Learning the basics of forex – the specificities of fundamental and technical analysis, how to read charts, pairing currencies appropriately,and so on and so forth– can only take you so far. What makes the difference between a rookie and experienced trader is leveraging all the tools to their advantage. In this article, we will focus on indicators and how traders can use them to their advantage. Here is a step by step guide for using trading indicators effectively.
Why should I use indicators?
One of the common dilemmas that rookie traders face is related to the importance of tools and, by extension, indicators. Are they really necessary? The answer is a definitive yes. In short, traders should take advantage of tools because succeeding in the forex market is a matter of timing and precision. In forex, you will be bombardedwith percentagesthat determine either your chances of winningor the risk of losing.
As a result, trading indicators will help you not only interpret the seemingly incoherent numbersand charts, but also respond to the realities of the market in a timely fashion. Furthermore, with indicators you can also start gradually building and charting your progress as a trader by documenting your percentage of winning and losing trades, helping you become a better and more confident professional overall. To conclude this entry, a good rule of thumb if you want to start trading on your terms is leveraging the advantages of various indicators and build your strategy accordingly.
Simple moving average
A Simple Moving Average (or SMA, in short) is one of the most common indicators used by traders. It essentially shows the average price of a specific asset (in our case, a currency pair) over a specific period of time. More specifically, the average calculatesthe arithmetic mean – to put this financial talk into perspective, a 20-day moving average is the average of the closing prices during the previous 20 days.
The Simple Moving Average is very useful because traders can use it to smoothout recent price movements which, in turn, makes spotting trends (more on that later) a lot easier. It is worth mentioning that the simple moving average is a lagging indicator, meaning that it takes into account the prices from the past and provides signals after the trend has begun.
In other words, the longer the period of the simple moving average, the greater the smoothing, which will lead to a slower reaction to the everchanging market realities. In theory, this would make it not the best indicator for receiving warnings in advance. On the other hand, it provides the trader with enough time to build the appropriate strategy and make the necessary adjustments. Even better, the simple moving average is very good for confirming trends.
Exponential moving average
Another useful forex indicator that all traders should consider using is the exponential moving average. While it shares some similarities with the simple moving average, the exponential moving average puts a particular emphasis on recent prices – so, in essence, it is a better indicator for responding to price changes in a timely fashion.
The standard exponential moving average areusually calculated over 50 and even 200 days of market activity, while 12 or 26-day EMAs are usedfor short-termstrategies. The simplest strategy based on the exponential moving average is to launch a trade each time two moving averages cross. After that, you buy in when the shorter moving average line goes above theslower moving average, or sell whenthe moving average crosses below the slower moving average.
As for exiting the trade, the common consensus is that traders should cash out as soon as the shorter moving average crosses thelonger MA. After doing all this, you should consider placing a new trade against the previous one (going short). This process is called ‘’squaring and reversing’’, a good market tactic for ensuring that no matter what position you take, you still remainon the winning side.
Trend confirmation tools
Apart from the simple moving average, there are great indicators for confirming trends. An indicator (tool) that is specifically cateredtoward trend confirmation can allow traders to be more confident in their positions. To be more specific, if the trend following indicator and the trend confirmation tools are bullish, then a trader can confidently look for ways to take a long position. If the same indicators are bearish, the trader should look for opportunities to short sell the pair of their choice.
We have already coveredthe moving average convergence divergence (MACD) above, so let us focus on another indicator called ‘’the rate of change’’. The rage of change indicator,is a momentum oscillator that calculates the change in price from one period to the next, in percentages. Without getting too technical, this oscillator signals overbought or oversold assets, as well as centerline crossovers and divergences.
The rate of change is one of the best indicators for determining the direction of an underlying trend. A typical forex year contains 250 trading days, which can be broken down into 125 days per halfyear, 63 days per quarter and 21 days per month.
There are several ways to use the rate of change. In addition to being used as a trend spotter, traders also use it as ad divergenceindicator for taking advantageof trends changes. For instance, if the value of an asset (currency) is rising over a given period of timeand the rateof change values are below the zeroline, traders can assume that downside trend change is about to occur (which incentivizes adopting a short position).
Ultimately, the best forex indicator is the one that works best for you. Since trading indicators were created to provide traders with a visual perspective of the market dynamics, you should experiment and find out which one makes your job easier. The indicators presented in this article are a good starting point, and hopefully, our guide will help you use them to your advantage.