I do know many forex traders had spend their time looking for that perfect moment to enter the markets or a telltale sign that screams "buy" or "sell". And while the search can be fascinating, the result is always the same. The truth is, there is no one way to trade the forex markets. As a result, successful traders must learn that there are a variety of indicators that can help to determine the best time to buy or sell a forex cross rate.
Here are four different market indicators that most successful forex traders rely upon while trading.
Indicator No.1: A Trend-Following Tool
It is possible to make money using a countertrend approach to trading. However, for most traders the easier approach is to recognize the direction of the major trend and attempt to profit by trading in the trend's direction. This is where trend-following tools come into play. Many people misunderstand the purpose of trend-following tools and try to use them as separate trading systems.
While this is possible, the real purpose of a trend-following tool is to suggest whether you should be looking to enter a long position or a short position. So let's consider one of the simplest trend-following methods – the moving average crossover.
A simple moving average represents the average closing price over the number of days in question.
Indicator No.2: A Trend-Confirmation Tool
Now we have a trend-following tool to tell us whether the major trend of a given currency pair is up or down. But how reliable is that indicator? As mentioned earlier, trend-following tools are prone to being whipsawed. So it would be nice to have a way to gauge whether the current trend-following indicator is correct or not. For this, we will employ a trend-confirmation tool. Much like a trend-following tool, a trend-confirmation tool may or may not be intended to generate specific buy and sell signals. Instead, we are looking to see if the trend-following tool and the trend-confirmation tool agree.
In essence, if both the trend-following tool and the trend-confirmation tool are bullish, then a trader can more confidently consider taking a long trade in the currency pair in question. Likewise, if both are bearish, then the trader can focus on finding an opportunity to sell short the pair in question.
One of the most popular – and useful – trend confirmation tools is known as the moving average convergence divergence (MACD). This indicator first measures the difference between two exponentially smoothed moving averages.
Indicator No.3: An Overbought/Oversold Tool
While traders are typically well advised to trade in the direction of the major trend, one must still decide whether he or she is more comfortable jumping in as soon as a clear trend is established or after a pullback occurs. In other words, if the trend is determined to be bullish, the choice becomes whether to buy into strength or buy into weakness. If you decide to get in as quickly as possible, you can consider entering a trade as soon as an uptrend or downtrend is confirmed. On the other hand, you could wait for a pullback within the larger overall primary trend in the hope that this offers a lower risk opportunity. For this, a trader will rely on an overbought/oversold indicator.
There are many indicators that can fit this bill. However, one that is useful from a trading standpoint is the three-day relative strength index, or three-day RSI for short. This indicator calculates the cumulative sum of up days and down days over the window period and calculates a value that can range from zero to 100. If all of the price action is to the upside, the indicator will approach 100; if all of the price action is to the downside, then the indicator will approach zero. A reading of 50 is considered neutral.
Indicator No.4: A Profit-Taking Tool
The last type of indicator that a forex trader needs is something to help determine when to take a profit on a winning trade. Here too, there are many choices available. In fact, the three-day RSI can also fit into this category. In other words, a trader holding a long position might consider taking some profits if the three-day RSI rises to a high level of 80 or more. Conversely, a trader holding a short position might consider taking some profit if the three-day RSI declines to a low level, such as 20 or less.
Another useful profit-taking tool is a popular indicator known as Bollinger Bands®. This tool adds and subtracts the standard deviation of price data changes over a period from the average closing price over that same time frame to create trading "bands". While many traders attempt to use Bollinger Bands® to time the entry of trades, they may be even more useful as a profit-taking tool.
