Other Common Indicators explained by professional Forex trading experts the “ForexSQ” FX trading team.
Other Common Indicators
A Brief Overview
There are dozens of technical indicators and tools you can use to analyze the market. In this section you will get to know about the most popular ones.
We recommend you to study them all and choose those in which you have confidence and with which you feel intuitively comfortable. Following too many oscillators usually leads to confusion.
More specifically in this section you will learn about:
- Bollinger Band: A band which is plotted two standard deviations away from a simple moving average, developed by famous technical trader John Bollinger. It is one of the most popular technical analysis techniques.
- Parabolic SAR (Stop and Reverse): When trading on trending markets, it is equally important to identify when the trend ends. The parabolic SAR might be just what you need!
- Pivot Points: They can be used to quickly determine market sentiment as well as to locate support and resistance levels.
- Ichimoku Kinko Hyo: The aim of this indicator is to provide you with a broad view of prices with just a single glance.
- Average True Range Indicator (ATR): It is used to measure market volatility and it will help you set your stop losses correctly.
- Average Directional Index (ADX): It is typically used to identify whether the market is ranging or starting a new trend.
The Bollinger band is a technical indicator used to measure market volatility and it gets its name from its developer, John Bollinger. Prices are banded with an upper and lower band plotted two standard deviations away from a simple moving average.
Trading with the Bollinger Bands
There are two main ways to use Bollinger bands to help us in our trading.
Trading the Squeeze
The narrowing of the bands is called a squeeze and is often an early indication that the volatility is about to increase sharply. When the Bollinger bands squeeze together, it usually means that a breakout is about to happen.
Because standard deviation measures volatility, these bands will be wider during increased volatility and narrower during decreased volatility.
When prices break out of a squeeze, a new trend is formed, and prices either move to the upside or downside. Prior to the break out we do not know the direction of the price move but the squeeze in prices is a good notification of an impending break out.
If the candles start to break out above the top band, then the move will usually continue to go up. If the candles start to break out below the lower band, then the price will usually continue to the down side.
Looking at the chart below, you can see that after the bands get narrower during the squeeze, prices break out with greater volume and rally higher.
If prices break out above the upper band, a new uptrend may be developing. Wait for a candlestick signal and buy just above the breakout. You can enter a buy position after the first candle closes above the upper band.
If price breaks out below the lower band, a new downtrend may be developing. This is a good opportunity to sell just below the breakout point.
Using Bollinger Bands as Support and Resistance Levels
Another way to use Bollinger bands is to use them as support and resistance levels and trade the bounce.
One thing you can notice about prices within the Bollinger band is that they tend to bounce off the upper and lower bands. The reason these bounces occur is because Bollinger bands act like dynamic support and resistance levels.
Using the bounce trading strategy is best when the market is ranging. The reason is because when the market is ranging, the price tends to return to the middle of the bands. The strategy is to buy when the price touches the lowerband and to sell when price touches the upper band.
Let us look at an example now.
You can see on the chart that prices tend to return to the middle of the bands. So when prices hit the upper band, they tend to bounce off this resistance level and fall back down towards the middle of the band. Likewise, when prices approach the lower band, they tend to bounce off this level, just like a support level, and head back to the middle of the band.
Therefore, a position to buy can be entered when prices bounce off the lower band and move upwards and a sell position can be entered when prices bounce off the upper band to fall back down. This is the whole idea behind theBollinger bounce.
Parabolic SAR (Stop and Reverse)
The parabolic system is a time/price reversal system that uses stop losses. Once a stop loss is hit, it gives you a signal to reverse your position. The SAR indicator is a trend-following system that looks like a series of dots that tend to curve like a parabola.
How to Use SAR in Trading
This system works well in a trend but not on a range. It gives a good indication of when a trend has ended and reversed. At the beginning of the trend, an uptrend for example, the dots (SAR) start off slow then accelerate as the trend develops and the dots soon catch up to the price action.
Buy and Sell Signals
Referring to the chart above, as the price moves higher, the dots are below the trend moving higher and are seen as bullish. This is a buy signal. The dots are deemed to be bearish once they move above the prices and the trend changes. This is a sell signal.
If you are already in a position, the SAR can help you time when to exit – so if you are long and the trend reversed, shown by the SAR, then exit (close) your long position.
