Last Updated on Friday, 04 April 2014 00:54 GMT
Monday, 13 May 2013 05:52

Forex Technical Indicators

Introduction to Technical Indicators

Forex technical indicators indicate Forex market trends, generate trading signals to enter and exit the market and also define the possible resistance and support levels. The following section will cover the most popular and commonly used indicators for technical analysis along with the concepts of the same. 

Concept and History

Concepts of technical analysis indicators in Forex tradingWhat is up today would go down some day and may again come up. Prices move in cycles and this was the foundation stone of the concepts of technical studies of the price action. When there is a cycle, there has to be a pattern associated with it and this thought process can be termed as the foundation stone of the technical indicators. Technical indicators are used to recognize the price action patterns in order to predict the future possibilities of the price action. Technical indicators work on the historical data and try to check the patterns. As they are not just checking the historic price data but also the present data continuously, a comparison of the current data is made with the historical price data. Whenever there is a significant change in the price action, a signal is generated. 

Generating a signal about some significant change in the pattern of the price action is one use of technical indicators. The other use is to see the pattern in a graphical form by eliminating the insignificant market moves which are also called market noises. Now these patterns can also be used to indicate the underlying trend situations and also to know the possible supports and resistance levels.

While the history of the concepts of technical analysis can be traced to the Jewish merchant Joseph de la Vega who was born in Spain. Japan’s rice merchant Homma Munehisa, born in 1724, can be called father of the technical analysis indicators. Homma Munehisa’s technical analysis methods evolved in candlestick chart patterns and candlestick chart itself is a form of technical indicator as it clarifies the underlying price action pattern in a much better way by eliminating the market noises.

Use

Technical indicators help us in analyzing the following:

Identification of the Trend

Analyze the price movement to see whether the trend for the currency pair is bullish (uptrend) or bearish (downtrend). Or the currency pair is running sideways (range movement).

Strength of the trend

To confirm if there is a trend (up or down) then whether the trend is strong and hence may continue or it's weak. If the trend is weak and getting weaker then it may indicate that a correction or reversal may take place soon.

Resistance and Support levels

If the currency pair price is falling then at what levels we can expect support and expect a reversal to upward movement. And If the currency pair is having an uptrend then at what levels we can expect resistance and can expect a reversal to downward movement. Resistance and support levels help us in deciding the entry, exit, stop loss and profit taking targets.

Extent of reversal in case of a consolidation

Let's say that a currency pair is having a trend (up or down) and the trend is slowing down. Our analysis says that the trend should continue even after this slow down but a correction in opposite direction may take place before the trend continues again... but correction to what level? Indicators like Fibonacci retracements indicate the possible retracement levels during a reversal or price correction during a trend.

There are so many technical indicators available with various online trading platforms. We prefer to keep it simple and to use a few popular ones. Let's have an overview of some of those.

Why Do Technical Indicators Work? 

Technical indicators are not magic and should not be considered as one. Let's see why the technical indicators work. As we had mentioned under the "concept and history" heading, an indicator analyzes the price action and tries to see the underlying patterns by eliminating the market noises. It also checks when there is a sudden break in the pattern and any new pattern forms. These changes generates  trading signals. The same patterns also help us in knowing the possible supports and resistances and the trend situation. 

Picture depicting break in pattern with

(Photo courtesy: B. Biswal)

All the above points help us in analyzing the price action to take trading decisions. To simplify it as an example let's assume that an indicator generates a signal that the ongoing downtrend has slowed down drastically and current price action has broken out of the ongoing downtrend pattern. This would indicate a good probability that at least some more upward gains can be expected and we can consider this indication as a bullish (buy) signal. This is the basic concept behind the technical indicators and that is also the reason that technical indicators work. 

However, the indicators do not work only because of the above. The most important reason lies somewhere else. A lot of traders may be using the same indicator and some very large volumes may be bought and sold because of the signals generated. When these large transactions take place those, in turn, move the prices further in that direction. This phenomenon increases the effectiveness of the technical indicator.

While the above statements seem to be very convincing about the effectiveness of the technical analysis indicators but  there is a word of caution there. You may be trading on an hourly chart while those big traders making those large transactions may be working on a chart of some other time frame. Hence the signal you are getting would not be same as the signals those other traders may be getting. The time frame of the charts play a key role when you work with any indicator. Please check this topic under the Forex technical analysis section.

Overview of Common Technical Indicators

Please check about the important technical indicators and a brief summary of the same is as follows. Please check the details on the individual pages of these indicators.

Parabolic SAR (Stop and Reversal):

  • To determine whether a trend is ending and/or a new trend may start.

Bollinger Bands:

  • To measure market’s volatility.
  • To Give buying /selling signals during non-trending /sideways market.
  • To Have an idea when the market may enter into a trend while running sideways.

Moving Average Convergence Divergence:

  • Identification of a new trend and more with MACD.

Stochastic Oscillators:

  • To identify where a trend might be slowing / ending and/or a new trend may start (indicating overbought/oversold levels)

Relative Strength Index:

  • To identify whether a trend might be ending and/or a new trend may start (overbought /oversold levels).
  • RSI also can be used to confirm trend formations.

Moving Averages:

  • To know resistance and support in sideways market
  • To identify trend reversal

ADX:

  • To know the strength of the trend

Fibonacci:

  • To know the probable support and resistance levels.

 Ichimoku Cloud:

  • Trend Identification. Strength of the trend. Buy and Sell signals and whether the signals are strong or not. Also resistance and support levels.

There are a large number of indicators which are used for technical analysis of various trading markets including Forex. However, it is always better to keep the trading simple by using only some important indicators. An effort to jump from one indicator to another or using a lot of indicators together can only confuse the trader. The links for the details of some of the most common technical indicators are given in the following section.

Detailed Guides to Common Forex Technical Indicators

Please check the details of the most common and popular technical indicators used in Forex analysis on the following pages: 

 

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