By Jay Kaeppel
on
November 10, 2010
Many forex traders spend their time looking for that perfect
moment to enter the markets or a telltale sign that screams "buy" or
"sell". And while the search can be fascinating, the result is always
the same. The truth is, there is no one way to trade the forex markets.
As a result, successful traders must learn that there are a variety of
indicators that can help to determine the best time to buy or sell a
forex cross rate.
Here are four different market indicators that most successful forex traders rely upon.
Indicator No.1: A Trend-Following Tool
It
is possible to make money using a countertrend approach to trading.
However, for most traders the easier approach is to recognize the
direction of the major trend and attempt to profit by trading in the
trend's direction. This is where trend-following tools come into play.
Many people misunderstand the purpose of trend-following tools and try
to use them as separate trading systems. While this is possible, the
real purpose of a trend-following tool is to suggest whether you should
be looking to enter a long position or a short position. So let's
consider one of the simplest trend-following methods – the moving average crossover.
A simple moving average represents the average closing price over the
number of days in question. To elaborate, let's look at two simple
examples – one longer term, one shorter term. (For related information
on moving averages, see Exploring The Exponentially Weighted Moving Average.)
Figure 1 displays the 50-day/200-day moving average crossover for the
euro/yen cross. The theory here is that the trend is favorable when the
50-day moving average is above the 200-day average and unfavorable when
the 50-day is below the 200-day. As the chart shows, this combination
does a good job of identifying the major trend of the market - at least
most of the time. However, no matter what moving average combination you
choose to use, there will be whipsaws.
Figure 1: The euro/yen with 50-day and 200-day moving averages |
Source: ProfitSource |
Figure 2 shows a different combination – the 10-day/30-day crossover.
The advantage of this combination is that it will react more quickly to
changes in price trends than the previous pair. The disadvantage is that
it will also be more susceptible to whipsaws than the longer term
50-day/200-day crossover.
Figure 2: The euro/yen with 10-day and 30-day moving averages |
Source: ProfitSource |
Many investors will proclaim a particular combination to be the best,
but the reality is, there is no "best" moving average combination. In
the end, forex traders will benefit most by deciding what combination
(or combinations) fits best with their time frames. From there, the
trend - as shown by these indicators - should be used to tell traders if
they should trade long or trade short; it should not be relied on to
time entries and exits. (For additional information, check out Forex: Should You Be Trading Trend Or Range?)
Indicator No.2: A Trend-Confirmation Tool
Now
we have a trend-following tool to tell us whether the major trend of a
given currency pair is up or down. But how reliable is that indicator?
As mentioned earlier, trend-following tools are prone to being
whipsawed. So it would be nice to have a way to gauge whether the
current trend-following indicator is correct or not. For this, we will
employ a trend-confirmation tool.
Much like a trend-following tool, a trend-confirmation tool may or may
not be intended to generate specific buy and sell signals. Instead, we
are looking to see if the trend-following tool and the
trend-confirmation tool agree.
In essence, if both the trend-following tool and the trend-confirmation
tool are bullish, then a trader can more confidently consider taking a
long trade in the currency pair in question. Likewise, if both are
bearish, then the trader can focus on finding an opportunity to sell
short the pair in question.
One of the most popular – and useful – trend confirmation tools is known as the moving average convergence divergence
(MACD). This indicator first measures the difference between two
exponentially smoothed moving averages. This difference is then smoothed
and compared to a moving average of its own. When the current smoothed
average is above its own moving average, then the histogram
at the bottom of Figure 3 is positive and an uptrend is confirmed. On
the flip side, when the current smoothed average is below its moving
average, then the histogram at the bottom of Figure 3 is negative and a
downtrend is confirmed. (Learn more about the MACD in A Primer On The MACD.)
Figure 3: Euro/yen cross with 50-day and 200-day moving averages and MACD indicator |
Source: ProfitSource |
In essence, when the trend-following moving average combination is
bearish (short-term average below long-term average) and the MACD
histogram is negative, then we have a confirmed downtrend. When both are
positive, then we have a confirmed uptrend.
At the bottom of Figure 4 we see another trend-confirmation tool that
might be considered in addition to (or in place of) MACD. It is the rate of change indicator
(ROC). As displayed in Figure 4, the red line measures today's closing
price divided by the closing price 28 trading days ago. Readings above
1.00 indicate that the price is higher today than it was 28 days ago and
vice versa. The blue line represents a 28-day moving average of the
daily ROC readings. Here, if the red line is above the blue line, then
the ROC is confirming an uptrend. If the red line is below the blue
line, then we have a confirmed downtrend. (For more on the ROC
indicator, refer to Measure Momentum Change With ROC.)
