Reading Market Indicators
If you frequent forex forums, this word will undoubtedly haunt you. Indicators. Everyone's talking about them, but what are they? What do they mean? And more importantly, how can they help you make better decisions when you trade?
The dictionary defines indicators as "a pointing or directing device, as a pointer on the dial of an instrument to show pressure, temperature, speed, volume or the like". In forex, an indicator is an equation that gathers past data in order to provide some sort of insight as to where the market may move.
I'm going to be going in alphabetical order listing all of the popular indicators, what they represent, and how traders use them to estimate future market movement.
This indicator is comprised of the nought line (featured as a blue line in the Rumus platform), the AC Red and the AC Green. The point of this indicator is to measure the acceleration and deceleration of the driving force of the market.
How do traders read this indicator?
Open Rumus and drag the indicator Acceleration Deceleration Oscillator (AC) onto a chart. Look at the vertical lines. When you see that these vertical lines are above the nought line (blue) and there are two green bars next to one another, this is an indication to buy. If you see that the lines are below the line and there are two red bars next to one another, this is an indication to sell.
Here's an example:
In the example above, we see 5 instances where positions could be opened according to the AC indicator. If you followed the rules of the AC indicator, you could have raked in roughly 500 pips!
Created by Marc Chaikin, this volume indicator measures the supply and demand of a currency by calculating the amount of people going long or short on a trade.
The formula for the Accumulation/Distribution indicator is:
Acc/Dist = ((Close – Low) – (High – Close)) / (High – Low) * Period's volume
How to read it:
When the indicator rises, this signifies a period of buying, where many traders are speculated to be buying this specific currency. A decrease in the indicator signifies a period where traders are selling the pair.
In the example above, we can speculate that many traders are longing the GBP/USD, as the Accumulation/Distribution line appears to be at a 15 day high. If you had gone long, as the indicator had told you, you would have found that the GBP/USD topped off at 1.6859 on November 16th!! That's a 300 pip profit!
The Alpha-Beta trend provides traders with a moving average price field (seen green on the Rumus platform) and two lines which act as a band. Within these bands is where we should expect price to travel.
The Aroon Indicator was created by Tushar Chande. Its purpose is to identify trends and trend reversals.
How it works:
The indicator is made up of two lines; the Aroon Down (blue in Rumus) and the Aroon Up (green in Rumus). As the names suggest, the Aroon Up measures the strength of uptrends while the Aroon Down measures the strength of downtrends. By looking towards the right of the indicators, you'll see a graph with values from 0-100. The higher up on the graph the Aroon lines cross, the stronger the trend.
When the Aroon Up moves above the Aroon Down, this indicates a bullish move. When the Aroon Down moves above the Aroon Up, this indicates a bearish move.
In this example, we see the Aroon Down crossing the Aroon Up from below, indicating a downtrend. If you followed this indicator, you could have made roughly 300 pips on this downtrend. The downtrend continues until their the Aroon Down crosses the Aroon Up from above at a relatively weak value of approximately 20, indicating an uptrend. If you were to reverse your position and sell, as indicated by the Aroon lines, you would have made an additional 150 pips on the uptrend!
It's full name is Average Directional movement Index, but we like to call it ADX for short. This indicator was created by Welles Wilder as an instrument to measure a trend's strength.
The equation for ADX is:
ADX = modify moving average of DX
DX = 100 x ( (+DI - -DI)/( +DI + -DI) )
+DI = +DMn / TRn , -DI = -DM / TRn
+DM = Ht - Ht-1 , -DM = Lt - Lt-1
CL = Ct - Ct-1
TR = largest of +DM,-DM ,and CL
+DI = current positive directional index
-DI = current negative directional index
+DMn = current modified moving average of +DM
+DM = current positive directional movement value
Ht = current hign
Ht-1 = previous high
Lt = current low
Lt-1 = previous low
-DMn = current modified moving average of -DM
-DM = current negative directional movement value
TRn = current modified modified moving average of the true range
TR = true range
n = number of periods
DX = current DX
reference from : J.Welles Wilder
Did you get that? If not, that's fine. You don't need to be a math champion to plot these graphs. You can easily graph the ADX, as well as all of the other indicators by using our Rumus platform.
