Price movements in the forex market may be hard to predict, but they aren’t entirely random, either. There is logic behind the way currency pairs rise or fall in value, and decades of forex trading have revealed that this logic can often be identified—and then predicted—through the use of technical indicators.
Technical indicators come in many shapes and sizes, and no specific indicator is viewed as a required tool for assessing potential forex trades. As traders gain experience and learn about the different technical indicators at their disposal, they end up developing a preference for specific indicators that align with their trading strategy and prove to be reliable over time.
These technical indicators can be broken down into three broad categories.
Lagging indicators are based on a currency pair’s past price data. Moving averages, trading volume, and other lagging indicators are used to confirm the existence of trends and patterns that are already taking place. By identifying these patterns in progress, traders can make trades based on their expectation that the currency pair will maintain this trend or pattern.
Common lagging indicators include:
- Bollinger Bands: Bollinger Bands are based on the simple moving average (SMA), which is itself a lagging indicator that may offer value to your trading strategy. Bollinger Bands represent two bands on either side of the SMA that represent one standard deviation of difference from the SMA line. Traders can use Bollinger Bands to identify overbought conditions—whenever the current price for a currency pair breaks above the upper line—or oversold conditions, when the price breaks below the lower band.
- Moving average convergence divergence (MACD): The MACD illustrates the relationship between the simple moving average and the exponential moving average. Crossovers between these two moving averages can indicate bearish or bullish momentum, setting up a pattern that traders can use to time their trades and evaluate the relative momentum of a price movement.
- Relative strength index (RSI): The RSI is one of the most popular oscillators, reflecting bullish or bearish price momentum for a given currency pair. The scale for RSI is 0-100. Whenever the RSI is above 70, an asset is considered to be overbought, indicating bearish future momentum for the currency pair. An RSI under 30 reflects oversold conditions and indicates that the price may soon rise.
- Any moving average or oscillator: All of these indicators are based on historical price data and price movements, which can be used to predict patterns, trends, and momentum for the relevant currency pair.
Whereas lagging indicators are used to identify trends that traders can take advantage of, leading indicators attempt to use existing currency pair data to project how the price may change in the future. Although leading indicators carry the risk of basing trades on projections that may not come to pass, the advantage of these indicators is that they can help forecast price movements before they occur, maximizing your profit potential.
Common leading indicators include:
- Fibonacci levels: These levels, based on mathematical ratios and a theory developed centuries ago, are one of the top indicators used to predict price movements by traders around the world. The sheer popularity of Fibonacci levels makes them a somewhat reliable indicator, because many traders time their entries and exits based on these levels.
- Lines of support and resistance: Lines of support and resistance can be reliable indicators to use in forex trading, especially when currency pairs are trading within a range. The premise for these indicators is that a range-bound currency pair will continue to move between lines of support and resistance until it breaks out above or below this range. Traders may use this strategy to generate profits off movement within a range, or to capitalize on a breakout outside of these lines.
- Ichimoku cloud: This sophisticated, data-driven leading indicator, which requires an experienced trading eye, uses the calculations of multiple moving averages to graphically illustrate potential lines of support and resistance. This tool is available through the MetaTrader 5 platform.
A confirming indicator on its own offers relatively weak information for traders to use. Instead, this type of indicator can be used to complement and confirm the suggestions of other indicators. Traders should think of confirming indicators as tools they can use to double-check their work when evaluating a trade with lagging or leading indicators. When certain indicators are recommending a trade, confirming indicators can be used to strengthen the trader’s confidence in that action.
For example, traders can use the average directional index (ADX) as a confirming indicator when evaluating trade opportunities with a currency pair’s moving average. The ADX on its own offers limited value because it can reflect the relative strength of a trend but doesn’t indicate whether that trend is rising or falling. When used with a moving average, though, it can offer important context to help traders evaluate the strength of trending price movements.
Similarly, volume is a useful confirming indicator when combined with other leading or lagging indicators. Volume on its own represents the relative trade activity on a currency pair—but without any other indicators, it’s impossible to know what this volume means, or why it matters. It can’t offer a clear call to action in any scenario, but it can be useful as a confirming indicator that helps traders identify and evaluate a price breakout.
Find the Indicators That Support Your Trading Strategy
If you’re still getting your feet wet as a forex trader, it’s important to be open to many types of technical indicators, and many different approaches to using them to identify trade opportunities. As you gain familiarity and experiment with the indicators that work best for you, you can narrow down your strategy to incorporate your favorite indicators and, hopefully, maximize your profit potential.
The information provided herein is for general informational and educational purposes only. It is not intended and should not be construed to constitute advice. If such information is acted upon by you then this should be solely at your discretion and Valutrades will not be held accountable in any way.