Many forex traders spend their time looking for that perfect moment to enter the markets or a telltale sign that screams "buy" or "sell". And while the search can be fascinating, the result is always the same.
The truth is, there is no one way to trade the forex markets. As a result, successful traders must learn that there are a variety of indicators that can help to determine the best time to buy or sell a forex cross rate. Here are four different market indicators that most successful forex traders rely upon.
A Trend-Following Tool It is possible to make money using a countertrend approach to trading. However, for most traders the easier approach is to recognize the direction of the major trend and attempt to profit by trading in the trend's direction.
This is where trend-following tools come into play. Many people misunderstand the purpose of trend-following tools and try to use them as separate trading systems. While this is possible, the real purpose of a trend-following tool is to suggest whether you should be looking to enter a long position or a short position.
So let's consider one of the simplest trend-following methods — the moving average crossover. A simple moving average represents the average closing price over the number of days in question.
To elaborate, let's look at two simple examples — one longer term, one shorter term. The theory here is that the trend is favorable when the day moving average is above the day average and unfavorable when the day is below the day. As the chart shows, this combination does a good job of identifying the major trend of the market - at least most of the time. However, no matter what moving average combination you choose to use, there will be whipsaws. The advantage of this combination is that it will react more quickly to changes in price trends than the previous pair.
Many investors will proclaim a particular combination to be the best, but the reality is, there is no "best" moving average combination. In the end, forex traders will benefit most by deciding what combination or combinations fits best with their time frames.
From there, the trend - as shown by these indicators - should be used to tell traders if they should trade long or trade short; it should not be relied on to time entries and exits. For additional information, check out Forex: A Trend-Confirmation Tool Now we have a trend-following tool to tell us whether the major trend of a given currency pair is up or down.
But how reliable is that indicator? As mentioned earlier, trend-following tools are prone to being whipsawed. So it would be nice to have a way to gauge whether the current trend-following indicator is correct or not. For this, we will employ a trend-confirmation tool. Much like a trend-following tool, a trend-confirmation tool may or may not be intended to generate specific buy and sell signals. Instead, we are looking to see if the trend-following tool and the trend-confirmation tool agree.
In essence, if both the trend-following tool and the trend-confirmation tool are bullish, then a trader can more confidently consider taking a long trade in the currency pair in question. Likewise, if both are bearish, then the trader can focus on finding an opportunity to sell short the pair in question. One of the most popular — and useful — trend confirmation tools is known as the moving average convergence divergence MACD. This indicator first measures the difference between two exponentially smoothed moving averages.
This difference is then smoothed and compared to a moving average of its own. When the current smoothed average is above its own moving average, then the histogram at the bottom of Figure 3 is positive and an uptrend is confirmed. On the flip side, when the current smoothed average is below its moving average, then the histogram at the bottom of Figure 3 is negative and a downtrend is confirmed. In essence, when the trend-following moving average combination is bearish short-term average below long-term average and the MACD histogram is negative, then we have a confirmed downtrend.
When both are positive, then we have a confirmed uptrend. At the bottom of Figure 4 we see another trend-confirmation tool that might be considered in addition to or in place of MACD. It is the rate of change indicator ROC. As displayed in Figure 4, the red line measures today's closing price divided by the closing price 28 trading days ago.
The blue line represents a day moving average of the daily ROC readings. Here, if the red line is above the blue line, then the ROC is confirming an uptrend.
If the red line is below the blue line, then we have a confirmed downtrend. In other words, if the trend is determined to be bullish, the choice becomes whether to buy into strength or buy into weakness. If you decide to get in as quickly as possible, you can consider entering a trade as soon as an uptrend or downtrend is confirmed. On the other hand, you could wait for a pullback within the larger overall primary trend in the hope that this offers a lower risk opportunity.
There are many indicators that can fit this bill. However, one that is useful from a trading standpoint is the three-day relative strength index , or three-day RSI for short. This indicator calculates the cumulative sum of up days and down days over the window period and calculates a value that can range from zero to If all of the price action is to the upside, the indicator will approach ; if all of the price action is to the downside, then the indicator will approach zero.
A reading of 50 is considered neutral. Generally speaking, a trader looking to enter on pullbacks would consider going long if the day moving average is above the day and the three-day RSI drops below a certain trigger level, such as 20, which would indicate an oversold position. Conversely, the trader might consider entering a short position if the day is below the day and the three-day RSI rises above a certain level, such as 80, which would indicate an overbought position.
Different traders may prefer using different trigger levels. A Profit-Taking Tool The last type of indicator that a forex trader needs is something to help determine when to take a profit on a winning trade. Here too, there are many choices available. In fact, the three-day RSI can also fit into this category. In other words, a trader holding a long position might consider taking some profits if the three-day RSI rises to a high level of 80 or more.
Conversely, a trader holding a short position might consider taking some profit if the three-day RSI declines to a low level, such as 20 or less. This tool adds and subtracts the standard deviation of price data changes over a period from the average closing price over that same time frame to create trading "bands". A trader holding a long position might consider taking some profits if the price reaches the upper band, and a trader holding a short position might consider taking some profits if the price reaches the lower band.
A final profit-taking tool would be a " trailing stop. There are many ways to arrive at a trailing stop. Figure 7 illustrates just one of these ways. Each day the average true range over the past three trading days is multiplied by five and used to calculate a trailing stop price that can only move sideways or lower for a short trade, or sideways or higher for a long trade.
The Bottom Line If you are hesitant to get into the forex market and are waiting for an obvious entry point , you may find yourself sitting on the sidelines for a long while. By learning a variety of forex indicators, you can determine suitable strategies for choosing profitable times to back a given currency pair.
Also, continued monitoring of these indicators will give strong signals that can point you toward a buy or sell signal. As with any investment, strong analysis will minimize potential risks. Dictionary Term Of The Day. A conflict of interest inherent in any relationship where one party is expected to Broker Reviews Find the best broker for your trading or investing needs See Reviews.
Sophisticated content for financial advisors around investment strategies, industry trends, and advisor education. A celebration of the most influential advisors and their contributions to critical conversations on finance.
Become a day trader. ProfitSource Many investors will proclaim a particular combination to be the best, but the reality is, there is no "best" moving average combination. ProfitSource In essence, when the trend-following moving average combination is bearish short-term average below long-term average and the MACD histogram is negative, then we have a confirmed downtrend.
ProfitSource A final profit-taking tool would be a " trailing stop. A conflict of interest inherent in any relationship where one party is expected to act in another's best interests. Passive investing is an investment strategy that limits buying and selling actions. Passive investors will purchase investments How much a fixed asset is worth at the end of its lease, or at the end of its useful life. If you lease a car for three years, A target hash is a number that a hashed block header must be less than or equal to in order for a new block to be awarded.
No thanks, I prefer not making money. Get Free Newsletters Newsletters.More...