Note in Figure 4 that the sharp price declines experienced by the
euro/yen cross from mid-January to mid-February, late April through May
and during the second half of August were each accompanied by:
- The 50-day moving average below the 200-day moving average
- A negative MACD histogram
A bearish configuration for the ROC indicator (red line below blue)
Figure 4: Euro/yen cross with MACD and rate-of-change trend confirmation indicators |
Source: ProfitSource.com |
Indicator No.3: An Overbought/Oversold Tool
While
traders are typically well advised to trade in the direction of the
major trend, one must still decide whether he or she is more comfortable
jumping in as soon as a clear trend is established or after a pullback
occurs. In other words, if the trend is determined to be bullish, the
choice becomes whether to buy into strength or buy into weakness.
If you decide to get in as quickly as possible, you can consider
entering a trade as soon as an uptrend or downtrend is confirmed. On the
other hand, you could wait for a pullback within the larger overall
primary trend in the hope that this offers a lower risk opportunity. For
this, a trader will rely on an overbought/oversold indicator.
There are many indicators that can fit this bill. However, one that is useful from a trading standpoint is the three-day relative strength index,
or three-day RSI for short. This indicator calculates the cumulative
sum of up days and down days over the window period and calculates a
value that can range from zero to 100. If all of the price action is to
the upside, the indicator will approach 100; if all of the price action
is to the downside, then the indicator will approach zero. A reading of
50 is considered neutral. (More on the RSI can be found in Relative Strength Index Helps Make The Right Decisions.)
Figure
5 displays the three-day RSI for the euro/yen cross. Generally
speaking, a trader looking to enter on pullbacks would consider going
long if the 50-day moving average is above the 200-day and the three-day
RSI drops below a certain trigger level, such as 20, which would
indicate an oversold position. Conversely, the trader might consider
entering a short position if the 50-day is below the 200-day and the
three-day RSI rises above a certain level, such as 80, which would
indicate an overbought position. Different traders may prefer using
different trigger levels.
Figure 5: Euro/yen cross with three-day RSI overbought/oversold indicator |
Source: ProfitSource |
Indicator No.4: A Profit-Taking Tool
The
last type of indicator that a forex trader needs is something to help
determine when to take a profit on a winning trade. Here too, there are
many choices available. In fact, the three-day RSI
can also fit into this category. In other words, a trader holding a
long position might consider taking some profits if the three-day RSI
rises to a high level of 80 or more. Conversely, a trader holding a
short position might consider taking some profit if the three-day RSI
declines to a low level, such as 20 or less.
Another useful profit-taking tool is a popular indicator known as Bollinger Bands®.
This tool adds and subtracts the standard deviation of price data
changes over a period from the average closing price over that same time
frame to create trading "bands". While many traders attempt to use
Bollinger Bands® to time the entry of trades, they may be even more
useful as a profit-taking tool.
Figure 6 displays the euro/yen cross with 20-day Bollinger Bands®
overlaying the daily price data. A trader holding a long position might
consider taking some profits if the price reaches the upper band, and a
trader holding a short position might consider taking some profits if
the price reaches the lower band. (Refer to The Basics Of Bollinger Bands® for more information on this tool.)
Figure 6: Euro/Yen cross with Bollinger Bands® |
Source: ProfitSource |
A final profit-taking tool would be a "trailing stop."
Trailing stops are typically used as a method to give a trade the
potential to let profits run, while also attempting to avoid losing any
accumulated profit. There are many ways to arrive at a trailing stop.
Figure 7 illustrates just one of these ways.
The trade shown in Figure 7 assumes that a short trade was entered in
the forex market for the euro/yen on January 1, 2010. Each day the average true range
over the past three trading days is multiplied by five and used to
calculate a trailing stop price that can only move sideways or lower
(for a short trade, or sideways or higher for a long trade).
Figure 7: Euro/yen cross with a trailing stop |
The Bottom Line
If
you are hesitant to get into the forex market and are waiting for an
obvious entry point, you may find yourself sitting on the sidelines for a
long while. By learning a variety of forex indicators, you can
determine suitable strategies for choosing profitable times to back a
given currency pair. Also, continued monitoring of these indicators will
give strong signals that can point you toward a buy or sell signal. As
with any investment, strong analysis will minimize potential risks.
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