Indicators: MACD, RSI and ADX made simple

Indicators are used by forex traders to assist with trading decisions and can be a powerful addition to many trading strategies. Indicators are applied to the price charts of forex pairs and can provide a trader with an additional understanding of the market and offer the all-important ‘edge’ to being successful. Although there are hundreds of indicators available, there are several key indicators used by forex traders which are considered the most reliable and effective. These can be grouped in to those indicators which are ‘trend-following’ indicators and those which are considered as ‘momentum’ indicators. Whilst both of these are effective, it is important to understand the broad differences between these groups are that ‘trend-following’ indicators are often lagging and reflect historical price data whilst momentum indicators are used for their predictive qualities.

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MACD

The MACD (moving average conversion-divergence) indicator is a favourite of many forex traders due to its ability to combine both the trend-following and momentum groups in to one indicator. It is used to identify the strength of the price and potential for direction change. As the name suggests, it identifies the divergence consists of two exponential moving averages. The ‘MACD line’ is calculated as the sum of the 12 EMA minus the 26 EMA and the ‘signal line’ is the 9 EMA of this sum. The ‘divergence’ is created when the MACD line crosses over and moves above of below the signal line, resulting in a positive or negative MACD reading. Traders use the MACD to confirm long or short forex positions and trade both the crossovers of the two lines and the positive or negative histogram reading generated by the divergence.

Relative Strength Index (RSI)

The Relative Strength Index is a momentum indicator measuring strength of the market in relation to whether it january be considered ‘overbought’ or ‘oversold’ and therefore the potential for further movement higher or lower. The calculation for the RSI includes the average gain and average loss over a period of 14, plotting the values on to an index with the values 1-100. Traders consider that when the value of the index reaches above 70 the currency pair january be considered overbought. Conversely, an index reading of below 30 represents an oversold value, suggesting that a correction or reversal january be imminent. The predictive capability of momentum indicators such as the RSI provides a valuable tool to forex traders. Used in conjunction with another indicator or trading signal, they can reinforce the decision to trade when the current price is considered ‘overbought’ or ‘oversold’. RSI, similar to the MACD, also shows traders when the strength of a current price move is diverging from the underlying strength. Divergence seen on the RSI can further be a signal of future correction or reversal of the price.

Average Directional Index

For trend traders, the ADX is an excellent tool for measuring the strength of the current trend. Using an index, the ADX will reflect high values for those forex pairs with a strong trend. This allows traders to quickly analyse whether a trend trading strategy can be employed on a currency pair. Although the ADX is a lagging indicator, and therefore does not have the direct predictive value of the MACD or RSI, it can be used to show when a trend is particularly strong and likely to come to an end. Similarly, a low reading on the ADX shows traders that the pair is range-bound and the potential for a breakout trend in the future is high.

How to use stop loss/take profit effectively in trading

Stop losses and take profit levels are used by forex traders to protect them from unnecessary financial risk and also to ensure that profits are taken for successful trades. Stop losses and take profit levels are both orders which are placed in the market to close an open position. Traders following a particular strategy are likely to nominate their stop-loss and take-profit level at the same time as they enter the trade. Both of these type of orders form part of a traders’ risk management strategy and ensure solid money management in controlling total potential loss and gain for each trade. Whilst stop losses are employed by almost all forex traders, take profit levels january be seen as less essential, although they remove many of the problems faced by traders holding winning positions.

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The importance of stop loss and take profit orders

Stop losses and take profit levels are important in helping to remove the necessity to make emotional decisions during real-time trading. The psychology of trading suggests that markets are controlled by fear and greed. Whilst different traders will express different levels of how much they are willing to lose or gain from a trade, stop losses and take profit levels allow this to be mechanised. This means that winning trades are less likely to turn in to losing positions and unsuccessful trades will not result in catastrophic losses. Stop losses are also important due to volatility that can occur in forex markets with sudden and unpredictable news and events which can cause large moves and cause heavy losses. Although regular stop loss orders are not guaranteed, and can therefore be exposed to similar slippage in fast-moving markets, it is possible to guarantee stops with many brokers which can defend traders against these moves.

Financial stop-losses

Stop loss levels should be calculated during the preparation of the trade as they form an essential part of a trader’s money and risk management strategy, their calculation should rely on two factors. The first of these is how much risk they will expose the trading account to during each trade. Ideally, this should be limited to 2% of the account value as an absolute maximum. The second factor is for the stop loss to be relative to the potential gains and therefore the take profit level. Ideally, the risk of losses on each trade should not be greater than the potential profits.

