The Effective Use of Technical Indicators

Technical traders often compute and plot mathematical quantities based on market observables like price and volume in order to indicate the past or present state of the market. They can often also use certain specific recognizable behaviors of the so-called technical indicators to predict the future behavior of the market and to generate buy and sell signals.

As useful as technical indicators can be to the forex trader, their effective use often requires keeping the number of indicators consulted down to a manageable level in order to facilitate quick trading decisions.

The following sections will cover some of the more popular technical indicators that many forex traders have found efficient and effective to use in practice when trading.

Popular Technical Indicators

A set of the most commonly followed technical indicators, that can be used as a basic group to get started analyzing forex price action with, might include the following:

Moving Averages

Traders might compute an average of the exchange rate for a certain period of time. This average is then superimposed on the price action so that it moves along as time progresses. The effect is to help smooth out the price data so that trends can better be identified.

Moving averages might be computed as simple, exponential or weighted averages, and they tend to be a lagging indicator of future price action with relatively little predictive power.

Nevertheless, some traders use crossovers between a short moving average and a longer term moving average as a trading signal, with the short term average crossing above the longer term average being a bullish signal and a crossover below being a bearish signal.

The Moving Average Convergence Divergence or MACD indicator is also based on this general idea which it enhances considerably. Learn more about the MACD indicator here.

Oscillators

Oscillators usually give the trader an indication of price momentum and/or an oversold or overbought condition in the market, and when they are measured on a scale of 0 to 100% they are known as banded oscillators.

Divergence of many oscillator indicators relative to the corresponding price action has important implications for possible market reversals.

Some popular oscillators are discussed further below.

The Relative Strength Index or RSI

The RSI is a very popular and useful indicator of overbought or oversold market conditions, and since it fluctuates in value between 0 and 100, it is considered a banded momentum oscillator. If the index is showing a number higher than 70, then the market is though to be overbought, but if the number is below 30, then the market is oversold.

Forex traders can also use the RSI to watch for regular and hidden divergence versus the price action that might indicate pending market reversals.

The Stochastics Oscillator

The Stochastics are a popular example of a momentum indicator. Its basic premise is that in an uptrend, prices tend to close in the higher part of the day's range to signal upward momentum. Conversely, while in a downtrend, closing prices tend to close in the lower part of the day's range, indicating downward momentum. Learn more about the stochastics indicator here.

Historical Volatility

Forex traders, and especially those trading currency options, often compute historical volatility for some specific time period. They generally do so by determining the annualized standard deviation of price movements during the chosen time frame.

When used as an indicator, historical volatility is related to standard deviation of exchange rate movements, and it is usually expressed on an annualized basis as a percentage.

Forex traders can use historical volatility to assess risk levels prevailing in the market for the particular current pair. This information can then be useful in appropriately sizing positions for risk management purposes.

Bollinger Bands

Another useful technical indicator related to market volatility is the Bollinger Bands that are typically depicted superimposed over the price action on a chart.

The central line of the indicator is a simple moving average, while the upper and lower lines of the indicators represent a certain number of standard deviations around the central line.

Forex traders tend to use this indicator to generate a signal to initiate a short position when the market exceeds the upper line or a long position when the market falls below the lower line. Learn more about the Bollinger Bands indicator here.

The On Balance Volume or OBV Indicator

Many technical analysts look at the trading volume statistics or the On Balance Volume indicator for a particular currency pair to confirm price breakouts for chart patterns and to support or negate other technical indicator trade signals.

The OBV indicator analyzes the performance of the exchange rate and then uses that information to place a positive or negative sign on trading volume data. A simple trading signal using the OBV indicator would be to watch for a switch in its sign to indicate a possible directional reversal in the exchange rate.

Keeping it Simple

One of the keys to using technical indicators effectively is to keep the number of indicators you watch to generate trading signals down to a minimum that will still show consistent profitability.

Basically, the risk of falling into the trading trap of "analysis paralysis" increases the more technical indicators you need to consult before making a trading decision.

Remember, the forex market often moves quickly, especially when key technical indicators or chart patterns forecast important exchange rate movements. As a result, any unnecessary delay in entering the market can be quite costly and may even turn what would initially have been a winning position into a losing one.