What is a forex indicator?

When we hear or read the words “forex indicator”, we at once think of technical indicators. These are the mathematical, graphical tools we place on our charts to make better-informed forex trading decisions.

Here we’ll discuss the diverse types of technical forex indicators available to you, and we’ll break them down into the four key groups and provide examples of how they work.

How are forex indicators used in the forex market?

Most traders use forex indicators to reveal market sentiment and to predict the direction a market will move.

Most indicators lag: they don’t lead; therefore, analysts and traders rely on the patterns already formed on their charts to make their predictions.

Forex traders will also use the indicators to make precise entry and exit decisions. They may wait for a combination of technical indicators to align to enter or exit.

Using technical indicators to adjust stop-loss orders or take profit limit orders is also common among traders.

Forex indicators have standard settings, and the mathematicians who invented them in the last century (before online trading) put them to work trading long term timeframes such as the daily or weekly charts.

The modern practice whereby traders using indicators to day trade or scalp markets isn’t ineffective as the mathematics used to calculate the indicators’ movements remains pure.

The primary use of forex indicators is to gauge market sentiment. They can illustrate quick changes in market volatility, sustained buying or selling volume and pressure. They can also confirm trends and indicate when a change could happen, making trend indicators a vital resource for day and swing traders.

Do all forex styles use similar indicators?

How you apply the indicators onto various timeframes will vary depending on your preferred trading style.

Scalpers and day traders might use different indicators and apply them differently on their charts than swing and position traders.

Scalpers and day traders will use indicators that illustrate rapid movements in price that have recently happened. In comparison, a swing trader and position trader might look for evidence that the current trade trend is continuing.

What are the best forex indicators?

There are many tens of indicators available through your trading platform and thousands of systems to select using a combination of indicators.

Forex traders will favour the indicators that work best for their style, method and strategy. Which ones you prefer will come down to your expertise, experience and personal preference.

There are four main groups of technical indicators which we’ll cover in more detail further on. Some traders might rely on simple moving averages, and others might use momentum and trend indicators.

Novice traders often duplicate or overcomplicate the process by placing too many on the chart, obscuring the signals. In contrast, the more experienced traders will tend to use indicators sparingly after experimenting with many combinations.

Which are the most popular forex indicators?

The most popular forex indicators are subject to interpretation. The MACD, RSI, stochastic lines, PSAR, moving averages, and Bollinger Bands are just some of the most widely used indicators.

These specific indicators have gained popularity due to the results which many traders have claimed to experience. Many traders will combine some of these to build an effective technical indicator trading strategy.

Forex indicators that work

What works to figure out market direction is a subjective issue and the subject of much debate, but all indicators should work in terms of their mathematical purity and modelling.

But they can’t, with any degree of certainty, predict the movement of price over the short, medium or long-term. When applied correctly on your charts, they can prove effective in suggesting what might probably happen next.

Indicators also deliver tremendous opportunity for traders to make three critical decisions.

1. When to enter a market
2. When to exit
3. When to adjust and where to place stop losses and limit orders.

Forex indicators available on MT4

A vast library of indicators will come supplied with your MT4 platform as part of your package from your broker.

You can extend this choice by browsing the various MT4 forums and official websites. You can also access a range of custom-made indicators developed by other traders in the diverse MetaTrader communities. And some traders will share their developments in the community free of charge.

Most common mistakes using forex indicators

Placing too many indicators on their charts is perhaps the most common mistake traders make, clouding their judgement and decision making.

Traders can also be guilty of chopping and changing indicators without giving their technical method and strategy enough time to prove effective. It’s best to evaluate the proficiency of your system over either a set period or several trades. In doing so, you should experience different trading conditions.

Another common mistake is to adjust the standard settings of the indicator to curve fit the earlier winning patterns. In simple terms, traders investigate the recent market patterns and then change the settings to make the movements more transparent and profitable.

