The most powerful tool of any forex trader is being able to identify whether the market is in trend or not, being able to work out if a trend is beginning or ending. Mastering this knowledge is one of the most powerful tools you can have as a forex trader. The strength of a trend is mostly referred to as momentum and there are several Momentum indicators, which are a type of Oscillator, that can measure this.
Momentum indicators vary between two points on a graph to indicate oversold and overbought positions. They are used as a signal to confirm a strong trend as well as trend reversal. The calculation behind the momentum indicator is the comparison between a certain price and price set a few periods before that.
The following are the most famous and commonly used indicators, the RSI, Stochastic Oscillator, Parabolic SAR, MACD, Moving Average and ADX.
RSI (Relative Strength Index)
The RSI indicates overbought conditions due for correction when the indicator is over 70 and oversold conditions due for bounce when the indicator is below 30. While these conditions can be accurate on occasion, they cannot provide accurate signals for trend traders.
It is very important to note that during strong trends the RSI may remain in overbought or oversold positions for extended periods of time. In an uptrend the RSI tends to be in the 40 – 90 range with the 40 – 50 zone acting as support. Conversely in a downtrend it stays in the 10 to 60 range with 50 – 60 zone acting as resistance.
The Stochastic Oscillator is similar in use to the RSI as it also identifies overbought and oversold positions. The Stochastic is scaled from 0 – 100 and when its above the 80 dotted line it indicates overbought conditions and when its below the 20 dotted line, oversold conditions.
As with the RSI, Stochastic overbought conditions do not necessarily mean bearish conditions as this may be sustained over a longer period of time in a strong uptrend, similarly oversold conditions may remain so over a sustained period in a strong downtrend. The settings that work best for me on this indicator are 14 for the K Period, 3 for the D Period and 1 for Slowing.
I found the Parabolic SAR to be one of the easiest indicators to use because of its simplicity. The Parabolic SAR plots dots or points in a chart to indicate potential price reversals in price movements. When the dots are below the candles, that’s a buy signal and if they are above the candles that’s a sell signal.
It should be worth noting that this indicator must be used in trending markets that have long rallies and downturns, not in choppy markets where the price movement is sideways. The indicator is also very good in determining whether you should close your position or keep it open.
MACD (Moving Average Convergence Divergence)
The MACD indicator is used to reveal changes in strength, direction, momentum and duration of a trend. This indicator normally has 3 numbers as its default settings, 12, 26, 9. So how do you interpret this numbers.
12 is the number of periods used to calculate the faster moving average. It represents the 12 previous bars of the faster moving average.
26 is the number of periods used in calculating the slower moving average. It represents the 26 previous bars of the faster moving average.
9 is the number of bars used to calculate the moving average of the difference between the faster and slower moving averages. It represents the 9 previous bars of the difference between the two moving averages by plotting vertical lines called a histogram.
As the histogram plots the difference between the fast and slow moving averages and you will see as they separate the histogram gets bigger. This is called divergence where the faster moving average is diverging or moving away from the slower moving average. Convergence the happens when the faster moving average converges or moves closer to the slow moving average.
So how do you use the MACD to identify buy or sell signal? There’s two ways you can do this. When the MA’s go above the 0 line, that is a buy signal and conversely when they go below the 0 line that’s your cue to sell.
The other strategy to use is when the histogram crosses the moving average above the 0 line, this indicates a sell signal and when the crossover happens below the 0 line that’s your buy signal.
ADX (Average Directional Index)
This is one of my favourite a simplest indicators. The ADX fluctuates from 0 to 100 with readings above 50 indicating a strong trend and below 20 a weak trend.
Simple and straight forward like that.