Five Important Trading Indicators Every Trader Should Know
Trading on the Forex market is not easy. Despite this, a number of traders are still able to consistently make profitable returns. Part of the reason for this is that they successfully use Forex indicators. The existence of the trading indicators implies that the Forex market is not random, as some economic theories contend. In this article, we will discuss the role of trading indicators in the financial markets and, in particular, introduce five important indicators and explain how they can help your trading in 2020!
The Forex markets have a tendency to behave in certain ways under certain conditions. 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 their users gain an edge by exploiting that knowledge. Make sure to use feature-rich trading software, such as MetaTrader 5 (MT5) to spot these opportunities.
Which Are the Best Trading Indicators for Forex & CFDs?
The best Forex indicator will be the one that suits your own trading style and psychology. Unfortunately, there is no single trading indicator which is best and fits all trading styles. A trading indicator that works for swing trading may not be the best for intraday trading. The good news is there is a wide variety of technical indicators available for all trading styles and financial markets. With time and experience, you should be able to find the right trading indicators for you and your preferred trading style.
Five Forex Indicators Explained
As noted earlier, there are a lot of contenders for the most popular trading indicator – and some get quite complicated, such as Forex technical indicators which measure 'open prices', 'highs', 'lows', 'closing prices' and 'volumes'. This is why you should start with the more simple Forex trading indicators. In this section, we will have a look at several different ones.
Simple Moving Average
A Simple Moving Average (SMA) is the average price for a specific time period. Here, average refers to the arithmetic mean. For example, the 20-day moving average is the mean average of the closing prices for the previous 20 days.
Why Use the SMA?
The purpose of the SMA is 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 the SMA is not the best trading indicator for receiving advanced warning of a move.
That being said, it is one of the best Forex trading indicators when it comes to confirming a trend. The indicator usually operates as one of multiple SMAs, on the same chart, with different time periods – one (or more) with a shorter time period and one with a longer time period. 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.
When Does it Signal a Trend?
The SMA signals a new trend when the long-term average crosses over the short-term average. If the long-term average is moving above the short-term average, this may signal the beginning of an uptrend. If the the long-term average is moving below the short-term average, this 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
Whilst similar to the simple moving average, the Exponential Moving Average (EMA) works out the average price over a specified time period but gives more weight to more recent price values. The amount by which this weighting decreases for each successively older price value is exponential, hence the name. This means that the EMA will respond quicker 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 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 or short for the currency pair being traded.
You then exit your trade when the shorter MA crosses the longer MA. The next step is to 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 do not want to be in the market all the time, this is not going to be the best Forex indicator trading strategy for you.
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 the trade. The filter says that 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.
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The Moving Average Convergence Divergence (MACD) Indicator
Depicted: Admiral Markets MetaTrader 5 with MT5-SE Add-on EURUSD H1 Chart. Date Range: 13 August 2020 - 18 August 2020. Accessed: 18 August 2020 - Please note: Past performance is not a reliable indicator of future results, or future performance.
Moving Average Convergence/Divergence (MACD) is a Forex indicator designed to gauge momentum. Not only does it identify 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, and 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 to find the optimal settings that work for you.
The Bollinger Band
Depicted: Admiral Markets MetaTrader 5 with MT5-SE Add-on GBPUSD H1 Chart. Date Range: 11 August 2020 - 18 August 2020. Accessed: 18 August 2020 - Please note: Past performance is not a reliable indicator of future results, or future performance.
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 with an additional amount, a trend may have then 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 trading indicators for Forex trading out of the various volatility channel methods available.
The Bollinger band uses two parameters:
- The number of days for the moving average
- 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.
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 was above the top of the channel, and you might take a short if the previous day's close is lower than the bottom of the band. The exit point would be the point when the previous day's close crosses back through the moving average.
Depicted: Admiral Markets MetaTrader 5 with MT5-SE Add-on GBPJPY Daily Chart. Date Range: 15 April 2019 - 10 October 2019. Accessed: 18 August 2020 - Please note: Past performance is not a reliable indicator of future results, or future performance.
Fibonacci retracement 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 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.
For example: 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 to move 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 to move 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.
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 and it is intended to predict price movements before they occur. This is in contrast to the indicators that use moving averages, and which only show trends 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 doing so, influence the market themselves.
The best indicator for Forex trading will be the one that works best for you and your trading style. Whether you consider yourself a day trader trader or a long-term trader, there will be a technical indicator to suit your needs. 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 how to trade effectively with indicators by practicing.
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This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.