Lesson 6 – Technical Indicators
If You Were Waiting For A Sign, This Is It
IntroductionTechnical analysts rely on an array of other technical tools such as indicators and oscillators in addition to charts to help them in their analysis. Some of the more commonly used indicators and oscillators include:
- Support & Resistance Lines
- Moving Averages
- Bollinger Bands
- Stochastic Oscillators
This lesson is designed to help you become more familiar with the study of technical analysis through the use of indicators. By providing a solid background to the key features, the lesson will help you to develop an understanding of the central aspects that are essential to understanding more complex sides of the field.
What are Technical Indicators?So what exactly is a technical indicator? A real-life example would be a driver using his indicator to let other drivers know that he intends to park his car in a nearby parking spot.
In essence, this would be a leading indicator: the driver is letting everyone around him know the general direction in which the car will move in the future. Leading indicators do the exact same thing. When looking at a currency in the Forex market, a leading indicator will indicate the general direction of the exchange rate. To be precise, their main function in this case is to provide buy and sell signals.
Looking back at the example, let’s say that an angry driver cuts the driver off and takes the parking spot. Now the driver has to drive around the car park looking for another spot (while cursing under his breath). Just as the driver’s indicator did not provide a guarantee that he could make the intended action, leading indicators in the Forex market do not provide a guarantee of what the price of a security will be in the future.
It is the collective participation of traders and institutions that determine what the price of a security should be at a specific point in time.
There are two main types of technical indicators. The first are leading indicators, which we briefly discussed above. The second are lagging indicators, which provide information about price movements that have already occurred. They are more useful as confirmation tools to verify the conditions of the market (or a security). In general, there are many categories that can describe the properties of the numerous indicators out there, but the two described above encompass a lot of them.
A quick note on leading vs lagging indicators: there is a lot online about leading vs lagging indicators, but the reality is that almost all indicators available on your trading platform, including even candlestick charts, are lagging indicators. The reason for this is that they are all based on price movements that have already occurred. Leading indicators typically result from correlated assets giving potential clues to price action (e.g. AUDUSD vs gold, which will be discussed in more detail in lesson 7), order flow and economic indicators.
Other categories include volume based and price based indicators. Volume based indicators use the trading volume of a security to provide information about market activity related to that security (although again, they are typically lagging, in that they use volume that has been traded, not will be traded). Similarly, price based indicators use the price action of a security to give the trader buy and sell signals or confirmations. Now that technical indicators and their purpose have been introduced, here are some examples.
Moving AveragesA moving average indicator takes the average of a specified number of periods, up to and including the most current period. For example, assume that you are looking at a daily chart, and that you retrieve today’s closing price, as well as the closing prices for the previous 19 days. If you average these numbers by taking the arithmetic average, you will obtain the value for today’s moving average.
This is an example of a simple moving average (SMA), where the weights of each price are equally distributed so that each price level has an equal impact on the value of the moving average. Another popular example of a moving average is the exponential moving average (EMA); this average weighs the recent price levels more heavily than older price levels. Both of these averages will be discussed in more detail below.
The above chart depicts the GBP/JPY exchange rate with the exponential moving average in blue, and the simple moving average in yellow. As you can see, the EMA moves closer with the current price trend than the SMA, due to its heavier weights on recent prices.
Both indicators are lagging indicators, since they ‘follow’ the price action, and therefore should be used as confirmation signals. A popular SMA is the 200-day SMA, considered by many traders to be the long-term trend of the asset in question.
In this lesson, both indicators will be looked at closely, because many traders are unaware of their underlying power. And if you can start using them right, then you can improve your performance without a doubt.
Simple Moving Average (SMA)This is simply the average closing price of an instrument – be it a stock, bond, commodity, or in this case, a currency pair – over the past X periods (e.g. minutes, hours days or months – you can use them on all timeframes).
Now, as you’ll no doubt know, it’s easy to calculate an average. If you have 6 different numbers and you want to find the average of those numbers, you add them all up and then divide by 6.
That’s exactly how moving averages work. You add up all the closing prices of the ‘X’ number of periods and then divide that total by the number X.
Exponential Moving Average (EMA)An exponential moving average works in the same way, but uses a weighting so that the most recent time periods hold more significance.
The reason moving averages are so powerful is that they provide an insight into price movement and market sentiment, and highlight strong trends in the market.
Importantly, they work as key support and resistance levels. Below are some examples to illustrate this.
In the EURUSD chart below, the 50 day SMA has been plotted in green and the 50 day EMA in red. Notice how the EMA turns up and down quicker than the SMA, reacting more to recent price trends.
For instance, choppy trading and the dip in September and October results in the EMA actually dipping more than the SMA.
What is important here is that even though the same period is being used for the moving averages (50 days) they actually react quite differently, and therefore you do need to be somewhat careful with what you want to plot.
Remember the EMA reacts more to the most recent moves in price while the SMA acts to smooth out price over a longer period.
This shows the difference between the two different types of moving averages and is key for understanding how they will react.
In large swings, the EMA is likely to move more than the SMA. Why is this important to know? Well, in large trending moves, SMAs will provide more of a smoothing effect. Thus, any minor retracements will be smoothed out for the trend.
When looking for reversals or changes in direction, the EMA will react faster to these changes, allowing you to get into the trade at a better price.
