What are Indicators in Technical Analysis?
Indicators are a tool that forex technical analysis, traders, and statisticians use in the financial markets to take a statistical approach instead of a subjective approach to trading. They will refer to such things as money flow, volatility, momentum, and trends to give themselves more insight to potential price movement. There are literally hundreds if not thousands of indicators available, so it goes without saying that there is a lot of debate as to which ones are the best.
Leading indicators are one of the two primary types of indicators available for traders. They tend to precede any price movement and predict the future. They tend to be used for range bound trading, as they can give you a bit of a “heads up” on a potential breakout of consolidation, which of course is a very powerful piece of information to have.
Some of the most popular leading indicators include the Stochastic Oscillator and the Relative Strength Indicator (RSI). The downside of leading indicators can “jump the gun”, and perhaps give false signals occasionally. It is because of this that most people will use more than just the leading indicator and use it as a secondary indicator beyond simple price action. As with most indicators, there is a complicated mathematical formula that shows momentum and where the market is ready to go.
By contrast, lagging indicators tend to follow price movements. They are most useful during a well-defined trend, as they tend to present signals much later than leading indicators. This unfortunately comes with the side effect of being less profitable, albeit more reliable. Lagging indicators have been popular for years and are still one of the most basic indicators that traders will use.
A couple of lagging indicators include Bollinger Bands and the Moving Averages. As an example, a moving average is a calculation of the average price of the last “N” candles, which by its very definition will lag the current price. However, in a trend, that can be useful information as it shows that the average price is going up or down. Again, as with mentioned previously, these indicators are typically part of a larger trading system.
Indicators are built in several different ways:
Oscillators are by far the most common technical indicator, generally being bound within some type of range. Quite often, there is a full range between two values that represent both overbought and oversold conditions. Typically, there is some type of line or indicator that lets you know when the market may be a bit too far into one realm or the other. A couple of examples might include the Stochastic Oscillator, Moving Average Convergence Divergence (MACD) and the Commodity Channel Index (CCI). While they may measure overbought and oversold conditions with different formulas, in the end they function in the same way.
The non-bounded indicator is much less common, but still will quite often be used to form signals in a trading system to show strength or weakness in a trend. Unlike oscillators, they don’t typically have a set range. For example, the accumulation/distribution line indicator that measures money flow into a security is one example of a nonbounded indicator. However, in the Forex world you will find this almost impossible to measure, although some variations of volume will be offered by Forex brokers, using the information off of their own proprietary servers which only make up a fraction of the market.
The use of indicators
While there are some trading systems that use indicators solely, this tend to be less commonly used these days. One of the most common indicator only systems is the moving average crossover system. This is simply the plotting of at least two moving averages on a chart, which if you will remember, are simply a mathematical average of a certain amount of prices over a certain amount of time, with one of the moving averages being the slower one, and the other being the longer one. The faster moving average is the one that has less candles factored into it, as it will change its direction much quicker. The longer one represents a more stable environment, because it takes much more information for the line to move.
If the quicker moving average crosses above the slower moving average, this can signify that perhaps momentum is moving to the upside, signaling a buying opportunity. Otherwise, if the moving average drops below the longer-term moving average, that’s typically a sell signal. With the moving average crossover system, you are constantly in the market, buying and selling as these lines cross. The biggest problem of course is that you need a strong trend to profit. In a sideways market, you could get crushed.
As a general rule, it’s best to combine support and resistance with these indicators as it gives you several kinds of confirmation for your trade. A typical example might be looking for support, a particularly supportive candle stick formation, and then a buy signal formed on the Stochastic Oscillator. The typical system will have a few steps to walk through in order to put money to work. Beyond that, you start to look at money management and then before you know you have an entire system put together. You should think of indicators as a tool, not the “holy grail” that many traders are always seeking. While they do increase your odds of success, nothing is perfect, and you should learn how they work and when they work if you are going to trade live accounts with them.
As there are literally hundreds of indicators out there to use, it becomes a personal preference as to which one makes the most sense to you. For what it’s worth, it seems that the longer that I trade, the less I use indicators in my decision-making. When I do, they are normally secondary and tertiary reasons.