Pivot points can be used to quickly determine market sentiment, as well as to locate support and resistance levels.
The pivot point indicator is known as a predictive indicator as opposed to a lagging indicator like moving averages because it uses more recent data in its calculation. It is comprised usually of seven horizontal lines arranged from top to bottom. The actual pivot point line is located in the middle of all the lines, below the three resistance lines and above the three support lines.
Advantages of Pivot Points
- Pivot points can be used to find the level where the market sentiment may switch from bullish to bearish or vice versa. Hence they are good for determining entry point and exit points and also for confirming trend direction.
- When used to identify support and resistance levels they are more objective compared to Fibonacci levels which involve a bit of subjectivism. There is a specific formula for calculating pivot points, whereas when picking swing highs and swing lows to plot the Fibonacci tool, each trader can be subjective and has a different opinion of where the swings are.
- Pivot points are easy to calculate, using high, low, and close prices. We will look at the calculations later on.
- Pivot points are good for range trading as well as break out trading, and good for short term trading (day-trading). This is because you can take advantage of small price movements and trade between support and resistance levels. For example range trade or trade the bounce.
How to Calculate Pivot Points
You can calculate pivot points by using the open, high, low, and close price for the previous period.
For example to calculate today’s pivot points you use yesterday’s open, high, low, and close values. To calculate this week’ pivot points, use last week’s open, high, low, and close values. To calculate this month’s pivot points, you use last month’s open, high, low, and close values.
Note that the forex market never closes during the 5-day trading week so for the close price it is common to use the New York closing time of 4:00pm EST as the previous day’s close.
The classic formula for pivot points is as follows:
First we calculate the pivot point line (PP) and then support levels (S1, S2, S3) and resistance levels (R1, R2, R3) are calculated off the pivot point.
Pivot point PP = (HIGH + LOW + CLOSE) / 3
First resistance (R1) = (2 x PP) – Low
Second resistance (R2) = PP + (High – Low)
Third resistance (R3) = High + 2(PP – Low)
First support (S1) = (2 x PP) – High
Second support (S2) = PP – (High – Low)
Third support (S3) = Low – 2(High – PP)
Trading with Pivot Points
Pivot points can be used for trading different markets. You can use them in a range, or to trade with the trend, or can even be used to trade breakouts.
When trading the trend, pivot points help you determine market sentiment. So if the pivot point price is broken in an upward movement, then the market is bullish, and if broken in a downward trend, it is bearish. Range-bound traders will enter with a buy order near support levels. Otherwise they can place a sell order when the price is close to a resistance level.
If you are a breakout trader, you can use pivot point price levels to enter and exit a trade. For example, if the trend is up and the price breaks above a pivot level, you can enter a buy position and then place your stop loss below the pivot level. For your exit point, you can place your target profit around the next highest pivot level.
Example of Range Trading with Pivot Points
As we mentioned earlier, pivot point levels are just like support and resistance levels, so prices will likely repeat these levels. In other words, prices will approach a pivot level then reverse and bounce back. This in essence is the act of “pivoting”. The more times these pivot levels are tested, the stronger the level becomes and this will give you a good opportunity to enter a trade at this level.
On the chart below the scenario is that prices are trading sideways, in a range. Prices have been hovering at the first support level for some time, so it looks like this is strong support. You could enter a buy order at this level and target the pivot point level (PP) or the first resistance level (R1).
Set a stop loss at the second support level (S2) or just below it, in order to minimize losses in case the S1 support level breaks and prices fall. To confirm if the support level is strong, you could use other indicators such as stochastics to see if prices are in oversold territory.
Now look at the chart below, where the scenario is the following: prices did move higher and hit the first target level at the pivot point level.
However, you might have experienced an alternate scenario and prices could have fallen and broken below support S1 instead. Let us look at this case and how you could use this as a trading opportunity as well.
Playing the Breaks with Pivot Points
We know that ranges will not last forever and there will come a time when prices will break the pivot levels. You should be prepared for such a case. There are two ways to trade breakouts: the aggressive way or the safe way. If you prefer to be more conservative and safe, for instance, you could wait for prices to retest support and resistance and then enter a position.
Below is an example of a chart with potential breakout trades using pivot points.
