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The Value of Indicators: MACD, RSI, Stochastic Oscillator

   

december-forex-recap

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

Unfortunately, one of the things underpinning the effectiveness of fundamental analysis is that all market participants act in a rational manner. Therefore, the value of indices, or commodities or currencies will track a reasonable expectation based on fundamental influences.  I say unfortunately as many market participants can be gripped by fear and greed and act in a manner that is anything but rational.

I have found that the main approach for most traders is 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 and demand of a financial product could be discussed for hours. However, 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, to a great extent, the present levels of supply and demand for a financial product, and what market participants may be thinking, and can therefore analyse it as a potential trade.

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.

I would like to take some time describing 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 several ways. A popular approach is to buy and sell when the RSI crosses the reference lines; that is, 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 USDCHF below with the 30 and 70 lines marked.  

202010-RSI

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 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 USDCHF below with the 30 and 70 lines marked.

202010-MACD

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 Oscillator measures the price relative to the high/low range over a set period, thus providing an indication of 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. 

The Stochastic Oscillator can be interpreted a few ways. One method is 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 USDCHF below with the 20 and 80 lines marked.

202010-Stoch

Which Indicator to Choose?

The truth is that I could keep going here for a long time, introducing the hundreds of technical indicators that have been developed over the years, but I am not going to do that.  This presents some interesting questions. If there are hundreds of indicators, then which one(s) should you use?   If there are hundreds of indicators available, then why I have chosen to introduce only these few in this article? Do you need to use any indicators?

These questions have troubled traders for years and will continue to do so. I went through the search myself, looking for the right indicator to use, and every time I heard someone new present a seminar about trading, I ended up considering the indicators that I had learnt about during the presentation in my own trading. I used to think as a lot of people do - that is, ‘If he or she is using these indicators, then they must work, so I am going to use them’.

Numerous texts include the more popular indicators, and many people assume that as they are so widely documented, they must be the best indicators to use. I believe that many losing traders rely too heavily on these indicators and the very mechanical systems that use them. Many would not 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, often they will not consider using any other variables other than those declared as the defaults or the variables that the creator of the indicator stipulated.

What you will also find is 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. It is likely that they 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 of interpreting it and applying it practically. You will also find other traders who have developed simple indicators themselves to assist them with their decision-making.

Even though I have introduced these indicators to you, I must honestly tell you that I personally don’t use any of them, and haven’t for many years now. The indicators briefly mentioned in this article were chosen because I believe them to be some of the more popular indicators, used by the greatest number of traders.

I am not saying that they don’t work or that they won’t assist you with your trading. I tested the various indicators to see if they would provide me with a significant advantage in my trading, and for me, they all came up negative. I therefore questioned the need to use any of them in my trading. The truth is that no indicator is infallible, and they often provide false signals. If they don’t provide a marked advantage to you, if they don’t provide you with an edge, then why use them?

The only indicators I use are some moving averages and a couple of quite simple indicators I developed myself, and most of them are limited to my entry decision only. The whole premise behind my use of indicators is to keep it simple.

Many argue that price is the best indicator. Studying price action might be the best way to anticipate price movement and identify the most likely outcome.

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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.

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