Reading Market Indicators: popular indicators, Part 1

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.

Acceleration Deceleration Oscillator (AC) , Accumulation/Distribution Line  , Alpha-Beta Trend , Aroon Indicators  , ADX Indicator , ATR , Awesome Oscillator , Bollinger ,CCI ,Fractal Indicator , Ichimoku Cloud ,MA

Acceleration Deceleration Oscillator (AC)

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!

Accumulation/Distribution Line

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!

Alpha-Beta Trend

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.

Aroon Indicators

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!

ADX Indicator

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 where : +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.

ATR

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 where: 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.

Awesome Oscillator

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. Saucer: 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. Twin Peaks: 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.

Bollinger

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.

CCI

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.

Fractal Indicator

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.

Ichimoku Cloud

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. Formulas: 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. The Kumo: 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.

MA

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.