Using a variety of indicators is one way to try to beat the market in Forex trading. Many indicators have been around for many years in other markets and have proven to be successful in helping traders understand these markets more in depth and enabling them to come out profitable.
One of the most popular indicators used in Forex trading is the momentum indicator. Momentum indicators are similar to other indicators and oscillators in that they shadow the main trend direction of the Forex pair being followed. Because the momentum indicator helps identify the main market direction and helps to spot potential market reversal points, many experienced Forex traders consider it to be the most important indicator in the industry.
What is momentum? Momentum is the movement that reflects market sentiment for a specific period of time. For example, if the Euro is declining against the US dollar, we would say this is a bearish momentum as the market is moving to the downside of the pair. The same is true of the reverse. Should the Euro take a turn upwards against the dollar, we would call that a bullish momentum as the market is now moving to the upside of the pair. Forex momentum can be used for either a particular pair such as EUR/USD or for a specific currency such as USD or a commodity such as gold.
Some traders use momentum indicators in Forex to determine a specific trading range. The momentum indicators can help spot a support and a resistance point where the trader can either trade the volatile movements within the range or try to identify a possible breakout that would lead to the consolidation of a larger number of pips.
Employing several indicators at once increases the chances of hitting the right time to execute a transaction or the best price to buy or sell a position. These indicators should be employed only after they have been tested and always in conjunction with a solidly laid out trading plan. In addition, it is prudent to use only the indicators that are familiar to you and whose main features and main reactions to various market conditions during a typical trading day are fully understood. Keep in mind that many trading indicators may not be useful at all on specific occasions such as during high volatility.
Another popular indicator is the ‘moving average crossover,’ considered to be a tool to follow trading trends. A simple moving average represents the average closing price over the number of days in question. There are different combinations that identify the major trend of the market but none of them are the ‘best’ combination. The Forex trader must decide on his own which combination (or combinations) fits best with his/her time frames. From there, the trend – as shown by these indicators – should be used to tell traders if they should trade long or trade short although it should not be relied on to time entries and exits.
In essence, if both the trend-following tool and the trend-confirmation tool are bullish, then a trader can more confidently consider taking a long trade in the currency pair in question. Likewise, if both are bearish, then the trader can focus on finding an opportunity to sell short the pair in question.
The moving average convergence divergence (MACD), considered a trend confirmation tool, is another type of Forex indicator. This indicator first measures the difference between two exponentially smoothed moving averages. The difference is then flattened and compared to a moving average of its own. When the current smoothed average is above its own moving average, this indicates an uptrend. When the current smoothed average is below its moving average a downtrend is confirmed.
Traders are often advised to hold off trading till the direction of the major trend is clear. Even then they must decide whether they are more comfortable jumping in as soon as a clear trend is established or after a pullback occurs. If the trend is determined to be bullish, the choice becomes whether to buy into strength or buy into weakness. If a trader decides to get in as quickly as possible, he/she can consider entering a trade as soon as an uptrend or downtrend is confirmed. On the other hand, the trader can wait for a pullback within the larger overall primary trend in the hope that this offers a lower risk opportunity. For this, a trader will rely on an overbought/oversold indicator. Of the many such indicators, the three-day relative strength index, or three-day RSI, is the most widely used.
RSI calculates the cumulative sum of up days and down days over the chosen period and calculates a value that can range from zero to 100. If all of the price action is to the upside, the indicator will approach 100; if all of the price action is to the downside, then the indicator will approach zero. A reading of 50 is considered neutral.