In the centre of every modern forex trading platform or charting application is a price chart which shows candlestick patterns typically. These candlesticks represent previous prices of a currency pair. Traders use technical analysis indicators to observe how the market previously behaved and try to predict how it could move in the future. Some techniques prove to be incredibly effective at gauging where and when to enter and exit positions.
Different indicators can exhibit various characteristics of the market. Technical analysts combine indicators which complement one another and collectively present a more precise and more reliable picture of possible price movements. Ideally, a technical analysis indicator will quite literally indicate what you should do by giving clear and actionable signals.
Every forex trader will eventually discover their preferred indicators and tools, but not before they have undergone years of screen time and agonising trial and error process.
If you’re new to the topic of speculating on financial markets, reading charts and conducting technical analysis, rest assured that you are in no way obligated to learn how to use every single indicator known to man. In fact, most new traders make the mistake of using too many indicators. Too many indicators can lead to decision paralysis or the increased likelihood of getting conflicting messages.
Are there too many technical analysis indicators?
Most platforms for trading forex come loaded with dozens of technical analysis indicators and tools. Besides the many pre-installed indicators within trading platforms, there are hundreds of technical indicators and thousands of more variations.
In the popular MetaTrader 4 platform, there are 30 technical analysis indicators. In MetaTrader 5, there are 38 indicators, in Currenex there are 31 indicators, in cTrader, there are 65, and last, but not least, in Tradingview there are more than 100 built-in technical analysis indicators.
Besides using an array of technical analysis indicators, traders incorporate various other indicators to understand how prices move. Forex trading platforms also offer drawing and annotation tools for making out points of interest as well as other objects like Fibonacci tools. Traders often rely on fundamental analysis, too, to help understand why prices are moving as they do.
Types of technical analysis indicators used forex
There are four main groups of technical indicators. They are categorised as Trend, Oscillators, Volatility and Volume. It’s not uncommon for an indicator to overlap into multiple categories. Here are the primary categories.
- Trend indicators are used to identify the direction of trends or the absence of trends in the market. Traders look at trends over different time periods as a currency pair could be trending upwards on the daily chart but trending down on the 15-minute chart.
- Oscillator indicators are momentum indicators used to identify overbought and oversold conditions and therefore illustrate the strength of a trend. As the momentum slows down, it suggests a trend is coming to an end, as momentum increases, it suggests that a trend could be breaking out.
- Volatility is a measure of how fast and how far prices move in a certain period in comparison to historical information. Volatility indicators are used to show volatile conditions in the market and highlight when volatility starts and stops.
- Volume is the measure of how much is being bought and sold in the market. When volume increases, it takes liquidity out of the market at a certain level which can initiate a breakout to a new price level. Volume indicators are applied to determine how active a market is based on the number of orders and sizes of the orders.
There are many other indicators which are categorised only as Other since they don’t strictly fall into any of the above categories.
In order to make projections about how the price of a currency pair or any other financial instrument will move, technical analysts often use indicators from each of the categories mentioned above as each bit of data can contribute towards making a valid trading decision.
Simple Moving Average
The Simple Moving Average (SMA) indicator falls under the category of Trend indicators. Moving averages are commonly used when analysing statistics in all environments and existed long before online trading platforms. In forex trading, Moving Averages are used to smooth out the volatility that is shown on a typical chart. For example, over the course of a day, prices move up and down frequently, but if you want to see if the market is trending up or down over a one week period, a Moving Average can be applied to show the average price of each day.
There are several adaptations of the Moving Average indicator. Some examples are Exponential, Weighted, Triangular, Time Series and Wilder Smoothing. Each of these moving averages has a slightly mutated calculation which ultimately shows the information in different ways. The Simple Moving Average as the name suggests is a simple version without any variations in the calculation.
Usually, the moving average line slices through the middle of the candlesticks. When the candlesticks drift away from the moving average line, traders can understand if the currency is trading above or below the average price. Traders use moving averages to recognise trends or when instruments move away from the trend.
A Simple Moving Average indicator plotted on a 15-minute EUR/USD chart
Moving averages on their own are pretty weak tools for making predictions as they simply process historical price data from the past and compare it to current price data. Moving averages are useful for confirming mid-term and long-term trends, identifying support and resistance levels and spotting anomalies.
Traders usually combine moving averages with other indicators to develop a system which can deliver actionable signals. In fact, many other technical analysis indicators in forex rely on moving averages and variations of moving averages in their calculations. One famous example of an indicator using moving averages is Bollinger Bands.
Bollinger Bands
The Bollinger Bands indicator is categorised as a Volatility indicator; the indicator is constructed as three wavy lines, which are also called bands. The centre line is a Simple Moving Average (as mentioned above). The upper band has a standard deviation of two added to the Simple Moving Average, whereas the lower band has a standard deviation of two subtracted from it. The logic of Bollinger Bands is that as price volatility increases, the bands loosen and drift further apart. As volatility decreases, the bands tighten and move closer together.
The currency pair will usually trade between the top and bottom bands. The banks help to place support and resistance levels which follow the current price. The higher band is interpreted as the resistance level, and the lower band is the support level. The middle band can also be interchangeably read as either a support, resistance or target level. It’s commonly accepted that the price will always return to the average price. Therefore if the market is trending up and brushes the upper band, it is predicted that the price will eventually return to the centre line, which is the Simple Moving Average. In this case, a trader would enter a short position at the top band and set the take-profit at the centre line.
Bollinger Bands indicator plotted on a 15-minute EUR/USD chart
Parabolic SAR
The Parabolic SAR indicator is categorised as a Trend indicator. The term Parabolic refers to the parabola or curve-like characteristic of this indicator, whereas SAR is an acronym for Stop and Reverse. Parabolic SAR is considered as a very easy to read indicator and is popular among new traders.
Parabolic SAR will show you when a trend stops and when it reverses. Dots plotted on the chart indicate a downtrend above the candlesticks on the chart; dots below the candles indicate an uptrend. When the curve switches from being below the candles to above, it signals the current uptrend is exhausting, i.e. stopping. When the dots continue to be printed on the opposite side, it shows the new direction of the trend, i.e. when the trend has reversed.
Parabolic SAR indicator plotted on a 15-minute EUR/USD chart
Is technical analysis in forex effective?
Everyone has their own opinion on how to conduct effective technical analysis in forex. Many traders have developed highly effective strategies, but it’s not done in isolation. There are so many characteristics traders need to be able to perform in the market. The bottom line is, you need to discover what works for you. Growing a forex trading account goes much further than just knowing when to open and close trades.