Investing 101: FX Indicators
Good morning and welcome to my last article covering technical analysis. For the remainder of the year, I have multiple articles in the works, including a live trading session, a Q&A with a stock trader on fundamental analysis, and another on forex psychology. Also, if you didn’t have a chance to see my recent feat in the cryptocurrency market, where basic chart patterns covered in the last article allowed me to accurately identify precise entry points, you can view it on the University of Birmingham Investment Society's Youtube channel! Today, we’ll go over three of my favourite Forex indicators.
One very popular entry trigger used by many traders is the moving average (MA) crossover. The golden cross is when the short-term MA breaks above the long-term MA and signals an entry trigger for a long position, and the opposite is true for a death cross. This is very time-frame-dependent and lags behind the initial reversal impulse. Sometimes, others use MAs as another form of support and resistance. For instance, when the price breaks above your MA, it may indicate a buy signal and the reverse if the price breaks below the MA.
Tip: For longer-term trades, 50-day MA and 200-day MA are commonly used. I refrain from using the crossover technique on short timeframes since it results in many fake-outs due to their lagging nature. Check for yourself!
Have a look at the daily EUR/USD chart below. Notice the location of the cursor - this is where you can find all of the indicators. In the upper left-hand corner, you can see all your chosen settings for a particular chart. In this example, we are looking at 50-day and 200-day MAs. There is a clear golden cross which accurately signaled a major upward rally. I also pointed out where we could see first signs of trend reversal to highlight the lagging nature of indicators. Here the price made a higher low and broke above the 50-day MA. Thus, with additional analysis we could’ve entered this trend prior to the golden cross formation, nevertheless, let’s not underscore the lengthy breakout after the cross itself!
Divergence is another method used by indicator traders. Bearish divergence is when the price is making a series of higher highs, whilst the indicator is beginning to create lower highs. The opposite is true of a bullish divergence - the price is making lower lows whilst the indicator is creating higher lows. An imbalance between the price action and the oscillator often signals a trend reversal before it happens. I personally use the relative strength index (RSI), but you could equally use moving average convergence divergence (MACD) or the stochastic oscillator.
On a side note, all three of these are also great indicators for signaling overbought/oversold conditions, which is another tool to add your trading basket. However, it doesn’t really mean much on its own, since prices can range in either condition, so a reliable entry trigger is necessary.
Tip: Like with any other indicator, divergence is more effective and reliable if it occurs on a higher timeframe.
The daily USD/JPY chart below shows a clear case of divergence. The currency is in a bearish market structure, creating a series of lower highs and lower lows. Between July and August, this contrasts with what the oscillator is showing - a series of higher lows. This may not always be sufficient on its own, but we got a long wick and a double bottom (another common pattern) to top it off. Shortly after, the market began its bullish momentum.
The Keltner Channel helps to identify overbought and oversold levels relative to the MA. This is not a very popular indicator from my experience, but I found it to be great at detecting potential entry and exit points. The top channel serves as a dynamic resistance and the bottom channel as a dynamic support. The price tends to fluctuate between the two channels in a ranging or a steady moving environment. On the other hand, in a sharp uptrend the price often remains confined to the upper channel, with the MA (middle line) acting as the support, and the opposite in a downtrend. A pullback to either support or resistance is often a good entry trigger.
Note: A more commonly used alternative is Bollinger Bands, but it tends to be much more volatile. Both of these, and many more, are covered on babypips.com.
Take a look at the 4H AUD/CAD example below. There are various points where the price bounced off the Keltner Channel, however I only highlighted the ones which looked like the best entry points to me (remember, analysis is very subjective!). This pair was in a bearish market structure, bouncing off the highs and lows of the channel. 12th October marked a sharp drop: notice how the price no longer retraced back to the upper channel but bounced off the MA (middle line). Each time that occurred, it would’ve been another great opportunity to enter a short position. On October 21st, the price retraced above the upper channel, signalling a potential change in direction. In early November the pair made a higher low and from there onwards there were several opportunities to jump on an upward rally as highlighted on the chart. Later we see a price correction, followed by another rally.
To finish off this series on basic technical analysis, I recommend “Short Term Trading Strategies That Work” by Larry Connors and Cesar Alvarez, which covers many topics I spoke about in much more depth. Although the majority of the recommended readings are on stock trading, we can equally apply these strategies to Forex, which is great!
Here I covered some of my favourite indicators, but I do recommend experimenting and finding the ones that resonate with you! Analysis is very subjective, and everyone sees the market completely differently- just check the overview section for any currency pair on tradingview.com where hundreds of traders post their analysis daily.
In the next article, you’ll get a chance to see how I combine everything I have covered so far in a single trading day. Hopefully, we’ll catch some pips!