Many forex traders spend their days searching for the right moment to enter markets. Although the process can be interesting, the end result is almost always the same. It is not possible to trade the forex markets in a single way. Forex traders should be aware of the many indicators available to help determine the best time to trade forex crosses rates.
Here are four of the best forex trading indicators that the most successful forex traders use.
Indicator Number 1: A Trend-Following tool
You can make money trading in the countertrend direction. Most traders find it easier to spot the direction of the major trends and to try to profit from trading in the trend’s direction. This is where trend-following software comes in.
Many people use them to trade separately, but it’s not possible. The real purpose of a trends-following tool is simply to tell you whether you should enter a long or a short market. Let’s look at one of the easiest trend-following strategies, the moving average crossover.
A simple moving average is the average closing price over a set number of consecutive days. For more information, let’s take a look at two simple examples, one for the long term and one for the shorter term.
Below is a chart that shows the 50-day/200 day moving average crossover of the euro/yen cross. The trend is said to be favorable when the 50 day moving average (in yellow), is higher than the 200-day average, and negative when it is below the 200. The chart clearly shows that this combination does a good job identifying the market’s major trend, at least most of it. No matter which moving-average combination, whipsaws will still be present.
Although many investors would claim that one combination is the best, there is no single “best” combination. Forex traders will reap the greatest benefits by choosing the right combination or combinations that suits their time frames. These indicators will show traders the trend and should be used for guidance. However, it shouldn’t be relied upon to determine when to trade long or short.
Indicator No.2: A Trend-Confirmation Tool
Now, we have a trend following tool that can tell us whether the major currency pair’s trend is up or down. But how reliable can that indicator be? Trend-following tools are susceptible to being whittled. It would be useful to be able check if the current trend following indicator is accurate.
A trend-confirmation software will be used to confirm this. Similar to a trend following tool, a trends-confirmation instrument may or not be designed to generate specific buy/sell signals. Instead, we want to find out if the trends-following and trend-confirmation tools agree.
A trader who is bullish on both the trend-confirmation and trend-following tools can consider taking a longer trade in the currency pair. The trader can also focus on selling short the pair if they are both bearish.
Moving average convergence divergence (MACD) is one of the most widely used and useful tools to confirm trends. First, this indicator measures the difference in two exponentially smoothed averages. The difference between the moving averages is then smoothed.
Indicator No. 3. An Overbought/Oversold Instrument
Traders must decide whether or not they feel more comfortable jumping in when a clear trend has been established. The trend will be bullish if it is clear that the trader must choose whether to buy into strength, or weakness.
If you are keen to enter as soon as a trend is confirmed, you could consider doing so immediately. In the opposite direction, you can wait for a pullback that is within the larger primary trend. This will offer a lower risk opportunity. An overbought/oversold indicator is used to help traders.
Many indicators can be used to fit this description. Three-day relative strengths index (or three-day RSI) is useful for trading. This indicator calculates the cumulative sum up- and down-days over the time period. The result can be anywhere from zero to 100. The indicator will approach 100 if all the price action is in the positive direction. Otherwise, it will approach 0. 50 is neutral.
Below is the chart that shows the three-day RSI (euro/yen cross) A trader looking for pullbacks would generally consider entering long if the 50day moving average is above 200 and the threeday RSI drops below a specific trigger level (e.g. 20, which would indicate an undersold position).
The trader might also consider entering a short position if his 50-day is lower than the 200-day. If the three day RSI rises above a specific level, such 80, it would signal an overbought market. Different traders may prefer using different trigger levels.
Indicator No.4: A Profit-Taking Tool
An indicator that helps forex traders determine when to make a profit from a winning trade is the last type of indicator. You have many options here. This category can include the three-day RSI. If the three-day RSI reaches 80, a trader might be willing to take some profits.
If the three-day RSI falls to 20 or below, a trader with a short position might be willing to take some profit.
Bollinger Bands is another popular indicator for profit taking. To create trading “bands”, this tool uses the standard deviation in price-data changes to calculate the average closing price for the period. Bollinger Bands can be used to time trade entry, but they could also be useful as a profit-taking tool.
The Bottom Line
If you’re hesitant about getting into the forex market or are waiting for an easy entry point, it is possible to stay on the sidelines for quite some time. Learn a variety forex indicators so you can choose profitable times to back any currency pair.
You can also monitor these indicators to identify strong signals which could indicate a buy signal. Strong analysis will reduce potential risks as with any investment.
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