Here we see prices were initially trading in a range between resistance levels R1 and R2. Then prices broke out of range. If you wanted to trade the aggressive way you would have bought right at the break out. But if you see on the chart, sometimes this method is risky. Sometimes there are false breakouts. In this example, prices did not continue moving higher and in fact moved back below the resistance level R3.
If you traded the safer way, you would wait after the breakout for prices to retest the pivot level. In this example, prices broke below R3 to move towards R2 but then retraced to retest R3. At this point you could have entered your sell position. Notice how R3, which was a resistance level, became support and then became resistance again. This role reversal of support and resistance helps you pick where to place your stop level.
Once a support level breaks, in theory, it will likely become support-turned-resistance level. Also once a resistance level breaks, it usually becomes resistance-turned-support. For example, if price broke R1 and moved up, you would buy after the break and place your stop level just below R1.
To set your profit target, aim for the next pivot point support or resistance level. Now look at the chart below:
Here you see that prices first broke above R1. You could set a stop loss level just below R1. Your first profit target is R2. Once R2 breaks, you could target R3 and your stop loss level (stop B) is now just below R2. If prices break above R3, place the stop loss below R3 (stop C).
Note that trading breakouts are more risky as prices move faster, especially in volatile markets if there is a news release. Also you are not sure if the breakout is a false one.
You could use momentum indicators to help you make better judgments about price direction. Also you could try recognize candlestick patterns.
Using Pivot Points to Determine Market Sentiment
In addition to using pivot points to determine entry and exit points when trading, they can also be used to gauge market sentiment. What this means is that you can tell whether traders are bullish or bearish. Are they more inclined to buy or sell?
The way you gauge sentiment is to focus on the pivot point and where prices are in relation to the pivot point. Depending on which side the price is on, you can tell whether buyers or sellers have the upper hand. Look at the EURUSD chart below for example. If the price breaks through the pivot point (PP) to move up, this is a sign that traders are more bullish on EURUSD and you could start buying.
After breaking the pivot point PP, prices then rise higher and higher, breaking through all the resistance levels, maintaining bullish sentiment. However, the alternate scenario is if the price breaks below the pivot point to move down, then you should start selling EURUSD. With the price being below the pivot point, this signals a bearish sentiment and that sellers could have the upper hand for this trading session.
Have a look at an example of bearish market sentiment.
In the chart above, we see that prices tested the pivot point PP, which held as a resistance level and so prices remained below PP, then moved lower and lower, confirming a bearish sentiment. In this case we see that sellers had the upper hand and this is an opportunity for you to sell.
Important to Keep in Mind!
As mentioned earlier, there could always be false breakouts. Do not just rely on pivot points. Use them in conjunction with other indicators such as momentum indicators, candlestick patterns, moving averages, etc. There are times when you think that traders are bearish on a currency pair, only to see that the pair reverses.
lets take the chart below as an example:
In this example, if you saw the price breaking lower from the pivot point you might have sold. However, you would have eventually lost money because later on in the trading session EURUSD moved back up, eventually breaking through the pivot point and moving higher and higher. What’s more, the pair stayed above the pivot point, showing how buyers have now taken control and market sentiment changed from bearish to bullish.
Consequently, you must always be cautious since traders can shift sentiment drastically, and use more than one indicator to gauge sentiment.
Here is a summary for using pivot point in trading:
- Pivot points are a technique used by traders to help determine potential support and resistance areas.
- Pivot points can be used for range, breakout, and trend trading.
- Range-bound traders will enter a buy order near identified levels of support and a sell order when prices approach near resistance.
- Pivot points also allow breakout traders to identify key levels that need to be broken for a move to qualify as a strong momentum move.
- Sentiment (trend) traders use pivot points to help determine the bullishness or bearishness of a currency pair.
- Using pivot point analysis alone is not always enough. Use them in combination with other technical analysis tools such as candlestick patterns, MACD crossover, moving averages crossovers, the stochastic, RSI, etc. The greater the confirmation, the greater your probability of a successful trade!
- Pivot points are short-term trend indicators, useful for only one day, and they need to be recalculated.
Ichimoku Kinko Hyo
The Ichimoku Kinko Hyo indicator was developed in the late 1930’s by a Japanese journalist named Goichi Hosoda. He used to write for newspapers under the “pen name” of Ichimoku Sanjin, from which the charting technique he developed derives its name.
