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The Value of Indicators: MACD, RSI, Stochastic Oscillator

   

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When it comes to trading, it is widely accepted that there are two main approaches to your analysis of potential trades: fundamental analysis and technical analysis.

Technical analysis is widely used by private traders and is becoming more and more popular. It involves the study of a financial product’s actual price to form an opinion on the likely future direction in which the price will move.

Fundamental analysis involves assessing the broader economy and what may specifically impact the financial product or asset you are going to trade. It is most heavily used by traditional stockbrokers and fund managers.

One of the things underpinning the effectiveness of fundamental analysis is that all market participants act rationally. Therefore, the value of indices, commodities, and currencies will track a reasonable expectation based on fundamental influences.

For this reason, many market participants can be gripped by fear and greed and act in a manner that is anything but rational. The best way to counteract these emotional impulses is through technical analysis. Technical analysis is the study of actual movements in the price of a financial product. Despite what people may tell you, there are only two things that move prices. They are supply and demand—nothing more and nothing less.

When demand for something is greater than supply, prices rise. Conversely, if supply is greater than demand, prices fall. The cause of supply of and demand for a financial product could be discussed for hours. But the interesting thing is that no one can be sure at any point why people may be buying and selling a product. Herein lies the beauty of technical analysis.

At no time does technical analysis attempt to determine why there might be supply and demand—only that there are certain levels of supply and demand. By studying actual movements in the price, we can determine the present levels of supply and demand for a financial product and what market participants may be thinking, and can, therefore, analyze it as a potential trade.

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Indicators

A major component of technical analysis is the use of indicators. Indicators are the result of mathematical calculations done on price and volume data and are displayed on charts. Using indicators, it is possible to anticipate the direction of a price’s movement with a reasonable level of accuracy. It should be noted that no indicator is perfect, and no single indicator will be right all the time. Indeed, several indicators will often produce varying signals.

Read on for a look at some of the more popular indicators that are used.

Relative Strength Index

The relative strength index (RSI) is a very popular indicator that was developed in 1978. In theory, the RSI measures the internal strength of a price and is calculated by comparing the average upward price change with the average downward price change over a set period. The fewer the number of periods you use, the more erratic the indicator becomes. A 14-period RSI is popular.

The RSI is plotted between the values of 0 and 100 and generally has reference lines placed at 30 and 70. The RSI can be interpreted in several ways. A popular approach is to buy and sell when the RSI crosses the reference lines. When the RSI crosses up above 30, this is interpreted as a buy signal, and when the RSI crosses down below 70, it is interpreted as a sell signal.

You can see an RSI plotted on a daily chart of the USD/CHF below with the 30 and 70 lines marked.

202010-RSI

Advantages to RSI

This technical indicator is easy to interpret on forex charts and offers insight into data points that can be very relevant when targeting price movements and momentum swings.

Disadvantages to RSI

The timeline for the price swings forecasted by RSI can be hard to determine, which can frustrate traders looking to time their trades wisely.

 

Moving Average Convergence Divergence

Another popular indicator is the moving average convergence divergence, more commonly referred to as the MACD. Although the construction of the MACD is quite simple, it is nonetheless quite powerful. The MACD is simply the difference between a short-term exponential moving average and a longer-term exponential moving average. The most common combination is that of a 12-period exponential moving average with a 26-period exponential moving average. 

Another line is plotted alongside the MACD for interpretation purposes and is called the signal or trigger line. The signal line is often a nine-period exponential moving average of the MACD itself. Both lines are then plotted on either side of zero. If the shorter-term moving average is above the longer-term moving average, the MACD will be above zero and vice versa.

You can see a MACD plotted on a daily chart of the USD/CHF below with the 30 and 70 lines marked.

202010-MACD

Advantages to MACD

This indicator is great for evaluating both momentum and trends and is more robust in the data points informing its insights than other indicators you may incorporate into your strategy.

Disadvantages to MACD

Because the time frame and other parameters of MACD are so frequently changed or customized, this indicator offers less of an objective frame of reference than other indicators and may mislead traders who customize the indicator to serve up more attractive insights.

Stochastic Oscillator

The stochastic oscillator is another popular indicator that is widely used by traders. The underlying premise is that when the price is rising, it tends to close near the high of a recent period, and when it is falling, the price closes near its low. The stochastic RSI measures the price relative to the high/low range over a set period, thus indicating where it is presently trading within its recent trading range.

The stochastic oscillator is plotted between the values of zero and 100 and has reference lines placed at 20 and 80. 

When comparing stochastic RSI and RSI as technical indicators, it’s important to note when the stochastic oscillator crosses the reference lines. When it crosses up above 20, this is interpreted as a buy signal, and when it crosses down below 80, it is interpreted as a sell signal. Another way of interpreting the stochastic oscillator is to consider readings below 20 to be oversold and readings above 80 to be overbought. 

You can see a stochastic oscillator plotted on a daily chart of the USD/CHF below with the 20 and 80 lines marked.

202010-Stoch

Advantages to Stochastic

The clear values for stochastic RSI offer clear entry and exit signals when planning your positions.

Disadvantages to Stochastic

When deciding between stochastic RSI and RSI as your go-to indicator, remember that both of these indicators don’t offer insights into the timelines you should expect when holding a position—which could push some traders out of their comfort zones.

 

Which Indicator to Choose?

Where there are hundreds of technical indicators that have been developed over the years, it’s easy to get overwhelmed by your options when building out a trading strategy. How can you know which indicators are the right ones for you? And, if there are so many indicators taking so many different approaches, why is it important to use indicators at all?

These questions have troubled traders for years—and there’s no end in sight. When looking for the right indicator to use, consider the indicators that have proven value to you, your mentors, or other forex experts you have learned to trust. 

Numerous texts include the more popular indicators, and many people assume that because they are so widely documented, they must be the best indicators to use. Many losing traders rely too heavily on these indicators and the very mechanical systems that use them. Similarly, many traders wouldn’t be able to provide a brief overview of how the indicator is constructed, let alone a more detailed explanation of why it should be used. Furthermore, they often won’t consider using any other variables other than those declared as the defaults or the variables that the creator of the indicator stipulated.

You will also find that profitable traders who do use them will often take the time to learn the actual mathematical construction of the various technical indicators to fully understand what each is displaying. They likely could construct them manually if the need arose. The importance of this is that they fully understand what the indicator is designed to achieve and, therefore, the best way to interpret it and apply it practically. You will also find other traders who have developed simple indicators themselves to assist them with their decision-making.

With time and experience, you will identify your preferred indicators to use as well as how, where, and in what combinations you want to apply them to your trading strategy. Although the temptation can often be to develop a highly complex strategy incorporating a number of different indicators, many traders find it easier and more effective to simplify their approach and strike a balance between accuracy analysis and cost-effective time management with an overall goal of maximizing your long-term profit potential.

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Disclaimer:

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.

This post was written by Graeme Watkins

CEO Valutrades Limited, Graeme Watkins is an FX and CFD market veteran with more than 10 years experience. Key roles include management, senior systems and controls, sales, project management and operations. Graeme has help significant roles for both brokerages and technology platforms.

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