Technical Indicators to Trade Currencies

The definitions below will give new traders a basic description of the technical indicators that come with the trading software.

• Simple Moving Average (SMA) - The average price of a currency pair over a given time period, (15 minutes, 1 hour, 1 day, etc.) where each period in the average is weighted equally. Since this indicator is widely used by day traders and swing traders in many markets, it is important to understand how it is calculated. A basic example to calculate the 4-day SMA will demonstrate this.
  

  Example (using closing prices of the EUR/USD):
  
  Day 1 Close = 1.1210
  Day 2 Close = 1.1250
  Day 3 Close = 1.1220
  Day 4 Close = 1.1240
  
  SMA (4) = (1.1210 + 1.1250 + 1.1220 + 1.1240) / 4 = 1.1230

  Consequently, the average price of the Euro - U.S. Dollar during the four days shown above is 1.1230.
  

• Exponential Moving Average (EMA) - Unlike the SMA that gives equal weight to all prices, the exponential average gives more weight to the most recent currency prices. The purpose of the exponential weight is to give more importance to the most recent data in the determination of trend direction.

• Bollinger Bands - The theory behind Bollinger Bands is that currency prices tend to stay within the upper and lower bands. Bollinger Bands are plotted a number of standard deviations above and below a moving average (SMA). The default values used in the software are a 20-period simple moving average and 2 standard deviations, which are commonly used values in the industry. A common use of bollinger bands when trading currencies is to sell when the price is close to the upper band and buy when the price is close to the lower band. A distinctive characteristic of Bollinger Bands is that the spacing between the bands varies with price volatility. During periods of extreme changes in foreign exchange rates (high volatility), the bands widen to become more forgiving. On the other hand, the bands become narrower during periods of low volatility, containing currency prices. Some forex traders use the band in combination with other indicators such as RSI (Relative Strength), MACD (Moving Average Convergence/Divergence), and Rate of Change, which are also available with the trading platform.

• Parabolic SAR - SAR stands for "stop and reverse." The Parabolic SAR is a time/price stop-loss system that can be used in conjunction with other technical oscillators and studies. The name of this system is derived from the parabolic shape of the dots that appear above and below the currency price. This indicator is commonly used to exit (sell) a long position when the price of a currency falls below the SAR dots and to exit (buy) a short position when the price rises above the SAR. Thus, the Parabolic SAR indicator can be thought of as a "trailing stop." When the price of a currency is above the SAR dotted line and the currency keeps going up, the dots keep rising just below the lows of the current uptrend. When the price falls through the trailing SAR dots, a sell signal is generated. Conversely, when a currency trader initiates a short position and the price of the currency keeps falling, the SAR dots will fall as well trailing the highs of the bars on the current downtrend. When the price of the currency rises above the SAR ceiling, a buy signal is generated to close the position. The SAR works best in trending markets.

• Rate of Change - A momentum oscillator in which the most recent price is divided by the oldest price. For example, to construct a 9 day rate of change oscillator, the latest closing price is divided by the close nine days ago and the result is multiplied by 100.

• RSI (Relative Strength Index) - A popular oscillator that measures relative changes between the higher and lower closing prices in currencies. The RSI is plotted on a vertical scale from 0 to 100. Values above 70 are considered to be overbought and below 30 oversold. Different interpretations of RSI signals can be used when trading currencies. A common use is to look for a divergence between the price of a currency and the RSI signal. A divergence is interpreted as a sign of an impending reversal; for example, if the price of the EUR/USD is making a higher high, but the RSI is failing to exceed its prior high, the general interpretation is that the price is about to fall (impending reversal). Conversely, if the Euro is making a lower low, but the RSI is not making a low that is lower than the previous bottom, the consensus is that an increase in price is about to take place. When this divergence pattern occurs when the RSI is below 30, it is said that a "bottom failure swing" has occurred. If it happens when the RSI is above 80, a "top failure swing" has taken place. Other uses of the RSI include selling when the indicator reaches or exits an overbought level and buying when it reaches or exits an oversold zone. The midpoint (50) level is also used by some traders in combination with other indicators to buy when the RSI goes above 50 and sell when it drops below the same level. The Relative Strength Index usually employs 9 or 14 time periods.

• Stochastics - The Stochastic oscillator is based on the principle that as currency prices increase, closing prices tend to be closer to the upper end of the price range. Conversely, in downtrends, the forex prices tend to be closer to the lower end of the range. Stochastics uses two lines, %K and its moving average %D (usually set to a 3-period setting) that fluctuate between the two extreme values of 0 and 100. The %K line measures where the most recent closing price of a currency is compared to the price range for a given number of periods (usually 14 periods are used). When the faster %K line crosses above the slower %D line and both lines are below 20 (oversold level), a buy signal is generated. When %K crosses below %D and both are above 80 (overbought level), a sell signal is given. Just like with the RSI, divergences between the Stochastic lines and the currency price can also be traded. The stochastic oscillators is used by many currency traders.

• Momentum - Measures the rate of change in currency prices (not the actual price levels). Ten (10) is a commonly used period for the momentum calculation. The momentum oscillator consists of the difference between the current closing price and the oldest closing price in a given number of periods; for example, the 10-day momentum is calculated by taking the current closing price, subtracting the price 10 days ago, and plotting the results around the zero line. The results plotted can be negative (current price is lower than oldest price) or positive (current price is greater than the oldest price). This indicator can be used as either a trend-following oscillator (similar to the MACD) or as a leading indicator.

• MACD (Moving Average Convergence/Divergence) - Consists of two lines. The first line (MACD line) is obtained by subtracting a 26-day exponential moving average (EMA) of a currency from its 12-day EMA. The second line (signal line) is usually a 9 period EMA of the MACD line. The result is an oscillator that fluctuates above and below zero (0). Currency traders have different ways to trade the MACD. One way is to buy when the MACD line goes above zero and sell when it goes below zero. When the MACD crosses over the zero line, it means the 12-day moving average went higher (crosses over) than the 26-day moving average. This is nothing more than a bullish moving average crossover. When the MACD falls below zero, it means that the 12-day moving average crossed under the 26-day moving average, implying a bearish shift in the currency. Some traders also trade off the crosses of the MACD line and the signal line (its moving average); that is, when the MACD crosses over the signal line, it generates a buy signal and when it crosses below it, a sell signal is generated. Divergences between the MACD and the currency rate can also be traded (like for Stochastics and RSI).

• ADX (Average Directional Movement Index) - Measures the degree of directional movement (strength of the current trend) in the price of a currency. The ADX is measured on a scale of 0 to 100. A reading above 25 can be considered directional. A rising ADX line indicates that the currency is a better candidate for a trend-following strategy. A falling ADX indicates a nontrending environment.

• William's %R - A momentum indicator that is similar to the stochastics oscillator, but is plotted on a reverse 0 to 100 scale. Therefore, the bullish signals occur under 80% (oversold level) and the bearish signals occur above 20% (overbought).

• Volatility - Measures the overall volatility (tendency to fluctuate) of a currency pair in a given time period.