However, this curve fitting generates false results because the past does not guarantee future market behaviour.

Traders who adjust the standard settings generally look to eradicate all losses from their technique rather than accept the potential random distribution between losses and gains.

The four types of forex indicators

1. A Trend-Following Tool
2. A Trend-Confirmation Tool
3. An Overbought/Oversold Tool
4. A Profit-Taking Tool

This section will define the various indicator groups and discuss some examples while highlighting their key features and benefits.

We’ll also describe how you can use one tool from each group to build a competent trading method and strategy.

Trend following tool

Most traders try to find the direction of the primary trend and profit by trading in the current trend direction. The purpose of a trend-following tool is to indicate whether you should consider taking a long position or a short position.

The most straightforward trend-following tool/indicator is a moving average, and one of the simplest trend-following methods is the moving average crossover.

A popular application of moving averages in the forex market involves using the 50 and 100-day moving averages plotted on the daily timeframe. The trend is bullish when the 50-day moving average is above the 200-day average and bearish when the 50-day falls below the 200-day.

The bullish crossover is known as the golden cross, and the bearish crossover is known as the death cross. Swing and position traders look upon these movements as long-term trend indications, and they’ll consider remaining long or short until the crossovers reverse direction.

Trend confirmation tool

A trend-confirmation tool doesn’t necessarily generate specific buying and selling signals. Instead, we’re looking for the trend-following tool and the trend-confirmation tool to confirm current market conditions.

If both indicator tools are bullish, traders can be more confident in their long positions. If both are bearish, traders should, in theory, feel more secure in their short market positions.

A popular trend confirmation indicator is known as the moving average convergence divergence (MACD). This indicator reveals the difference between two exponential and smoothed moving averages.

This difference is then smoothed and compared to a moving average of its own making. The histogram is positive when the current smoothed average is above its moving average, and an uptrend is confirmed.

Alternatively, if the current smoothed average falls below its specific moving average, the histogram is negative, and a downtrend is confirmed.

An overbought/oversold tool

After choosing to trade the primary trend direction, a trader must be ready to decide when the trend is nearing its end. The RSI (relative strength indicator) can help measure the relative strength left in a market move.

Tools like the RSI help you figure out if the market is overbought or oversold. You don’t want to go long if the bullish movement is nearing its end. Likewise, you don’t want to go short if the bearish trend is close to a finish.

This RSI calculates the cumulative sum of up and down days and calculates a value from zero to 100. If all price action is to the upside, the indicator will approach 100 in overbought conditions. Whereas, if the price action is to the downside and oversold, the reading will approach zero. A reading of 50 is considered neutral.

Traders use different techniques with the RSI. For example, they might only go long if the market becomes oversold, or they might prefer to wait for the trend to be confirmed once the RSI reading rises above 50 and other confirmation tools align. They might then exit the long trade once the RSI enters the overbought territory, perhaps a reading of 80 or more.

Profit-taking tool

A popular indicator known as Bollinger Bands is a profit-taking tool. This tool takes the standard deviation of price changes over a period. These are then added or subtracted from the average closing price to create the three trading bands over that same timeframe.

Traders sometimes use Bollinger Bands to time the entry of trades. However, they also excel as a tool to bank profits. A trader holding a long position might consider taking some profits if the price reaches the upper band. A trader holding a short position might consider taking some profits if the price approaches the lower band.

Conclusion

Forex indicators can prove to be invaluable tools for forex traders to make decisions. They’re not infallible as they only indicate market direction.

Using them to attach discipline to any trading method and strategy is perhaps the most valuable feature of technical indicators.

We all need reasons to enter and exit markets. We also need metrics to place and adjust our stop-loss orders and limit orders.

Experimenting with forex indicators is a vital aspect of a trader’s education. You’ll then begin to fashion a robust method and strategy where an edge with positive expectantly can develop.

Click on the button below to Download our "What is a forex indicator? " Guide in PDF