Technical Indicators Defined and Explained
Technical indicators are chart analysis tools that can help traders better understand and act on price movement. There is a huge range of technical analysis tools available that analyze trends, provide price averages, measure volatility and more.
In this piece, we explore the types of technical indicators available, from RSI to Bollinger Bands®, explain how to respond to technical signals, and reveal the top tips to making the tools an effective part of your trading journey.
Types of Technical Indicators
There are four main types of technical indicators: Trend Following, Oscillators, Volatility and Support/Resistance. They are grouped based on their function, which ranges from revealing the average price of a currency pair over time, to providing a clearer picture of support and resistance levels.
List of Technical Indicators
1. Trend Indicators
Trend following indicators were created to help traders trade currency pairs that are trending up or trending down. We have all heard the phrase ‘the trend is your friend’ – these indicators can help point out the direction of the trend and can tell us if a trend actually exists.
Moving Average Indicator
A Moving Average (MA) is a technical tool that averages a currency pair’s price over a period of time. The smoothing effect this has on the chart helps give a clearer indication on what direction the pair is moving – either up, down, or sideways. There are a variety of moving averages to choose from, with Simple Moving Averages and Exponential Moving Averages being the most popular.
Ichimoku is a complicated looking trend assistant that is simpler than it appears. This Japanese indicator was created to be a standalone indicator that shows current trends, displays support/resistance levels, and indicates when a trend has likely reversed. For more, check out our Definitive Guide to Trading Trends with Ichimoku Cloud.
The Average Direction Index won’t tell you whether price is trending up or down, but it will tell you if price is trending or is ranging. This makes it the perfect filter for either a range or trend strategy by making sure you are trading based on current market conditions. For more, see our article How to Use ADX to Identify Forex Trends.
2. Oscillator Indicators
Oscillators give traders an idea of how momentum is developing on a specific currency pair. When price treks higher, oscillators will move higher. When price drops lower, oscillators will move lower. Whenever oscillators reach an extreme level, it might be time to look for price to turn back around to the mean.
However, just because an oscillator reaches ‘Overbought’ or ‘Oversold’ levels doesn’t mean we should try to call a top or a bottom. Oscillators can stay at extreme levels for a long time, so we need to wait for a valid sign before trading.
The Relative Strength Index is arguably the most popular oscillator to use. A big component of its formula is the ratio between the average gain and average loss over the last 14 periods. The RSI is bound between 0 – 100 and is considered overbought above 70 and oversold when below 30. Traders generally look to sell when 70 is crossed from above and look to buy when 30 is crossed from below. Click here to learn about A Better Way to Use RSI to Signal When to Take a Forex Trade.
Stochastics offer traders a different approach to calculate price oscillations by tracking how far the current price is from the lowest low of the last X number of periods. This distance is then divided by the difference between the high and low price during the same number of periods. The line created, %K, is then used to create a moving average, %D, that is placed directly on top of the %K. For more, check out our article How to Trade With Stochastic Oscillator.
The Commodity Channel Index is different than many oscillators in that there is no limit to how high or how low it can go. It uses 0 as a centerline with overbought and oversold levels starting at +100 and -100. Traders look to sell breaks below +100 and buy breaks above -100. To see some real examples of the CCI in action, take a look at how to Trade Forex with the CCI Indicator.
The Moving Average Convergence/Divergence tracks the difference between two EMA lines, the 12 EMA and 26 EMA. The difference between the two EMAs is then drawn on a sub-chart (called the MACD line) with a 9 EMA drawn directly on top of it (called the Signal line). Traders then look to buy when the MACD line crosses above the signal line and look to sell when the MACD line crosses below the signal line as seen here. There are also opportunities to trade divergence between the MACD and price.
3. Volatility Indicators
Volatility measures how large the upswings and downswings are for a particular currency pair. When a currency’s price fluctuates wildly up and down it is said to have high volatility. Whereas a currency pair that does not fluctuate as much is said to have low volatility. It’s important to note how volatile a currency pair is before opening a trade, so we can take that into consideration with picking our trade size and stop and limit levels. Read our article on the Top 10 Most Volatile Currency Pairs for more.
Bollinger Bands® Indicator
Bollinger Bands® print three lines directly on top of the price chart. The middle ‘band’ is a 20-period simple moving average with an upper and low ‘band’ that are drawn two standard deviations above and below the 20 MA. This means the more volatile the pair is, the wider the outer bands will become, giving the Bollinger Bands® the ability to be used universally across currency pairs no matter how they behave.
Bollinger Bands® is a registered trademark of John Bollinger.
The Average True Range tells us the average distance between the high and low price over the last set number of bars (typically 14). This indicator is presented in pips where the higher the ATR gets, the more volatile the pair, and vice versa. This makes it a perfect tool to measure volatility. For more, see How to Use ATR in a Forex Strategy.
4. Support/Resistance Indicators
Support and resistance is key to technical analysis. The concept refers to the price levels on charts that form barriers to an asset price being pushed in a given direction. For more, see our article on Identifying Support and Resistance and make sure you consider the indicators below.
Pivot Points are one of the most widely used in all markets including equities, commodities, and Forex. They are created using a formula composed of high, low and close prices for the previous period. Traders use these lines as potential support and resistance levels, levels that price might have a difficult time breaking through.
Price channels or Donchian Channels are lines above and below recent price action that show the high and low prices over an extended period of time. These lines can then act as support or resistance if price comes into contact with them again. For a deeper look at using this tool successfully, read Breakout Trades and the Power of Price Channels.
Technical Indicators: A Summary
Each of the technical indicators above can help you to advance your technical analysis and better understand price action, but it’s important to remember not to get bogged down and to choose only the indicators that work for you.
Overly complicating your approach with too many indicators can force traders to process too much information, resulting in ‘paralysis by analysis’. As a result, it’s best to keep it simple and only use a handful in accordance with the goals set out in your trading plan.
Become a Better Trader With our Trading Tips
For more information on the indicators you should know, check out the more condensed 4 Effective Trading Indicators Every Trader Should Know.
For those wanting to take their indicator trading to new levels, we offer in-depth free trading guides on topics like Ichimoku.
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