The top 5 forex indicators are Moving Averages, Relative Strength Index, Fibonacci retracements, Bollinger Bands, and Average True Range.
While many traders expect the indicators to be their saviors, their practical application is usually more complicated. Rarely, if ever, are indicators a standalone solution. Yet, they can be a valuable addition, to give a lot of information at one simple glance.
One of the oldest, most popular indicators, moving average, is just price derivation. It shows the average price movement in a period of time.
Moving averages are generally used for gauging trends, as the 50-day moving average shows the medium, while the 200-day moving average shows the long-term trend.
3 of the most popular types of moving averages are:
- Simple (SMA): Also known as arithmetic moving average, it calculates average price within a period of time, taking into account each value equally.
- Exponential (EMA): Also known as an exponentially weighted moving average. It uses an exponentially decreasing weight from each previous value, giving recent prices more weight.
- Weighted (WMA): Similarly to the exponential moving average, weighted moving average assigns more importance to the recent values, but the importance between them reduces gradually, not exponentially.
Except for trend identification, moving averages are used for crossover signals. For example, when a faster-moving average (shorter period) crosses the longer moving average (longer period), it signals a potential shift in the trend.
Average True Range (ATR)
Initially developed for commodities, ATR is a volatility indicator that helps visualize the average movement of the market.
In forex, ATR is a helpful filter in deciding which pairs to trade, which size to use, and where to place stop loss or take profit order.
Since higher ATR means higher volatility, traders will look for such pairs as they need volatility to profit.
For example, if EUR/USD has a 55 pip ATR and GBP/USD has a 75 pip ATR, it will be easier to capture a meaningful move on GBP/USD. Yet, this is only true for strategies with a high win rate. Because, when trading a volatile forex pair, you might win more, but you have to use wider stop-loss, and consequentially a smaller size as well.
Among traders, a rule of thumb is to use at least 10% of ATR as a stop-loss and 25-30% for a realistic take profit.
A method of technical analysis, Fibonacci retracement projects the key levels between the extreme points of support and resistance.
Named after the Italian mathematician Leonardo “Fibonacci” Bonacci, it is a sequence of numbers whose next value equals the sum of two previous values. For example: 0,1,1,2,3,5...
In finance, the sequence is a series of numbers between 0 and 1, converted into a percentage. Between the extremities, these values equal to 0, 21.6%, 38.2%, 50%, 61.8%, 78.6% and 100%. Although 50% is officially not a number in the sequence, traders use it as an inflection point between the bullish and bearish bias.
EUR / USD, 15-min chart with Fibonacci Retracement, Source: TradingView
Traders will notice how the price respects the first 23.6% level as it acts as resistance. Once it broke, price retested it, and it turned into support. Traders in a long position can observe the 38.2% level above as the next inflection point.
Relative Strength Index (RSI)
RSI is a popular momentum indicator that measures the magnitude of recent price changes. It falls into the category of oscillators, as it oscillates between 0 (minimum value) and 100 (maximum value). Generally, readings below 30 are considered oversold, while values over 70 are considered overbought.
While RSI can have different uses, it is notable for predicting turning points through bullish or bearish divergence.
For example, if price makes a higher high, while RSI simultaneously shows a lower value - this is a bearish divergence. It means that the current trend might be fading, as it is losing momentum. On the contrary, bullish divergence would show a lower low in price, but a higher low in RSI, just like in the following example.
EUR / USD, a 5-min chart with RSI, Source: TradingView
As you can see from the example, while the price set a clear lower low, RSI printed a clear higher low, indicating the failing bearish momentum. For traders who were in a short position, this was a good signal to take profits.
Bollinger Bands are an indicator invented by market technician John Bollinger in the 1980s. They are a versatile yet straightforward tool to get a lot of information in one glance.
Bollinger Bands are composed of 3 lines. The middle line is a simple moving average, while the lower and upper bands are standard deviations. In statistics, the standard deviation measures the dataset’s dispersion relative to its mean.
For Bollinger Bands, traders typically use a 20-period moving average and 2 standard deviations. In statistics, 2 standard deviations should capture 95% of the dataset if the data is normally distributed.
Like other indicators on our list, Bollinger Bands aren’t a trading system. They’re one of the tools for observing the volatility, often playing a part in the breakout or mean reversion trading systems.
Yet, the most helpful concept around the Bollinger Bands is the band squeeze - an early warning sign of incoming volatility.
As you can see in the following example:
EUR/USD 5-min chart with Bollinger Bands, Source: TradingView
After the Bollinger Bands converged, the pair traded in a 5 pip range for over an hour before finally breaking out and dropping almost 30 pips. Then, the bands converged again, signaling another period of low volatility, followed by a new breakout - this time to the upside.
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Novice traders might think that indicators show information otherwise hidden from sight, but that is not true. Price movement shows every available piece of information. Indicators are simply derived from that information.
While very useful time-savers, traders should avoid the temptation to construct trading systems with many indicators as it will obscure their view from the critical point at any financial chart - the price.