Did you know that most trading platforms offer in excess of 100 indicators? This, as you can imagine, often leaves traders overwhelmed, particularly in the earlier junctures of their journey.
Before we get into the ‘meat and potatoes’ here though, remember that the best indicator will always be the one that suits YOUR trading style and personality. To help with this, the team have collaborated and come up with three of, what we believe to be, the most useful technical indicators on the market.
So, without further ado, let’s jump right in and look at our first indicator on the list: the Relative Strength Index, which is a real personal favourite of ours.
Developed by J. Welles Wilder, the Relative Strength Index, or RSI, is a momentum oscillator. This is an incredibly popular indicator among market technicians, and comes as standard (calculation based on 14 periods) on the MT4 platform.
The indicator’s primary use is to identify overbought and oversold readings in the market. Traditionally, an RSI value beyond 70 indicates overbought conditions, whereas an RSI value below 30 suggests oversold conditions. An example of such is shown below:
Because the RSI can create false signals, some traders elect to use more extreme values of 80-20 as shown on the chart below.
During strong trends, traders also need to be aware that the RSI can remain overbought or oversold (depending on which direction the trend is facing) for extended periods of time. This is important to recognize since it can lead to numerous false signals. Here’s a good example of this at work on the H4 timeframe, although the last overbought reading actually saw the pair retrace:
Something else we feel worthy of attention is the RSI often forms structures which may not be visible on the candlestick chart. Trendlines, support and resistance, double bottoms and tops are just some of the technical formations to keep an eyeball on.
On the M30 chart below, you’ll see the trendline support drawn on the RSI suffered a break marked by a green check. From a technical perspective, this shows that the USD/JPY was likely in the phase of weakening. On this occasion, it was correct. Following the RSI trendline break, the candles popped to a fresh high and then shortly after aggressively declined in value.
Another interesting setup was a basic resistance turned support pattern on the RSI, again denoted by a green check mark. What should stand out here is that the candles failed to make it back to price support, while the RSI support was respected. Of course though, this could have easily ended with the RSI support being ignored and the candle support coming into play.
A final point we want to touch on regarding the RSI is divergence. Put simply, divergence occurs when the underlying price (the candles) prints a new high/low that is not confirmed by the RSI indicator. The chart below shows two examples of divergence in action. To the left, we have negative bearish divergence. This basically means that although the candlesticks put in a fresh high, the RSI suggests a sluggish market by printing a lower high. To the right, we have the same scenario in view, but in the opposite direction (bullish divergence). As you can see, the candlesticks put in a lower low, while the RSI printed a higher low, indicating a possible reversal might be at hand.
Our second indicator on the list, also developed by J. Welles Wilder, is the average true range or ‘ATR’ for short. By and of itself, this indicator is used to measure volatility.
Similar to the RSI discussed above, the ATR also comes as standard on MT4 platforms with a default value set at 14.The ATR appears on the chart in the shape of a moving average and measures the average range of a pre-determined number of sessions in pips.
At the top left-hand corner of the ATR window on the EUR/USD daily chart below, you’ll notice two important values highlighted (green arrows): 14 and 0.0090.
14 communicates to the trader the number of periods being calculated, and 0.0090 indicates, on average, how many pips the instrument ranged over the last 14 periods (or days in this case). What this does is give you a probable range of 90 pips to look for the following candle/day.
When the ATR line rises in value, this signals that volatility is increasing. Conversely, a decline implies volatility is decreasing. What the ATR does not do is signify which direction the market is moving.
There are a number of ways one can use this indicator to their advantage. A key use, however, is to determine how much a pair is likely to move. For example, looking at the chart plotted above, we can expect price to correct once the major has achieved 90 pips.
Using the diagram below, we look to measure the distance, or true range, in the following ways:
Another interesting feature this indicator offers is the ability to help determine how far a stop-loss order or take-profit level should be set. Take the H4 EUR/USD chart shown below as an example. Imagine the pair just connected with the current support and price already (for educational purposes) moved 20 pips from the previous candle close. Therefore, knowing that the ATR value shows 39 pips, placing the stop 10/15 pips below this level is probably not the best move, given price could easily stretch 20 pips beyond the level. In this case, we’d personally look to have a stop of at least 30 pips, thus clearing ATR value and allowing the trade some room to breathe.
Like the RSI and ATR, moving averages are lagging indicators and also come as standard on MT4 platforms. Of itself a moving average is used to smooth out price fluctuations over a given period.
For the purpose of this section, we’re going to hone in on the simple (SMA) and exponential (EMA) moving averages, which are both displayed on the chart below (calculated using a value of 200 periods).
Basically, the slower the moving average, the smoother it’ll appear on the chart as it’s calculated over a longer period. The 200 moving averages are considered relatively slow – notice that despite the ebbs and flows of surrounding price action, the lines remained reasonably content.
If you were to plot a 14 EMA (a considerably faster moving average) as seen on the chart below, you will quickly see the difference:
By this point, you may be asking yourself what the difference between the two moving averages is. The only difference is the sensitivity between the two calculations. The EMA applies a higher weighting to RECENT prices, whereas the SMA assigns EQUAL weighting to all values.
Let’s calculate the simple moving average to give you an idea of what we mean. To calculate a 5 SMA, you simply divide the number of five price closing points by the total number in the series. So, let’s say that price closed at 1.2000 on the first day, the second day at 1.2050, third at 1.2120, fourth at 1.2100 and on the fifth day price closed at 1.2200. So, 1.2000+1.2050+1.2120+1.2100+1.2200 = 6.047, therefore a 5-period SMA (6.047/5) = 1.2094. In our example above, the EMA would put more weight on more recent prices: days 3, 4 and 5 and would therefore be slightly more sensitive. All platforms do this calculation for you, so we see little point in drowning ourselves in the math any further.
So, how are these lines helpful to traders? One well-known technique is using moving averages to determine the current trend. If price action remains above the moving average, then the uptrend is considered intact. A sustained move below the moving average, however, portends a down trending market. Using the charts above, the 200 SMA/EMA indicates that H4 price is still trading in an uptrend, while the 14 EMA shows the buyers and sellers currently battling for position.
Another popular technique is the moving average crossover. This can be used as either part of an entry method, or to indicate a potential trend change. Looking at the M15 chart below, we can see that the EMAs crossover at certain points and thus signal a buy or sell trigger.
Personally, we would advise only using this as an entry technique when united with other technical tools. For instance, an EMA crossover positioned within a strong supply or at the underside of a resistance level would add weight to the crossover coming to fruition, and producing a profitable sell trade.
Another use is to use these lines as dynamic support and resistance. Using the same M15 chart below, we’ve plotted the 200 EMA to show points of potential support and resistance:
Just to be clear though, we’re not advocating trading this as a lone indicator. It’s ALWAYS best when the line fuses with other technical tools.
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