Making the trade:
In the Rumus platform, the ADX line is a yellow line, while the DI+ line (Positive Directional Indicator) is red and the DI- line (Negative Directional Indicator) is blue. When the ADX (yellow line) is above 40, this indicates a strong trend. When the ADX is below 25, this indicates a weak trend. If you see the ADX indicator moving below 20, this is a sign that a new trend is developing, and that it may be a good time to make a move.
When should you enter a trade?
When the +DI (red) line crosses above the –DI (blue) line, this is an indication to BUY.
When you see the –DI (blue) line crossing above the +DI (red) line, this is an indication to SELL.
In the following picture, you can see that the ADX value (yellow line) is very low at 16, indicating that a new trend is emerging. At the same time, our –DI (blue) line is crossing above our +DI (red) line. What's the result? In this case, if you followed the ADX's rules, it resulted in a 185 pip profit.
The Average True Range. This indicator was another one of Welles Wilder's brain child. Using this indicator, traders can compare the current market with historical volatility.
The formula for this one is almost as hairy as the ADX's:
ATR(t) = TR(t) + TR(t-1) + … TR(t-n+1) / n
n= Moving Average period
TR(t) = MAX ( ABS(H(t) – L(t) ), ABS (H(t) – C(t-1) ), ABS (L(t) – C (t-1) )
H(t) = High
L(t) = Low
C(t) = Close
You can take out your calculator and start working, or you can access this indicator in the Rumus platform.
How does it work?
The ATR line moves up when the markets are more volatile and moves down when the markets are less volatile. It doesn't give any indication about market direction or duration.
The Awesome Oscillator.
The Awesome Oscillator is a neat indicator that has several different types of interpretations.
Zero Line Cross:
The first indication to buy or sell is the most obvious one; a buy signal is indicated when the AO Green line passes above 0, and a sell signal is indicated with the AO Red line passes below 0.
Slightly more complex; when there are two red bars followed by a green bar above the zero line, this is a buy signal. Conversely, if there are two green bars followed by a red bar below the zero line, this is a sell signal.
A buy signal is created when the histogram is below the zero line and the last indicators low is higher than the preceding low. The histogram must remain below zero between these two troughs. When the higher low is made and followed by a green bar the buy signal is generated.
A sell signal is created when the histogram is above the zero line and the last bars high is lower than the preceding peak. The histogram must remain above zero line between the two peaks. When the lower high is made and followed by a red bar a sell signal is generated.
Named after it's created, John Bollinger, this indicator is used by traders to compare relative price and volatility.
The bollinger indicator consists of three lines. The outer bands act as resistance points. If price touches the upper band, it is considered overbought. If price touches the lower band, it's considered underbought. What does this mean? It means that if prices touches one of the bands, there's very good chance that it'll bounce back.
If you take a look at the CAD/JPY day chart above, you'll see that when price touches the bands, it has a very good tendency to bounce back to the middle band.
The Commodity Channel Index is a momentum indicator created by Donald Lambert. The CCI measures price in relation to its moving average. This signals when the market is overbought/oversold or when a trend is weakening.
How it's used:
Most traders use this indicator to see if a currency is overbought or oversold.
When the CCI is above 100, this is a bullish signal.
When the CCI is below -100, this is a bearish signal.
In addition, some traders also believe that a cross from a negative to positive is potentially a bullish sign, while a cross from positive to negative is potentially a bearish sign.
In the example above, the CCI line is at -250, indicating an extremely bearish signal after price dipped over 100 pips. Using this indicator, a trader would have known to go long while the currency recouped and cashed in on the pips.
The Fractal Indicator is used to see Highs and Lows within trends and should be paired up with the Alligator Indicator.
Using the Fractal Indicator, traders shouldn't close a buy position if the fractal is below the Alligator's teeth and should not close a sell position if the fractal is higher than the Alligator's teeth.
The Ichimoku Cloud was created by a journalist known by the pseudonym Ichimoku Sanjin. It receives its name from the most noticeable aspect of the actual indicator; the Ichimoku Cloud or Kumo.
