Reading Market Indicators: popular indicators, Part 2

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.
MACD , Alligator Indicator , MFI , Momentum , Parabolic SAR , Pivot Points , Price Chanel , Price Oscillator , RSI Indicator , Stochastic Indicator , William’s Percentage Range Indicator , ZigZag

MACD

The Moving Average Convergence/Divergence, created by Gerald Appel. This indicator can tell a trader when to buy or sell. This is a very simple indicator to read. The indicator is composed of two lines; the MACD Fast (seen as a solid red line in Rumus) and MACD Slow (seen as a dotted blue line in Rumus). When the MACD Fast (red) line crosses the MACD (blue) line from above, this is an indication to sell. When the MACD Fast (red) line crosses the MACD (blue) line from below, this is an indication to buy.

In this example of a GBP/USD hour chart, we can see that by following the indicators closely and open positions at the point where the MACD Fast and MACD Slow lines intersect; we could perform back to back BUY/SELL positions and make a considerable profit. In theory, you can open and close positions each time the MACD Fast and MACD Slow cross and make profit. The only problem here is estimating when the indicators will cross. There’s really no way of tell for how long price will ride, either. If only there was an indicator that could do this…

Alligator Indicator

The Alligator indicator builds on what the MACD indicator lacks. The indicator consists of three lines; all of which are smoothed moving averages. There’s the blue line (considered the Alligator’s Jaw), which is a 13 period Moving Average moved 8 bars into the future, the red line (considered the Alligator’s Teeth), which is an 8 period Moving Average moved 5 bars into the future, and the green line (considered the Alligator’s Lips), which is a 5 period Moving Average moved 3 bars into the future. The concept for the Alligator is similar to the MACD. When the Alligator’s Lips (the green line, which is the fastest line here) crosses the other lines from above, the action to take is a short position. When the Lips are crossing the other lines from below, the action is a long position. When all three lines are moving together as a whole, the alligator’s mouth is wide open and a position should be held until its jaws snap close.

In the example above (a GBP/USD hour chart), we can see three instances when the Alligator’s jaws were wide open. If you followed the indicator and had patience, you could have made more than 500 pips in the ten day span.

MFI

The Money Flow Index. This momentum indicator is similar to the RSI indicator. How it is used: When the indicator is above 80, it’s considered overbought. Below 20 suggests that it’s oversold.

Momentum

The momentum indicator measures the speed at which price changes. When using the momentum indicator, if the line is above 0, the price has upwards momentum. When the indicator is below 0, the price has downwards momentum.

Parabolic SAR

The Parabolic Stop and Reversal. The Parabolic SAR indicator is used to identify downtrends and uptrends in the market and is used by some traders as a trailing stop indicator.  The indicator is comprised of PSAR dots, which appear either above price, indicating a downtrend, or below price, indicating an uptrend.

In the USD/CHF hour graph above, traders can see that when the PSAR dots are below the price bar, the indication is a bullish trend. PSAR dots above price is a clear indication of a bearish trend.

Pivot Points

Pivot points are simply three levels of resistance and three levels of support.  Now only if reading the lines were simple, we’d all be rich. Formula: The formula for Pivot Points isn’t difficult to come up with: Resistance 3 = High + 2*(Pivot - Low) Resistance 2 = Pivot + (R1 - S1) Resistance 1 = 2 * Pivot - Low Pivot Point = ( High + Close + Low )/3 Support 1 = 2 * Pivot - High Support 2 = Pivot - (R1 - S1) Support 3 = Low - 2*(High - Pivot) We have to look at price when the market opens.  If price is above the pivot point, then we’ll have a bias to long trades on this day.  If price is below the pivot, we’ll have a bias to short trades on this day. When trading with pivot points, it’s very important to look at R1 and S1 for reversals or breakthroughs.  Determining whether or price will break or reversal can be extremely hard to do.

Price Chanel

The Price Chanel indicator was created to aide traders reading Elliot waves. By itself, this indicator can be useful by providing lines of resistance and support. In addition, when the indicator is in a downward slope, this signifies a bearish trend, while an upward slope signifies a bullish trend.

Price Oscillator

The Price Oscillator is the difference between two moving averages.  Traders use this oscillator to determine trends. How to read it: Bullish Trends:  Using the Price Oscillator, we know a bullish trend is occurring when: Price makes a lower low while the Oscillator makes a higher low. Price makes a higher low while the Oscillator makes a lower low. Bearish Trends: Using the Price Oscillator, we know a bearish trend is occurring when: Price makes a higher high while the Oscillator makes a lower high. Price makes a lower high while the Oscillator makes a higher high. Look below for an example of how to read the chart.

In the example above, we see that a Bullish Hidden Divergence is forming, since price is making a higher low while the oscillator makes a lower low. The result was a bullish trend that would have won you approximately 150 pips.

RSI Indicator

The Relative Strength Index indicator.  This indicator can tell a trader whether or not a currency is overbought or oversold. Formula: RSI = 100 – (100 / 1+RS) RS= Average of x days’ up closes / Average of x days’ down closes If you look at the RSI indicator, you’ll see that the indicator is measured from a range between 0 and 100.  If the indicator is above 70, the currency is considered overbought, and if the indicator is below 30, it’s underbought.

Above is a EUR/USD hour chart. Towards the left side of the chart, you can see that the RSI indicator deemed the currency underbought. If opened a long position when the indicator dipped, you could have made roughly 200 pips.

Stochastic Indicator

If you’re a fan of the RSI and MACD indicators, the Stochastic Indicator will be perfect for you. This indicator is a combination of both indicators, giving traders a clear point of entry (via Moving Averages) while seeing whether or not the currency is overbought or underbought. Let’s take a look at the same example using Stochastic Indicators:

As you can see, all entry points are labeled using moving averages while the trader has a good idea of whether or not the currency is underbought or overbought.

William’s Percentage Range Indicator

This indicator, created by Larry Williams, is similar to the Stochastic Indicator, and is used by traders to determine whether or not a currency is overbought or oversold. Whereas the Stochastic Indicator has internal smoothing, William’s Indicator is plotted on an upside-down scale (0 on top and 100 at bottom). How does it work? A common practice amongst William’s Percentage Range users is to buy when %R reaches 100% and to sell when %R reaches 0%.

ZigZag

The ZigZag indicator focuses only on important price reversals to give traders a very plain and rigid view of how price has moved. ** The above charts were made using the Rumus trading platform. Charts and indicators are available on the Rumus trading platform.