Using the EURUSD again, look at the same chart below but with the 50-Day EMA (red) and 200 Day SMA (green).
Notice how these moving averages react to price (the candlesticks).
What’s interesting about this is how those moving averages appear to be acting as ‘support’ levels.
In case you’re new to this, ‘support’ is an area where, historically, buyers have come into the market to support it.
Note the circles that have been added to the chart. See how at those points, the price has come down to the moving average and then moved higher as the buyers have come in. The chart below shows even further back in time:
This chart also shows EURUSD, but a few months before. And again, what’s interesting about these moving averages is that they form key physiological levels in the markets, which can act as dynamic ‘support’ and ‘resistance’.
Again, ‘resistance’ is an area where historically the price has had difficulty getting through.
You can see that on the bottom three circles. Each time the price has reached the red moving average, it’s bounced off it and headed lower as the sellers have come in.
Here’s another example. Take a look at this next chart. This time, it shows the Australian dollar trading against the Canadian dollar (AUDCAD) using a daily candlestick chart where each candlestick represents one day’s price action.
You can see that the actual price of the currency pair, shown by the candlesticks, has been moving up and down on a daily basis, as you would expect from any market. That’s what markets tend to do.
But look at the blue line plotted across the chart – the moving average.
This shows the price action smoothed out over time, by taking the average price of each day over the past 200 days.
And once again, the blue circles are showing areas of support and resistance.
Price does not move in a smooth, uniform manner. Instead, it tends to move up and down in a zig-zag pattern. When price has been moving up (like in the AUDCAD chart above) or down (like in the final EURUSD chart above), sooner or later there tends to be what we call a ‘correction’.
The easiest way to explain a correction is as a small bounce in the opposite direction to the trend. If the overall trend is established and powerful, these corrections can be great opportunities to take advantage and get in on the trend.
Using moving averages to jump on a trend
One very simple strategy that is surprisingly powerful is to look for these small corrections to touch what is referred to as a support or resistance zone.
These are areas where there are more orders and momentum in the direction of the trade.
In other words, if price is moving down but there is a small correction to the upside, then orders will push price back in the direction of the trend. If price is moving up, but corrects to the downside, buy orders will push the price back up.
Support and resistance zones are actually built by orders in the market. They are in fact other traders, banks and commercial companies trading FX for various reasons (most are actually trading for commercial reasons, like multinational companies, rather than speculating).
Now here’s something you might not already know, but which can help you in your Forex trading.
As it turns out, each currency pair has a set of moving averages that tend to work as key psychological support and resistance zones.
The most common of these are the 200 day SMA, 50 day SMA or EMA, along with the 9,12,14,18 and 21 day SMAs and EMAs depending on the currency pair.
Take a quick look at the charts to see what I mean.
Take your favourite trading platform and a daily chart. Plot a few of those moving averages that were just mentioned in different colours, and see how they react with the candlesticks on your chart. Then, do the same on a smaller timeframe. You’ll see what happens when the price meets the MAs.
So, beyond spotting support and resistance zones, what else can moving averages be used for? Well, they are also really good at spotting trends.
Below, using our EURUSD daily chart again the 9 (Green), 21 (Yellow) and 50 (Red) day EMAs have been plotted, and just for good measure, the 200 day SMA (Blue) has been left on the chart as well.
The rules for this are simple. In short, the moving averages need to align. In a downtrend, the shorter-term moving averages must be below the longer-term ones. And in an uptrend, the shorter-term moving averages are above the longer-term ones.
For a down trend; 8 < 21 < 50 < 200
For an uptrend; 8 > 21 > 50 > 200
Anything else is market noise.
In an uptrend, you should therefore be looking for long entries; and in a downtrend, for short entries. If you get a little more practiced with these, you can in fact use them to determine how strong the trend is instead, using a combination of the above rules broken down; i.e.:
Short-Term Correctional Uptrend; 8 > 21 < 50 < 200
That’s the concept. But don’t worry, you’re not expected to take this and start finding trades right away using moving averages. More detail will be covered later, but first, there’s one more important fact to address.
This fact is, if you get to understand how each currency pair reacts to these moving averages, you can actually create a profitable trading strategy on these alone.
There are very wealthy and highly successful Forex traders trading only off moving averages. They are that powerful - if used well. In 2012 alone, with the most basic moving average cross over strategy, you could have returned more than 20% on a single currency pair, only trading 30 minute charts.
In fact, with minor tweaks to the above example for trend trading the EURUSD in 2012, on a daily timeframe, you could have returned 10% using only a 5% account risk, and you only would have placed 7 trades in total for the whole year.
The best moving averages to start with are the 8, 21, 50 day EMA and 200 day SMA. Why? Well, there are several reasons.
To start with, it turns out that these levels act as quite good support and resistance levels – and they seem to work on most popular currency pairs, as demonstrated above with the EURUSD.
Also, the 21 and 50 EMAs allow you to quickly view medium term trends. In short, when the 21 is above the 50, it points to an uptrend. When the 21 is below the 50, you’re looking at a downtrend.
There’s one more thing worth knowing about moving averages: they are commonly used by other market participants, which means there’s an increased chance of them working.
After all, if lots of traders are using the same indicators, and arriving at similar conclusions about a trend, then it’s more likely to happen. No guarantees, of course, but you get the idea.