Common Uses for Technical Indicators

[RichardCox 10]

Traders looking for the perfect moment to open or close a trade are often disappointed because there is such a wide variety of methods that can be used to identify that ideal moment and commit to a decision. Because of this, traders should be aware of the ways indicators are commonly used so that the best timeto buy or sell a currency can be more easily determined. Here we will look at four broad approaches for using technical indicators to identity these decision points.

 

Indicators as Tools for Trend Following

 

For traders that find contrarian approaches too nerve-racking, a more common alternative (used by the majority of traders in the forex markets) involves identifying the dominant trend in a forex pair and then placing trades in that same direction. Mistakes can often occur, however, when trend-following tools are used as trading systems in themselves and while this can lead to potential profits, the true purpose of these tools is to identify the dominant direction and to place appropriate trade (either a buy or sell).

 

Since most technical traders tend to have moving averages on their charts, an example can be seen in a bullish or bearish crossover. While there is generally a wide range of answers for which moving average combination is the best, the reality is that there is no superior combination, as some moving average combos will tend to work better on different time frames. The main point to remember, however, is that these tools are meant to be used in order to determine a directional bias more than they are to be used as a way to time trade entries or exits.

 

Indicators as Tools to Confirm Those Trends

 

Once a trend-following tool is used to identify the dominant trend, the next step is to determine the reliability of the initial indicator (as a means for avoiding choppy trading conditions). Here, indicators can be used to confirm trends but, in contrast with the first category, these tools are meant to be used in order to substantiate an initial bias and increase the probability of a successful outcome (but not necessarily identify an actual trend direction). In the best case scenario, the trend following and trend confirming tools will agree, and make it easier to isolate suitable trading opportunities.

 

An example of a trend confirmation indicator can be seen with the MACD, which measures the difference between two EMAs and then compares this calculation to its own moving average. Traders can use indicators like the MACD to confirm the validity of a bullish or bearish trend. Other examples include the Rate of Change indicator (ROC), but there is a wide variety of choices that can be accessed in your trading station.

 

Using Indicators to Identify Overbought and Oversold Conditions

 

The next issue to consider is whether or not to jump into a trade as soon as a signal agreement is identified, or to wait for pullbacks within the trend. Getting into the trade quickly can lead to less favorable entry levels, but, at the same time, waiting for pullbacks (which might not actually materialize) can lead to missed trades. To help make this decision, indicators can be used as a tool for identifying overbought and oversold conditions. One of the most common choices is the RSI indicator, which calculates the sum total of positive days and negative days over a given time period and assigns an accompanying value between zero and 100.

 

Trader thresholds for overbought and oversold territory can vary but, in general, RSI readings below 30 signal oversold conditions while readings above 70 suggest overbought conditions. More conversative traders will change these levels to 20/80 in order to remove lower probability signals. For this type indicator, traders again will be looking for agreement with other trading signals, as multiple this suggests a higher probability of accurate forecasting.

 

Using Indicators to Identify Profit-Taking Levels

 

Finally, we will look at the use of indicators as a way of determining when to take profits on a successful trade. The RSI indicator is one that can fit into a few different categories, with traders looking to exit long positions once prices become overbought or exiting sell positions once prices become oversold. So, looking at some alternatives, profit-taking can be aided with indicators like Bollinger Bands, which are calculated by adding and subtracting the standard deviations of changes in price data over a given time period.

 

Many traders use Bollinger Bands to time trade entries, but in many cases, this indicator is more useful as a tool in profit-taking decisions. Traders in long positions typically take profits once prices reach the upper Bollinger Band, while those in short positions will exit on approach of the lower Band. Using indicators in these ways can help to take some of the mystery out of trading decisions and help to separate high probability exits and entries from those that are less suitable. With any trade, approaching indicator analysis from a variety of perspectives can help to reduce risk.