Best Technical Indicator in Forex

What is the best technical indicator in Forex? The million dollar question... Only if it was that easy! The truth is that success comes from knowledge. And knowledge of technical indicators is a huge part of Forex trading.

Why are Technical Indicators important?

The Forex market has a tendency to behave in certain ways under certain conditions. The market behaviour repeats itself, meaning the certain price patterns will occur again and again. And that's where Forex indicators come in. They are designed to recognise these patterns as they are formed and help you interpret them to your advantage. However, more often than not, Forex traders don't give them a chance because they assume they are complicated.

Average True Range, MACD, Relative Strength Index, Stochastic. It sounds more like parts of the washing machine than anything Forex related. But don't judge the book by its cover. They're not as complicated as they may seem.

Below, we will discuss the role of trading indicators in the financial markets and, in particular, introduce seven of the most popular technical indicators and explain how they can help your trading in 2021! Remember, if your indicators generate signals that don't translate into profit over time, then they're simply not the way to go!

Simple Moving Averages (SMA)

Simple Moving Average, also often referred to as SMA, are technical indicators that refer to the average closing prices over a certain time period. They are plotted on the chart as lines that smooth out price action and can be used to determine the trend.

Simple Moving averages can be calculated by taking a certain number of closing prices, adding them together and dividing them by the total number of closing prices used. For instance, if you wanted to calculate the SMA for a five-day period, you would use the closing prices of the last five days and then divide it by five.

So if the last closing prices were: 80, 81, 81, 82 and 83, you would add these together and divide it by five, resulting in an average of 81.4. Afterwards, each time a new price becomes available, the average "moves".

In our case, let's say the next number in the sequence would be 82, the oldest rate (80) would be dropped and the new average would equal 81.8.

The longer your chosen SMA period, the slower it will react to the price movement.
The shorter your chosen SMA period, the faster it will react to the price movement.

Exponential Moving Averages (EMA)

Exponential Moving Averages, also often referred to as EMA, are trend indicators similar to Simple Moving Average, that differ in the fact that they give more weight to the most recent price values and the closing prices of the first few candles will have almost no effect.

As a result, compared to SMA, EMAs are more responsive to changes and represent recent price action more accurately. So if we used the same example as above and we wanted to calculate the EMA for a five-day period, you would put more weight on the prices of the most recent (day 3, 4 & 5) and less weight on day 1 and 2.

The formula to calculate the EMA is rather complex and goes like this:
EMA = (Close - previous EMA) x (2 / n + 1) + previous EMA

In comparison to SMA, traders consider the EMA to be more accurate of the current market situation as it is less responsive and therefore affected by a larger number of data points.

MACD

The Moving Average Convergence Divergence (MACD) is a momentum oscillator used to trade trends.

It is designed to measure the characteristics of a trend which include its direction, magnitude, and rate of change.

The MACD indicator is displayed on a forex chart as two lines MACD and signal line, and one histogram (bars). It fluctuates above and below a centerline (zero line) as the moving averages converge, cross and diverge.

So if the distance between EMAs gets bigger, the histogram rises. It is also called divergence.
If the distance between EMAs gets closer, the histogram reduces. It is also called convergence.

When the MACD crosses above the signal line, this signals an emerging uptrend. Forex traders use this as an indication to buy. When the MACD falls below the signal line, this signals an emerging downtrend. Traders use this as an indication to sell.

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ATR

The Average True Range (ATR) is a volatility indicator which shows how much price fluctuates, on average, during your chosen time period.

Average True Range can be interpreted in the following way:

  • The higher the value of the indicator, the more likely it is that the trend will change.
  • The lower the value of the indicator, the weaker the trend is and the less likely it is that the trend will change.

Remember, the Average True Range indicator does not identify trends, but instead the degree of price volatility and is used to confirm the market's enthusiasm (or lack of) for range breakouts.

Stochastic

The Stochastic oscillator is a popular technical indicator tool used for predicting trend reversals.

The stochastic indicator works on the theory that the momentum of a price changes before the price actually changes its direction. As a result, forex traders use the Stochastic oscillator to predict trend reversals.

The oscillator works on the following theory:

  • In an uptrend, prices remain equal or higher than the previous closing price.
  • In a downtrend, prices remain equal or lower than the previous closing price.

It is a two-line indicator that can be applied to any chart and fluctuates between 0 and 100. The Stochastic technical indicator also tells traders when the market is overbought or oversold.

  • When the Stochastics are more than 80, this indicates that the market is overbought.
  • When the Stochastics are less than 20, this indicates that the market is oversold.

Momentum Indicator

Momentum indicator is a type of oscillator which identifies when the price is in an uptrend or a downtrend and how strong it is.

It measures the rate of change in prices as opposed to the actual price changes themselves.

Momentum indicator can be interpreted in the following way:

  • If the most recent price is higher than the past price, this means that the MI is positive.
  • If the most recent price is lower than the past price, this means that the MI is negative.
  • If a momentum value is more than zero, this indicates that the price is in an uptrend.
  • If a momentum value is less than zero, this indicates that the price is in a downtrend.

Relative Strength Index (RSI)

The relative strength index or RS is an oscillating momentum indicator used in technical analysis to measure the strength or weakness of a currency pair by comparing its upward movements versus its downward movements over a given time period.

It does this by keeping track of recent price gains and losses and compares them to the current price.

The Relative Strength Index is displayed as an oscillator and can range anywhere from 0 to 100.

Many traders believe that an asset at around the 70 level is in overbought territory, whilst an asset at around the 30 level is oversold.

If price hits or comes close to one of these extremes (0 or 100), this typically means that a reversal is about to take place.