The Effective Use of Technical Indicators

Technical traders often compute and plot mathematical quantities based on market observables like price and volume in order to indicate the past or present state of the market. They can often also use certain specific recognizable behaviors of these so-called technical indicators to predict the future behavior of the market and to generate buy and sell signals.

As useful as technical indicators can be to the forex trader, their effective use often requires keeping the number of indicators consulted down to a manageable level in order to facilitate quick trading decisions.

The following sections will cover some of the more popular technical indicators that many forex traders have found efficient and effective to use in practice when trading.

Popular Technical Indicators

A set of the most commonly followed technical indicators that can be used as a basic group to get started analyzing forex price action with might include the following:

• Moving Averages

Computing moving averages involves taking the average of price action seen over a moving range of time periods. They can be simple, exponential or weighted, where more weight will generally be given to more recent price data.

Moving averages are lagging indicators so traders will often use them to smooth the price action and help them identify trends. Furthermore, the convergence of moving averages of different time periods generates trading signals and can be measured with a Moving Average Convergence Divergence (MACD) histogram.

• Oscillators

Oscillators usually give the trader an indication of price momentum and/or an oversold or overbought condition in the market, and when they are measured on a scale of 0 to 100% they are known as banded oscillators.

Divergence of many oscillator indicators relative to the corresponding price action has important implications for possible market reversals.

Some popular oscillators are discussed further below.

o       The Relative Strength Index or RSI - The RSI is a very popular and useful indicator of overbought or oversold market conditions, and since it fluctuates in value between 0 and 100, it is considered a banded oscillator. If the index is showing a number higher than 70, then the market is though to be overbought, but if the number is below 30, then the market is oversold.

o       The Stochastics Oscillator - The Stochastics are a popular example of a momentum indicator. Its basic premise is that in an uptrend, prices tend to close in the higher part of the day's range to signal upward momentum. Conversely, while in a downtrend, closing prices tend to close in the lower part of the day's range, indicating downward momentum.

• Historical Volatility

Forex traders, and especially those trading currency options, often compute historical volatility for some specific time period. They generally do so by determining the annualized standard deviation of price movements during the chosen time frame.

Forex traders can use historical volatility to assess risk levels prevailing in the market for the particular current pair. This information can then be useful in appropriately sizing positions for risk management purposes.

• Volume and On Balance Volume

Many technical analysts look at the trading volume statistics or the On Balance Volume indicator for a particular currency pair to confirm price breakouts for chart patterns and to support or negate other technical indicator trade signals.

Keeping it Simple

One of the keys to using technical indicators effectively is to keep the number of indicators you watch to generate trading signals down to a minimum that will still show consistent profitability.

Basically, the risk of falling into the trading trap of "analysis paralysis" increases the more technical indicators you need to consult before making a trading decision.

Remember, the forex market often moves quickly, especially when key technical indicators or chart patterns forecast important exchange rate movements. As a result, any unnecessary delay in entering the market can be quite costly and may even turn what would initially have been a winning position into a losing one.