Technical stop losses

Some experienced forex traders prefer to use technical stop loss levels in order to protect their accounts. These stop loss levels favour swing traders who hold longer term positions and require that the trade has a reasonable amount of space to ‘breathe’. The reason why these stops are technical is that they are usually placed at levels which would show that the trade has failed should they be triggered. Amongst others, this could be above or below a key support or resistance level, pivot level or identified Elliot wave within a price chart. Even though technical stop losses january offer more flexibility to forex traders, they are generally only employed where the potential profit is anticipated to far exceed the loss that these stop losses represent.

When a stop loss can be moved

Although it is considered unwise to get in to the habit of extending stop losses once the trade is active and as the price moves closer to the original level, most traders enjoy moving their stop loss to break-even once the trade moves in to profit. By moving the stop loss to the entry price, a trade becomes almost entirely risk-free and allows the trader to focus entirely on the profit level that they require. Employing a take profit order once the stop loss is at break even will assist with the difficulties of knowing when to close the trade.

How to successfully trade with trends

One of the major difficulties in trading trends is that by the time the trend has been established it is often too late to enter a trade. Whilst trends are simple and appear obvious looking retrospectively at forex charts, they can be difficult to enter early and also very difficult to exit in real-time trading situations. Becoming involved early in a forex trend relies on entering with a signal that the market is either going to continue in its current trend or reverse to form a new trend. There are multiple ways to try to do this with the aim of making the most out of the large, profitable trends and also some key problems which are often experienced trading the trend.

Trading the beginning of a trend

One of the most difficult aspects of trend trading is trying to establish when a trend is about to begin. Typically, trends in a new direction will start with a reversal pattern and many traders will look to hold these positions as the trend continues to make their position profitable. Key reversal patterns for technical traders are double tops and bottoms, breakouts and exhaustion indicators such as heavily overbought or oversold momentum indicators. Once it has been established the market is likely to begin trending in the other direction, a good entry will be based on correct trading of that particular reversal pattern. One of the key problems in trading these patterns is the likelihood that once the pattern has completed successfully the trader will be shaken out by corrections as the new trend takes hold. As can be seen from historic chart data, trending prices do not move smoothly and the potential for a position to be closed during pull-backs is obvious. A technique to counter this issue is to move the stop to break even as soon as reasonable possible after the first retest of this level. Needless to say the initial establishment of a new trend is difficult to hold in real-time with profits being erased by market corrections throughout the trend.

Trend trading with moving averages

Trading using the crossover of two moving averages is a very popular trend-following method which works exceptionally well during back-testing. The problem with moving averages, however, is that they lag the real-time situation and provide delayed entry and exit signals as a result. The benefits are that they can provide good signals for longer-term trends and which make up for this. Moving average trend-following strategies also january help to avoid whipsaws and false breakouts which are often experienced in trying to catch the start of a new trend.

Holding on during the trend

The ability to hold on to a trade during a trend without any idea when this january end is certainly aimed toward the more patient trader. Indicators such as momentum oscillators will assist with this and some traders prefer to build their position on the pull-backs during an established trend. Drawing trend lines will also allow you establish when the trend january no longer be valid as this should act as a very reliable support level between the highs or lows of the trend. Looking forward to areas on different timeframes where additional resistance january occur, such as round numbers, important previous highs/lows and technical levels will give a good indication of where a trend january struggle to continue.

Exiting near to the end of a trend

Exiting during a trend trade is also very difficult when using popular signals such as price crossing below or above a moving average due to the lag with such indicators. Other ways to establish an exit january be the breaking of the trend support line. One popular technique is to wait for the trend line to be broken with a price bar closing below this in order to signal the potential end of the trend. The old trend line will then act as resistance during any subsequent retest of this level in order to confirm that the current trend has ended with perhaps a correction on a larger timeframe is underway.

Using fundamental analysis in long term and short term trading

Fundamental analysis is used by traders to predict the future price movement of currencies. Favoured by longer term traders, fundamental analysis attempts to understand and apply the larger, underlying economic trends that can be seen to drive currency values. It also takes account of news events, reports and international environment that exchange rates operate to create a clearer picture of market sentiment and direction.

Fundamental analysis involves the analysis of underlying market trends

Trading forex using fundamental analysis has been used by large institutional investors who take account of the real factors driving markets in taking large trading positions. This analysis, however, can also be used by smaller and forex traders very effectively. The key to this is a general understanding of which key events drive the value of currencies up or down. One of the most widely used examples of fundamental analysis is following the movement of central bank interest rates to influence a decision to go short or long. Interest rates are a key indicator of a currency’s medium-term strength and reflect the basics of supply and demand that drive currency markets.

