar (except the first one);
CLOSE – The current closing price;
N – The smoothing period.
 
4.    Linear Regressed Moving Average- LMA: Even though the SMMA gives precise values compared to SMA and EMA, the lagging value makes it less preferable for technical analysis. Linear Regressed Moving Average gives higher weight to the recent price move than the older one and makes the lagging factor absent. The factor is assigned to each value based on the total period under study (not like the exponential weight given to each value under Exponential Moving Average). Though, LMA is difficult to plot, it is useful for finding the counter trend.

Strategy
Having discussed various leading and lagging technical indicators, we’ll move on to describing a strategy that signals a trade opportunity. In the following strategy, we’ve used three technical indicators, namely Williams Percentage Range for 21-period and RSI for 9-period (Leading Indicators) together with 40-day and 80-day EMAs (Lagging Indicator). Williams Percentage Range is used to identify the entry point; RSI is used to know the strength while EMAs are used for identifying the support and resistance levels.

RULES for SHORTS:
Ø  40 EMA must be below 80 EMA, then wait for a pullback to or close to 40 EMA
Ø  Williams % must be above -20 and then go through and close to below -20
Ø  RSI must be below or at 50 and going down
Ø  Trade towards 5m and 1H supports
Ø  Use HOURLY Pivot Points in order to identify Stop-loss points

Sell Signal
The following example is a sell trade on EURUSD M5 chart which happened on May 28 using the strategy described above. The 40-day EMA trades below 80-day EMA, signaling a downtrend, though, the pair moved higher during 18:25 to 20:15 due to the pullback, which lead RSI and William % range to trade above 70 and -20 levels respectively. The pair then tested 80-day EMA resistance level, signifying an opportunity to enter into a sell trade . At 20:20:00 the pair started declining which was accompanied by a close below -20 level of Williams % range and a drop below 50 level by RSI, signaling the actual sell trade. The horizontal support level on M5 chart, which can be easily identified, became the target level. You can see that within the time span of 40 minutes 25 pips of profit could have been generated, if this strategy had been used.

 
RULES for LONGS:
Ø  40 EMA must be above 80 EMA, then wait for a pullback to or close to 40 EMA
Ø  Williams % must be below -80 and then go through and close above -80
Ø  RSI must be above or at 50 and going up
Ø  Trade towards 5m and 1H resistance
 
Buy Signal
In case of a long position, we will show the following M5 chart of EURUSD on May 29 as an example. You can see that the 40-day EMA crossed 80-day EMA and the Williams % range also reversed from -80 levels, signaling the buy trade. Further, the RSI reversal at 40 level also supported the strength. If the trade had been performed exactly as described, it would have generated nearly 90 pips of profit within almost 3 hours.

 
Concluding Remarks
The above mentioned indicators are the core of Forex technical trading. Every successful strategy uses indicators that were carefully chosen and adapted to that particular strategy. The best strategies contain no more than 3 indicators. A leading indicator, a lagging indicator and usually moving averages which serve as dynamic support and resistance levels.
As with all strategies- always DEMO trade those prior to trading them LIVE.
 
At any use of the analytical material taken from the site of company Admiral Markets, and the secondary publication on any other resources, the rights to intellectual property for a dealing center «Admiral Markets», reference to the company site is obligatory.

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