Forex Indicators

Forex Trading Indicators

11.1. What are forex indicators?

RSI, MACD and Stochastic are the 3 most widely used forex indicators, employed primarily to identify overbought and oversold market conditions. These indicators are plotted at the bottom of a price chart and move back and forth (the reason they are also called oscillators) between a minimum and a maximum value. A currency pair is considered overbought when an oscillator indicator moves close to its upper extreme (bearish signal) and oversold when it approaches its lower extreme (bullish signal). Both of these conditions suggest that the market has become overextended and is, therefore, vulnerable to a correction or reversal.

Forex indicators are secondary to trend analysis, which means their signals should be used to trade in the direction of the prevailing trend. More specifically, a bullish oscillator signal should be used to buy only in an uptrend (or to cover shorts in a down trend) and a bearish oscillator signal should be used to sell only in a downtrend (or to cover longs in an up trend). For example, you can use the weekly Stochastic signals to determine the direction of the prevailing trend and the daily Stochastic signals for timing the entries in accordance with this trend.

RSI, Stochastics and MACD are commonly used to confirm the end of corrections in the trending markets, validate trading range boundaries, and to predict terminations of sustained trends (e.g. completion of the fifth subwave of an impulse wave).

forex indicators

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forex indicators

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forex indicators

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11.2.1. What is RSI?

RSI (Relative Strength Index) is plotted on a 0 to 100 scale. It shows the average direction in which the currency prices are closing over a recent time period (usually the last 14 days). As long as the prices are closing further above the preceding candles' closes than they do below them - the index will stay above 50. When the prices start to close further below the preceding candles' closes than they do above them, the index will move below the 50 level. Another way to think of RSI is a forex indicator which compares total lengths of white and black candlestick bodies (when there are no gaps). If out of the last 14 candlesticks the total length of white bodies exceeds that of the black bodies – the index will stay above the 50 level, or below it when the opposite is the case. When RSI rises above the 70 level the market is considered to be overbought, if it falls below the 30 level the market is oversold.

11.2.1. RSI Signals:

There are 3 types of signals given by RSI: when it diverges from the currency prices, when it interacts with its trendlines and when it moves above or below its reference lines.

When RSI diverges from the currency prices it gives the strongest signal of a possible trend reversal. A bearish divergence occurs when the prices make a new high but RSI fails to set a new high. A bullish divergence occurs when the prices reach a new low but RSI does not. Divergences can involve two or more price points and are most powerful when the first RSI point is above (for bearish divergences) or below (for bullish divergences) its reference line.

rsi bullish divergence

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rsi bearish divergence

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Quote: "Divergence is the single most indicative characteristic of the Relative Strength Index", J. Welles Wilder, creator of RSI, in his book, "New Concepts in Technical Trading Systems".

Trendlines work very well with RSI. 14-day RSI tends to break its trendlines a few days in advance of the currency prices, signalling likely changes in trend direction. A bullish RSI signal is given when it breaks above its down trendline. A bearish RSI signal is given when it breaks below its up trendline.

rsi trendline trading strategy

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The third type of signals occur when the index turns back from an overbought or oversold territory. A bullish signal is given when RSI crosses back above the 30 line. A bearish signal is generated when the index crosses back below the 70 line.

rsi bullish signal

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rsi bearish signal

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11.3.1. What is Stochastic?

Stochastic is plotted on the vertical scale from 0 to 100. It measures a currency pair's ability to close near the top or the bottom of the recent price range (usually the last 14 days). In an up trend prices will tend to close near the highest recent price, resulting in above 50 reading on Stochastic. In a down trend prices will tend to close near the lowest recent price, resulting in below 50 reading on Stochastic. When a trend approaches its turning point the closing prices will usually move away from the highest/lowest price of the recent price range. If the prices rise during the day but cannot close near the highest price of the last 14 days - the 14-day Stochatsic will turn down. If the prices fall during the day but cannot close near the lowest price of the last 14 days - the 14-day Stochastic will turn up. When Stochastic rises above the 80 level a currency pair is considered to be overbought. When it falls bellow the 20 level the pair is said to be oversold. Stochastic is used primarily on the daily charts.