Interest rates are very important indicators of the fundamental direction of forex markets

When interest rates are raised, for example by the European Central Bank, the demand for the Euro increases as large investors take advantage of the improved interest that they will gain if they buy and hold Euro’s. This creates a fundamental demand for the Euro and increases its relative value against other currencies that have not increased the rate of interest payable. Both short and long term traders can enjoy the trading opportunities that interest rate decisions offer, although markets tend to be significantly more volatile around the time of the news release. Such large fundamental influences such as interest rate changes, however, are not often made on monthly basis and for this reason they are used by forex traders wanting to buy and hold a currency for longer periods. The understanding for fundamental traders is that the short-term fluctuations in the technical signals will give way to the fundamental demand over time.

News and other events also determine market direction

Fundamental analysis also looks to interpret newsworthy global and domestic events in order to predict future movements in the forex markets. Whilst all major news events will affect currency values, their effect will depend on their location and impact within the global financial system. A good example of this fundamental data influencing the value of forex pairs is the tendency for the US dollar to be seen as a “safe haven” investment during periods of instability. The US dollar will tend to rise in value whenever an event occurs which could be seen as destabilising or risky for financial markets. Poor GDP data, outbreak of war or the debt issues of a Southern European country can trigger a medium-term rise in the US dollar’s value. Fundamental analysts will point to the fact that investors see an intrinsic value in US dollars which will protect them from being negatively affected by the instability created by the event.

Trading decisions based on political and economic knowledge

Trading using fundamental analysis requires both a basic understanding of economics and world affairs as well as the ability to apply the relevance of these to individual currencies. These underlying factors can be seen to dictate the general direction of currency values and are especially effective over time using key economic indicators such as GDP figures, interest rates and unemployment figures. Large fundamental events such as the release of non-farm payroll data, indicating employment levels in the US, have the ability to cause havoc on both stock and currency markets from the moment that they are released. Beyond the initial fervour of activity, their impact on the general sentiment of a currency’s value can last for several weeks or even months.

Effect of inflation/consumer price index in Forex trading

Inflation rates and the Consumer Price Index (CPI) are major economic indicators which have a direct impact on the forex markets. The CPI is a key determinant of the level of inflation in an economy and is calculated by taking a household “basket of goods” and comparing the value of these to a previous period. If the value of these basic goods can be seen to increase, for example the cost of milk and bread, then this provides the basis for the economy’s rate of inflation. For forex traders, rising inflation is then seen as an indicator that there is surplus money in the economy which the central bank, or interest rate decision-makers will try to reduce. The most effective way to reduce inflation will be to increase interest rate which in turn lowers borrowing and creates demand for this excess money to be stored away in bank accounts to accrue favourable interest.

The CPI and how it affects inflation

The consumer price index is an important measure for both governments and traders in its effect on currency values. Whilst inflation itself, caused through the rise in the CPI, is not necessarily negative for an economy in the short term, the longer-lasting effects can potentially be very damaging. Booming economies tend to experience inflation which, left untouched, results in a decrease in the competitiveness in terms of international trade.

Within the CPI index, there are a wide range of goods which are weighted in regards to their importance. These include goods such as transportation, food, housing, medical care and leisure to form the “headline inflation” rate. Some of the goods incorporated in the CPI Index also highly susceptible to volatile changes in value, such as energy and agricultural foodstuffs, and these are excluded in the US from the ‘Core CPI rate’ which acts to reduce the impact of price shocks on the CPI index rate. Both of these figures are released in the US around mid-month and are normally expressed as an increase or decrease in percentage terms. As with other key economic indicators, analysts create benchmark estimations prior to the release of this data and figures above or below these have a highly influential effect on forex markets. Figures arriving above expectations have a tendency to increase the value of a currency as it increases the likelihood that inflationary pressure will result in a rise in interest rates.

Inflation, unemployment and how these influence forex trading

Inflation caused by rising CPI data puts considerable pressure on Central Banks and Federal Reserves to raise the rate of interest. Policymakers at the central banks are also aware that the result of this is that the value of the currency will appreciate as investors and speculators are attracted to these higher returns. Inflation also has a directly inverse relationship with unemployment and in reducing one the other will invariably rise. The reason for this is that reducing inflation in an economy makes companies appear to be earning less in real terms and they are therefore unlikely to increase their workforce. Since unemployment and inflation are both used by forex traders to indicate future interest rate activity, they are seen as two of the key indicators for currency speculators to use in anticipating increases or decreases in the value of currency pairs.

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