The Ichimoku Cloud is a series of five formulas and lines that, at first glance, can look very intimidating to a first time trader. The indicator is made up of two Senkou lines (the area between these lines is shaded in, making the cloud), a Tenkan line, a Kijun line and a Chikou Span.
Tenkan Line = (highest high + lowest low) / 2 Calculated over last 9 periods
Kijun Line = (highest high + lowest low) / 2 Calculated over last 26 periods
Chikou Span = (most current closing price plotted 26 time periods back)
Senkou Span A = (Tenkan line + Kijun Line) / 2 plotted 26 time periods ahead
Senkou Span B = (highest high + lowest low) / 2 calculated over past 52 time periods, sent 26 periods ahead.
Similar to the Bollinger Bands, the actual Ichimoku Cloud, or Kumo, represents resistance and support levels. If price moves above the cloud, we're in a bullish trend and the top of the cloud turns into the first support level, while the bottom of the cloud turns into the second support level. If price moves below the cloud, we're in a bearish trend, and the bottom of the cloud will act as a resistance level and the top of the cloud turns into the second resistance level. If price is moving within the cloud, there's no bias to the trend.
Tenkan & Kijun Lines
The market will move upwards when price is above the Kijun (shown purple in Rumus) line. When price is below the Kijun (purple) line, the market will move down.
The Tenkan (shown red in Rumus) line will show the direction of the trend.
These lines will tell us whether or not the trend is going to be bullish or bearish. When the Tenkan (red) line crosses the Kijun line (purple) from below, this tells us that the signal is bullish. When the Tenkan (red) line crosses the Kijun (purple) line from above, this tells us that the signal is bearish.
The Chikou Span
The Chikou Span (shown black in Rumus) shows us what price was 26 periods ago. How does this help us? Since price tends to move in trends, it gives us some insight to how strong a trend is. When the Chikou Span is below price, this indicates a bearish trend. When the Chikou Span is above price, we have a bullish trend.
Let's look at this example from a GBP/USD hour chart. The Chikou is below price, indicating a bearish trend. In the example above, we see that the Kijun crosses above the Tenkan when price is at 1.6017. Price then plows through both resistance levels of the Kumo. If we follow the rules of Ichimoku and sell when these lines cross and close when the Kijun crosses back below the Tenkan at 1.5783, we would have made a 234 pip profit.
The Moving Average indicator. It's one of the oldest and most widely expanded on indicators.
As the name suggests, the moving average reveals the average of price over a specific period of time.
The Moving Average Convergence/Divergence, created by Gerald Appel. This indicator can tell a trader when to buy or sell. This is a very simple indicator to read.
The indicator is composed of two lines; the MACD Fast (seen as a solid red line in Rumus) and MACD Slow (seen as a dotted blue line in Rumus).
When the MACD Fast (red) line crosses the MACD (blue) line from above, this is an indication to sell. When the MACD Fast (red) line crosses the MACD (blue) line from below, this is an indication to buy.
In this example of a GBP/USD hour chart, we can see that by following the indicators closely and open positions at the point where the MACD Fast and MACD Slow lines intersect; we could perform back to back BUY/SELL positions and make a considerable profit.
In theory, you can open and close positions each time the MACD Fast and MACD Slow cross and make profit. The only problem here is estimating when the indicators will cross. There's really no way of tell for how long price will ride, either. If only there was an indicator that could do this…
The Alligator indicator builds on what the MACD indicator lacks. The indicator consists of three lines; all of which are smoothed moving averages. There's the blue line (considered the Alligator's Jaw), which is a 13 period Moving Average moved 8 bars into the future, the red line (considered the Alligator's Teeth), which is an 8 period Moving Average moved 5 bars into the future, and the green line (considered the Alligator's Lips), which is a 5 period Moving Average moved 3 bars into the future.
The concept for the Alligator is similar to the MACD. When the Alligator's Lips (the green line, which is the fastest line here) crosses the other lines from above, the action to take is a short position. When the Lips are crossing the other lines from below, the action is a long position. When all three lines are moving together as a whole, the alligator's mouth is wide open and a position should be held until its jaws snap close.
In the example above (a GBP/USD hour chart), we can see three instances when the Alligator's jaws were wide open. If you followed the indicator and had patience, you could have made more than 500 pips in the ten day span.
