Different analytical tools in your trading tool kit can help you locate buy and sell signals, identify and anticipate market trends, and help inform what position you should take. But to create a consistent and effective forex strategy, you need to understand how your chosen indicators can be used as checks and balances in a more comprehensive trading strategy.
The most successful traders are able to manage risks and rewards and see the bigger picture of their trading decisions by populating their tool kit with four types of tools: trend following, trend confirming, overbought and oversold, and profit taking. We’ve outlined why these four roles are essential and how they can complement one another to make you a savvier trader.
Although Wall Street movies like to glorify characters who make it their mission to predict the future, in reality it’s generally more profitable and less risky to trade with the current trend, especially in the context of forex. Being a solid forex trader doesn’t require a crystal ball or even a Michael Burry-like affinity for statistics. If you can identify a trending market and accurately determine trend direction and strength, you’ve established the cornerstone of a profitable trading strategy.
Trend-following tools are typically lagging indicators—they follow price action movement rather than precede it. The most common trend-following tool is a moving average, which analyzes current price action against the average closing prices from a set look-back period. The direction of a moving-average trendline and the amount of time it’s been tracking in that direction can tell you if the market is ranging, experiencing an uptrend, or in a downtrend. The slope of the line can also indicate the strength of the trend, with a more precipitous slope indicating a stronger trend.
Using a trend-following tool like a simple moving average ultimately gives you more clarity and big-picture market context than looking at a small window of your price action graph. Similarly, drawing trendlines onto your price action graph is another simple trend-following tool that you can use to visualize trend direction, as illustrated by the graph shown.
By drawing a line across all price action peaks and dips in a given period, you can use the slope and direction of your trendline to give you insight into current trend direction and strength. Trendlines can also be used as support and resistance levels to help identify breakouts and reversals.
Once you have an idea of how the market is behaving, your next step should be to confirm trend strength, direction, and momentum using another indicator in your tool kit. This decreases your vulnerability to false signals and will help inform your entry and exit points. One of the most common trend-confirming tools used in forex is the Moving Average Convergence Divergence, or MACD. The MACD plots an exponential (weighted) moving average with a simple moving average on a graph adjacent to price action. The interaction of the resulting two lines helps traders confirm trend momentum and strength. Because price momentum generally shifts before price itself, any changes in momentum are interpreted as early signals of a potential trend change. Confirming trend momentum alongside direction and strength allows you to more accurately determine the risks and rewards of entering into a position at different points. When trend strength and momentum are strong, it’s generally understood to be less risky to enter into a trend-following position to capitalize on the current movement. When trend strength and momentum begin to increase or decrease, traders look for ideal exit and entry points that present the greatest profit potential and least amount of risk.
Overbought and Oversold Tools
To determine ideal entry and exit points, most forex traders consult overbought and oversold momentum indicators. Based on the concept of support and resistance, when the price of a currency pair reaches an overbought or oversold threshold, it will reverse in the opposite direction. For this reason, trending markets oscillate between sustained uptrends and downtrends, seesawing in a predictable fashion between overbought and oversold levels.
Ideally, traders aim to ride out uptrends and downtrends for the longest possible duration, switching positions at pivotal market turning points that represent the greatest profit opportunities. Indicators that define overbought and oversold conditions help traders anticipate when a trend may be reaching a breaking point, thereby informing positioning and signaling ideal exit and entry points. Typically, overbought readings are thought to be bearish (sell) signals and oversold readings are understood to be bullish (buy) signals, anticipating a trend reversal to the opposite side.
The most popular overbought and oversold tools are the RSI (Relative Strength Index) and the Stochastic Oscillator. Because both tools are range-bound (banded) momentum oscillators, they clearly define support and resistance levels for the market in question. That said, markets can remain in overbought and oversold territory for different periods, so overbought and oversold readings are not immediate invitations to enter into a position. Many traders will use the RSI, the Stochastic Oscillator, and the MACD in tandem to confirm buy and sell signals and wait for confirmation of the reversal (consulting their price action graph, trend-following indicators, and trend-confirming indicators) before entering into a trade.
Profit-taking tools are best used to identify exit points that favorably balance risk and reward. To determine when to exit your position and take a profit, you must be able to identify when the current trend is primed to reverse or stagnate. Many overbought and oversold momentum indicators can also be used as profit-taking tools—the key is to have a separate tool for each function so as not to rely too heavily on the signals of one indicator.
Bollinger Bands are another common profit-taking tool. Unlike the RSI and the Stochastic Oscillator, Bollinger Bands are three lines plotted directly onto your price action graph. A simple moving average (SMA) is used as a centerline (or center band), and a given standard deviation is calculated above and below this SMA to account for variation in closing prices. The upper Bollinger Band represents overbought conditions, and the lower band represents oversold conditions. Because these overbought and oversold levels are calculated using a standard deviation, they often provide more accurate representations of current market volatility than an average alone could provide. As such, they’re ideal for confirming the signals produced by other indicators in erratic markets and for locating precise profit-taking points.
Putting It All Together
Many indicators fall into more than one of these four basic categories. The key to a successful forex trading strategy lies in understanding the different potential functions of each indicator and making sure that you provide for each of these essential roles in your trading tool kit. As you learn more about how different indicators work and their unique benefits and pitfalls in different market conditions, you’ll get better at determining which indicator to use in which role to inform your trading strategy.
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.