What Are Forex Indicators?
When traders talk about “forex indicators,” 99% of the time they’re talking about technical indicators in the context of currency trading.
(This is also what this guide is about.)
Basically, technical indicators are computerized calculations used to forecast price changes in financial markets. They can be applied to any chart, including those of currencies.
The calculations are based on past market prices and sometimes volume. Because currency trading is decentralized, meaning there’s no central exchange that would record all transactions, volume data is not accurate.
We’re going to talk about that in more detail when we discuss volume-based indicators. Now, you just need to know that most forex traders use indicators that rely on price.
These are the most popular indicators, anyway, so it doesn’t make a big difference.
What about past prices? Why are they so important?
It all comes down to technical analysis.
Technical analysis says that the market is driven by humans and human nature doesn’t change over time. Consequently, simply by looking at the price, you can spot certain behavior patterns that repeat themselves.
Technical analysis organizes and categorizes these patterns to indicate when there is a greater probability of one thing happening over another.
Looking for well-known patterns such as different chart formations is one of the most common ways forex traders come up with trading opportunities nowadays.
But there’s a catch: A great deal of subjectivity is involved. Therefore, it’s hard to measure the statistical effectiveness of most techniques.
That’s why some people started to develop indicators. These take the raw data and give it back in a way such that there’s no ambiguity.
There are hundreds of indicators out there that, if used correctly, can help identify overbought/oversold markets, trend changes, or optimal risk parameters.
Demystifying Forex Indicators – The Secret to Getting Them to Work for You
Forex indicators are created from price data. It’s not some sort of insider information. It is the same price data that is already available on your chart.
When your indicator is a derivative of price, its ability to predict future prices goes only so far as how the price itself predicts the future.
It makes sense.
The problem is, the price is not very good at predicting the future. No matter what techniques you use, at the end of the day, the future is unknown.
The great thing is that, to be a profitable trader, you don’t have to know the future. You only need a system that identifies situations with a favorable risk/reward ratio (RR) and a tiny statistical advantage.
The key is the RR, because even if you have only a few wins, you can be profitable up to the point where the sum of wins exceeds the sum of losses.
So, you must construct a system that can identify these trade set-ups and that is comprehensive enough to govern your entire trading business.
Here is what it looks like:
First, there is the “identifying situations” part. Call it a trading strategy. Then there’s the “big-picture” part. Call it the trading plan. These two parts make up your trading system.
The place where you use indicators is the trading strategy. Once you have built a strategy, make sure you back test it on historical market data to see if the indicators perform as you expect.
If yes, great, you’re good to go. If no, you can always go back and make improvements. This is how you can benefit from indicators.
In particular, indicators can:
Help automatize your strategy.
Generate trading signals.
Show overbought and oversold situations.
Help measure the strength of trends.
Types of Forex Indicators – Trend, Volatility, Momentum, and Volume
Anyone who has been trading forex for a while knows that there are many indicators.
Before you can start using them, there is one final piece you must put in place. It’s essential to understand the four types of indicators.
With this information, you’ll know what indicators work best for a particular purpose. Not only that, you’ll also be able to use them more effectively – supplementing one with another and not using indicators with conflicting signals.
With that said, let’s get into it.
Trend indicators show you trends. It sounds deceptively simple, but there’s a lot to it.
Why do they exist in the first place? Wouldn’t it be easier to look at the chart and see if the price goes up or down?
If you don’t have a reasonable process for determining trends, there’s a very good chance that you will see what you want to believe.
Now, of course, you can have a reasonable process without indicators. For example, you can make rules such as two higher highs and higher lows for an uptrend.
However, you can also say that there’s an uptrend when the price is above its 100-day average or when the MACD shows positive values.
It’s just a matter of preference.
Trend indicators in this sense act as trend filters, though it’s possible to use them for generating trading signals.
Usually, when a trend indicator is used for trading signals, a shorter lookback period is applied to make it more leading than lagging.
As always, the “best” setting is hard to figure out. However, you can get close by doing a lot of backtesting.
Experimenting with different settings makes sense anyway because sometimes you will find that the lookback period must be adjusted for more volatile pairs.
Volatility indicators show you how dramatically the price can change over a short period.
There are different ways to calculate volatility. Usually, it involves monitoring the closing prices to determine how far they spread out around the average price.
High volatility means that there are large swings in the price in either direction. Low volatility means that prices tend to move in smaller increments and behave more predictably.
You can use most volatility indicators to generate trading signals. However, perhaps an even more common use is to determine an optimal distance between the entry price and your stop loss.
When the volatility is high, you might keep wider stops so that there’s less chance of a random price swing taking you out of the market. On the other hand, when the volatility is low, you might keep tighter stops to have a better RR.
It’s important to note that even currency pairs with generally low volatility can experience periods of extreme and rapid movements. This happens especially after news releases.
Momentum indicators show the perceived strength of trends.
You may recognize that a currency pair has been trending for a while, but how do you know if the trend is strong or is about to reverse?
Unfortunately, nobody knows for sure.
What momentum indicators do is monitor the rate of change in prices. They show whether the trend appears to be healthy or is running out of steam.
Most popular momentum indicators, such as the RSI and the Stochastics Oscillator, have boundaries that indicate when the market may be overbought or oversold.
An overbought reading simply means that the price has experienced an intensive upside momentum. Therefore, there is a higher likelihood of a correction shortly. The reverse is true for oversold readings.
Momentum indicators are leading indicators and typically used for coming up with trading opportunities.
Volume indicators measure whether or not traders are enthusiastic about a currency pair.
In the stock market, the volume is the number of shares that changed hands during a given period at the exchange. For futures and options, it is the number of contracts traded.
But what about forex?
If you read our Forex Market Guide, you might remember that there isn’t a central exchange that records currency transactions. It happens over the counter.
Therefore, forex volume indicators don’t have volume data on the entire market. What they have is the volume coming through your broker.
(The CLS group is the largest FX settlement service in the world, which means it has very accurate data about the trades of players who move the market.)
Notice the word “patterns” and not “numbers.” We talk about general volume patterns that accompany trends and important price areas. We don’t care about the exact numbers because those will be inaccurate.
Looking at the patterns is enough to get a sense of the strength behind trends and important price levels.
For example, if a trend is strong, it’s likely accompanied by rising volume. That’s because increasing enthusiasm is needed to keep pushing the price in a certain direction.
Most volume-based forex indicators are calculated based on both price and volume. They might be leading or lagging.