Most Important Forex Indicators All Forex Traders Should Know

Trading the Forex market is not easy. Despite this, a number of traders are still able to consistently make profitable returns.

How?

Part of the answer is that they successfully use Forex trading indicators. The existence of proven best Forex indicators implies the Forex market is not a random walk, as some economic theories contend.

The flaws of the human psyche mean that markets do not always behave rationally. The Forex markets have a tendency to behave in certain ways under certain conditions.

Want to know the best part?

This behaviour repeats itself, meaning that certain price patterns will occur time and again. The best Forex indicators attempt to recognise such patterns as they form and to gain an edge by exploiting that knowledge. Make sure to use feature-rich trading software.

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Which are the best indicators for Forex trading?

The best Forex indicator will be the one that suits your own style and psychology. Which is to say, there is no one Forex best indicator that fits all trader's styles.

The good news is there is a wide variety of Forex indicators available. With time, you should be able to find the right indicators for you.

Great Forex indicators help follow trend

As noted earlier, there are a lot of contenders for best Forex indicators – and some get quite complicated. This is why you should start with more simple Forex trading indicators.

Let's overview some of the more well-known indicators.

Simple moving average

A simple moving average (SMA) is the average price for a specific time period. Here, average means arithmetic mean. For example, the 20-day moving average is the average (mean) of the closing prices during previous 20 days.

Why use average?

The purpose it to smooth out price movements in order to better identify the trend. Note that the SMA is a lagging indicator, it incorporates prices from the past and provides a signal after the trend begins. The longer the time period of the SMA, the greater the smoothing and the slower the reaction to changes in the market.

This is why SMA is not the best Forex indicator for advance warning of a move.

But here's a good part – it is one of the best Forex indicators when it comes to confirming a trend. The indicator usually operates with averages calculated from more than one data set – one (or more) shorter time period and one longer.

Typical values for the shorter SMA might be 10, 15 or 20 days. Typical values for the longer SMA might be 50, 100 or 200 days.

You might be wondering – when does it signal a trend?

It signals a new trend when the long-term average crosses over the short-term average. The long-term average moving above the short-term average may signal the beginning of an uptrend. The long-term average moving below the short-term average may signal the beginning of a downtrend.

You can experiment with different period lengths to find out what works best for you.

Exponential moving average

While similar to the simple moving average, this Forex trading indicator focuses on more recent prices. This means that the exponential moving average (EMA) will respond more quickly to price changes.

Typical values for long-term averages might be 50-day and 200-day EMAs. 12-day and 26-day EMAs are popular for short-term averages. A very simple system using a dual moving average is to trade each time the two moving averages cross. You buy when the the shorter moving average (MA) crosses above the slower MA, and you sell when the shorter MA crosses below the slower MA.

With this system, you will always have a position, either long the currency pair in question or short it.

You exit your trade when the shorter MA crosses the longer MA. You then place a new trade in the opposite direction to the one you have just exited. By doing this, you are effectively squaring and reversing.

If you don't want to be in the market all the time, this is not going to be the best Forex indicator combination. In that case, a combination using a third time period might suit you better.

A triple moving average strategy uses a third MA. The longest time frame acts as trend filter. When the shortest MA crosses the middle one, you do not always place a trade.

The filter says you can only place long trades when both shorter MAs are above the longest MA. You can only go short when both are below the longest MA.

MACD indicator

MACD indicator

The moving average convergence/divergence (MACD) is a Forex indicator designed to gauge momentum.

Want to know the best part?

As well as identifying a trend, it also attempts to measure the strength of the trend. In terms of giving you a feeling for the strength behind the move, it is perhaps the best indicator for Forex.

Calculating the divergence between a faster EMA and a slower EMA is a key concept behind the indicator.

The indicator plots two lines on the price chart. The MACD line is typically calculated by subtracting the 26-day EMA from the 12-day EMA, then a 9-day EMA of the MACD is plotted as a signal line.

When the MACD line crosses below the signal line, it is a sell signal. When it crosses above the signal line, it is a buy signal.

You can set all three parameters (26, 12 and 9) as you wish. As with moving averages, experimentation will help you find the optimal settings for you.

The Bollinger band

Any list of proven best Forex indicators needs to include some form of volatility channel.

A volatility channel is another method of identifying a trend. It uses the idea that if the price goes beyond a moving average plus an additional amount, then a trend may have begun.

A Bollinger band is a volatility channel invented by financial analyst John Bollinger more than 30 years ago. It is still among the best indicators for Forex trading out of the various volatility channel methods.

The Bollinger band uses two parameters:

  1. the number of days for the moving average
  2. the number of standard deviations that you want the band placed away from the moving average.

The most common values are 2 or 2.5 standard deviations. In statistics, the standard deviation is a measure of how spread apart the values of a data set are. In finance, standard deviation acts as a way of gauging volatility.

What's the bottom line?

A Bollinger band will adjust to market volatility. It widens as volatility increases and narrows as volatility decreases. A long-term trend-following system using Bollinger bands might use two standard deviations and a 350-day moving average.

You would initiate a long position if the previous day's close is above the top of the channel, and take a short if the previous day's close is lower than the bottom of the band.

The exit point would be when the previous day's close crosses back through the moving average.

Fibonacci retracement

Fibonacci retracement

This indicator is based on the idea that after an extreme move, a market will have an increased chance of retracing by certain key proportions.

Those proportions come from the Fibonacci sequence.

This is a sequence of numbers known since antiquity, but popularised by the Italian mathematician known as Fibonacci. The modern sequence begins with 0 and 1. Any subsequent number is the sum of the preceding two numbers in the sequence.

Hence the sequence begins – 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233…

The Fibonacci ratios come from these numbers. The most important ratio is 0.618. This number is calculated by looking at the ratio of one number to the number immediately following it in the sequence.

This value tends toward 0.618 as you progress through the series. For example, 89/144 = 0.6181 and 144/233 = 0.6180.

Another key ratio is 0.382.

This is derived from the ratio of a number to another number two places further on in the sequence. The ratio tends toward 0.382 as you progress through the series. For example, 55/144 = 0.3819 and 89/233 = 0.3820.

The last important key ratio is 0.236. This is derived from the ratio of a number to another number three places on in the sequence.

What does this all mean?

The theory is that after a major price move, subsequent levels of support and resistance will occur close to levels suggested by the Fibonacci ratios. So it's a leading indicator – it is intended to predict price movements before they occur. This is in contrast to indicators that use moving averages, which show trends only once they have begun.

There is an element of self-fulfilling prophecy about Fibonacci ratios. There are many traders who may act on these expectations and, in turn, influence the market.

The final verdict

The best indicator for Forex trading will be the one that works best for you. You may find it is effective to combine indicators using a primary one to identify a possible opportunity and another as a filter.

The filter would determine whether the overall conditions are suitable to trade.

As with most other activities, you will learn trading with indicators by practicing. Right now you can find all the indicators we have discussed and more in MetaTrader 4 Supreme Edition and try out strategies risk free with a demo trading account. Also, you can learn more about trading systems by watching our upcoming webinars.

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