The Money Flow Index. This momentum indicator is similar to the RSI indicator.
How it is used:
When the indicator is above 80, it's considered overbought. Below 20 suggests that it's oversold.
The momentum indicator measures the speed at which price changes. When using the momentum indicator, if the line is above 0, the price has upwards momentum. When the indicator is below 0, the price has downwards momentum.
The Parabolic Stop and Reversal.
The Parabolic SAR indicator is used to identify downtrends and uptrends in the market and is used by some traders as a trailing stop indicator. The indicator is comprised of PSAR dots, which appear either above price, indicating a downtrend, or below price, indicating an uptrend.
In the USD/CHF hour graph above, traders can see that when the PSAR dots are below the price bar, the indication is a bullish trend. PSAR dots above price is a clear indication of a bearish trend.
Pivot points are simply three levels of resistance and three levels of support. Now only if reading the lines were simple, we'd all be rich.
The formula for Pivot Points isn't difficult to come up with:
Resistance 3 = High + 2*(Pivot - Low)
Resistance 1 = 2 * Pivot - Low
Pivot Point = ( High + Close + Low )/3
Support 1 = 2 * Pivot - High
Support 2 = Pivot - (R1 - S1)
Support 3 = Low - 2*(High - Pivot)
We have to look at price when the market opens. If price is above the pivot point, then we'll have a bias to long trades on this day. If price is below the pivot, we'll have a bias to short trades on this day.
When trading with pivot points, it's very important to look at R1 and S1 for reversals or breakthroughs. Determining whether or price will break or reversal can be extremely hard to do.
The Price Chanel indicator was created to aide traders reading Elliot waves. By itself, this indicator can be useful by providing lines of resistance and support. In addition, when the indicator is in a downward slope, this signifies a bearish trend, while an upward slope signifies a bullish trend.
The Price Oscillator is the difference between two moving averages. Traders use this oscillator to determine trends.
How to read it:
Bullish Trends: Using the Price Oscillator, we know a bullish trend is occurring when:
- Price makes a lower low while the Oscillator makes a higher low.
- Price makes a higher low while the Oscillator makes a lower low.
Bearish Trends: Using the Price Oscillator, we know a bearish trend is occurring when:
- Price makes a higher high while the Oscillator makes a lower high.
- Price makes a lower high while the Oscillator makes a higher high.
Look below for an example of how to read the chart.
In the example above, we see that a Bullish Hidden Divergence is forming, since price is making a higher low while the oscillator makes a lower low. The result was a bullish trend that would have won you approximately 150 pips.
The Relative Strength Index indicator. This indicator can tell a trader whether or not a currency is overbought or oversold.
RSI = 100 – (100 / 1+RS)
RS= Average of x days' up closes / Average of x days' down closes
If you look at the RSI indicator, you'll see that the indicator is measured from a range between 0 and 100. If the indicator is above 70, the currency is considered overbought, and if the indicator is below 30, it's underbought.
Above is a EUR/USD hour chart. Towards the left side of the chart, you can see that the RSI indicator deemed the currency underbought. If opened a long position when the indicator dipped, you could have made roughly 200 pips.
If you're a fan of the RSI and MACD indicators, the Stochastic Indicator will be perfect for you. This indicator is a combination of both indicators, giving traders a clear point of entry (via Moving Averages) while seeing whether or not the currency is overbought or underbought.
Let's take a look at the same example using Stochastic Indicators:
As you can see, all entry points are labeled using moving averages while the trader has a good idea of whether or not the currency is underbought or overbought.
This indicator, created by Larry Williams, is similar to the Stochastic Indicator, and is used by traders to determine whether or not a currency is overbought or oversold. Whereas the Stochastic Indicator has internal smoothing, William's Indicator is plotted on an upside-down scale (0 on top and 100 at bottom). How does it work?
A common practice amongst William's Percentage Range users is to buy when %R reaches 100% and to sell when %R reaches 0%.
The ZigZag indicator focuses only on important price reversals to give traders a very plain and rigid view of how price has moved.
** The above charts were made using the Rumus trading platform. Charts and indicators are available on the Rumus trading platform.