There are 2 types of Stochastic - the fast and the slow Stochastic, the slow one being the most commonly used among the forex trading community. A Stochastic is made up from two lines - the fast line, called %K and the slow line, called %D (which is a smoothed %K line). The %D line is more important and should be first reviewed for the signals. A short-term Stochastic (e.g. 5 days) can be used to catch minor currency price reversals; a longer-term Stochastic (e.g. 14 or 21 days) can be used to capture more important market turns.

11.3.2. Stochastic Signals:

Apart from indicating overbought and oversold market conditions Stochastic gives 2 types of signals - when it diverges from the currency prices and when its lines cross.

Stochastic gives its most powerful signals when it diverges from the prices. A bearish divergence occurs when a currency pair rises to a new high but the %D line fails to move above its previous peak. The bullish divergence occurs when a currency pair falls to a new low but the %D line fails to move below its previous bottom. The actual signal to act is given when the %K line crosses above the %D line for bullish divergencies or below it for bearish divergencies. The closer the first %D point is to an extreme reading and the further it is from the second point - the stronger the bullish or the bearish signal given by Stochastic.

stochastic bullish divergence

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stochastic bearish divergence

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Another type of Stcohastic signals are given when the %K line crosses over the %D line in overbought or oversold territory. A bullish signal occurs when the %K line crosses above the %D line below the 20 level. A bearish signal is generated when the %K line crosses below the %D line above the 80 level. Crossover signals occurring between the 20 and the 80 levels should be disregarded unless confirmed by other technical studies (e.g. closeness of a trendline).

stochastic forex indicators

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11.4.1. What is MACD?

MACD (Moving Average Convergence Divergence) is used mainly to anticipate crossovers between two exponential moving averages (usually the 12-period and the 26-period EMA of closing prices). This forex indicator consists of two lines - the fast MACD line which is the difference between the two moving averages and the slow Signal line which is the 9-period exponential moving average of the MACD line. When the fast MACD line is above the zero level this means that the shorter-term moving average is above the longer-term moving average. The opposite is the case when the fast MACD line is below the zero line. The MACD line moves to zero when the two moving averages coincide. A histogram is used to clarify the difference between the MACD and the Signal line - by scaling each of its bars to clearly represent the distance between the two. Unlike Stochastic and RSI, this indicator is not bounded by a maximum or a minimum value; therefore, you should use the levels reached by MACD at past market tops and bottoms as benchmarks against which to evaluate its movement.

11.4.2. MACD Signals:

The most common signals occur when the MACD line crosses the Signal line. A bullish signal is generated when the MACD line crosses above the Signal line - when the lines are below the zero level. A bearish signal is produced when MACD line crosses below the Signal line - when the lines are above the zero level. The further crossover is from the zero level the stronger its signal. These crossover signals are in essence warning that the dead or the golden moving average cross (which occurs when MACD line crosses the zero level) has a high probability of happening in the near future. When histogram starts to move towards the zero line while the prices are still actively trending this is often seen as an early indication that crossover signal can soon be given. The following picture shows two types of signals in action.

macd signals

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The second type of signals are given when MACD line diverges from the currency prices. A bullish signal is given when a currency pair makes new lows while MACD line does not. A bearish signal is given when a new price high is not accompanied by a new MACD line high. Some traders use histogram divergencies in the same manner as MACD line divergencies are used.

macd bullish divergence

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macd bearish divergence

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Note: Most technical analysis reports distributed by investment banks include oscillator analysis.

11.5. Mastering Forex Indicators

If you want to use oscillators effectively you should train yourself to recognize situations when they are close to giving their signals (e.g. by using a daily checklist or by programming corresponding alerts in the forex charting packages which have this functionality - for example, in IntelliCharts). It is also a good idea to combine different indicators to fine-tune your entries or exits and to crosscheck their signals (e.g. Stochastic and RSI give their best signals when they are both in overbought or oversold territory; Stochastic divergence is more powerful when it is backed up by MACD divergence). Most books on technical analysis include detailed instructions on how to use RSI, MACD and Stochastic as well as other popular forex indicators.