Trading forex at the most basic level comprises of making use of indicators in order to ascertain the best possible trade entry and exit signals.
Save for some elite few traders who purely trade off price action, the majority of forex traders always make use of one forex indicator or the other in order to trade. Trading off price action is something that requires many years of experience. But remember that almost every new forex trader started off from the same starting point, which is making use of indicators.
Understanding how forex indicators work is important. You will be using indicators in forex trading systems, at some point.
Types of Forex Indicators
At the core of every trading system is a forex indicator and there are many types of forex indicators available now a days.
However, at the broadest level, forex indicators are categorized into the following:
- Trend Indicators
- Momentum Indicators
- Volatility Indicators
- Volume Indicators
- Cycle Indicators
Each of these five types of forex indicators is used to measure a certain aspect of the price movement.
Trend indicators are a set of indicators in forex that is used to show you the overall trend in price movements. Forex prices, as you might know tends to move up, down or sideways (range). Trend indicators help you define the prevailing direction of the price (rising price, falling price or sideways moving price).
Some of the well known trend indicators are:
- Average Directional Index or ADX
- Moving average convergence divergence or MACD
- Parabolic SAR
Obvious from the name, momentum indicators help you visualize the speed of prices. In other words, how fast the price is rising or falling. Momentum indicators help you understand the strength and weakness of a price in a given time.
In momentum indicators, if the momentum or speed weakens it means that the prevailing trend is coming to end and vice versa.
Some examples of the momentum indicators are:
- Commodity Channel Index or CCI
- Relative Strength Index or RSI
- Stochastic Momentum Index
Such kind of indicators show you how volatile the price is. In other words, volatility indicators help you measure the size and magnitude of the prices. They help you visualize the intensity in the price fluctuation and a change in volatility results in a price change.
Example volatility indicators are:
- Average True Range or ATR
- Bollinger Bands
The volume indicators shows you the investor interest or market participation. Higher volume infers that the price is reaching an important market level, often resulting in the start of a new trend. Volume indicators in a way represent the up/down/sideways movement in the price.
Example volatility indicators are:
- Money Flow Index
- Market Facilitation Index
Cycle indicators are based on the belief that forex prices tends to move in repeating patterns or waves. The factors that influence these patterns could be seasonal, event based and so on. There are many market theories surrounding the patterns or waves in forex.
The most famous of such pattern or cycle indicators are:
- Elliott Waves
- Schaff Trend Cycle
- Wolfe waves
In most cases, if you are using the MT4 trading platform, most of the indicators you find by default fall into any of the above five categories and can be used free of cost.
What forex indicator is ideal for you?
Most often, beginner forex traders tend to make use of more than three indicators, making their charts look very messy. Furthermore, using too many indicators can often result in emotional trading kicking in which would lead to an equity loss rather than help you make profits.
By having a sound understanding of the main types of forex indicators can help you to find out a trading system that is best suited to you.
Forex Indicators – Filtering out the noise
Before we proceed any further, I must mention that I have come across forex indicators that claim to be the best and that you should not be using any other indicator. The truth is far from it.
No matter when you use RSI and MACD or if you trade off Pivot Points of Fibonacci, as long as you stick to a trading style and system and manage to make profits from it, that is all that matters.
There is no hard and fast rule as to many indicators you should use. Some traders are more confident trading off three or more indicators, while the elite traders just make use of price action. It all comes down to experience, which stresses the point that traders need to first try out different indicators on a demo account and see what trading style suits them best.
Another important factor to note is that there is not one indicator that can give you accurate 100% profits or signals and this is what makes it exciting and unique.