If you translate Ichimoku, it means at a glance. Meanwhile Kinko translates as equilibrium and Hyo means chart. The aim of the Ichimoku Kinko Hyo indicator on a chart is to provide us with a broad view of prices with just a single glance. So you would know whether to buy or sell with the information given. Basically this multiple aspect indicator provides traders with the insight of trend, momentum, support and resistance, as well as entry and exit points, all at once, all on a chart.
Key Elements of Ichimoku Kinko Hyo
Looking at the Ichimoku chart we can see that the indicator is constructed using five lines. A description of each line is given in the chart below:
The tenkan sen is the red line on the chart and is known as the turning line. It provides buy or sell signals when combined with the kijun sen. It is a faster moving average based on a 9 period exponential moving average derived from the following formula:
Note that you do not have to calculate this yourself, since the charting software does this for you automatically.
The kijun sen is the blue line, and is known as the standard line, or base line. This moving average is slower than the tenkan sen and is a 26-period moving average derived from the formula:
The Chikou span is known as the lagging line. It is the current closing price plotted 26 days back. For example, today’s closing price plotted 26 days back. The first thing you notice on an Ichimoku chart is a cloud-like feature. This cloud is called the kumo, and it is formed by the Senkou span A and Senkou span B lines.
Senkou Span A
The Senkou span A leading line 1 is calculated by the following formula plotted 26 days ahead.
Senkou Span B
The Senkou span B leading line 2 is calculated by the following formula plotted 26 days ahead but using a default period of 52.
Using the Ichimoku Kinko Hyo in Trading
We have established that the Ichimoku Kinko Hyo indicator provides the trader with various levels of support and resistance, entry and exit points, direction of the trend, and strength of the signal. Let us look at how we can incorporate this into our trading.
Support and Resistance with the Kumo
The kumo (cloud) is composed of two Senkou Span lines and where the area between them is shaded in, it makes a cloud-like shape. The cloud incorporates various levels of support and resistance. The theory of this indicator is that when the price is above the cloud, then the top of the cloud will act as a general support level. When the price is below the kumo, the cloud base will act as resistance.
Finding the Trend
We can see that the kumo is a good trend indicator. If the price is above the kumo, the overall trend is bullish while below the kumo indicates a bearish trend. Meanwhile prices in the cloud mean the trend is unclear and basically a range.
Looking at the example of the chart below, we can see that when prices are above the kumo, there is a bullish trend.
After that prices began to decline and moved below the kumo, indicating that the trend had become bearish.
During sideways price action, prices tend to trade inside the kumo, and are neither above nor below it.
Tenkan Sen & Kijun Sen Lines for Buy and Sell Signals
You saw earlier that the Tenkan sen and the Kijun sen line were moving averages (9 and 26 day exponential moving averages). When combined, they provide bullish or bearish signals and hence are good for indicating entry and exit points.
A buy signal is created when the Tenkan sen line moves above the Kijun sen, (bullish signal). A sell signal is created when the Tenkan sen line crosses below the Kijun sen line (bearish signal).
Look at the chart below.
Chikou Span for Signal Strength
There is also one last line called the Chikou Span, which is representative of the current price moved back 26 periods ago. This is where the strength of the signal comes in. Chikou span is essentially a confirmation of the bullish or bearish sentiment. For example, if you have a sell signal (downward crossover of the Tenkan sen over the Kijun sen) and the Chikou span is below the closing price and below the kumo, we can say the strength is with the sellers. Then the signal strength is considered strong.
Also, if you have a buy signal (Tenkan sen crosses the Kijun sen from below) and the Chikou Span is above the price and kumo, then there is strength to the upside. The signal strength increases.
The Ichimoku Kinko Hyo conveys a great deal of information on trend existence, direction, support and resistance.
- It is good for identifying the trend
- Can be used in a way similar to moving averages
- Allows for wider support and resistance zones
- Decreases the risk of trading false breakouts
Average True Range (ATR) Indicator
The Average True Range (ATR) indicator simply measures the degree of price volatility from high to low over a given time period. Note that the ATR does not indicate the direction of the price trend, it just measures how much the price can potentially move, usually by a number of pips. This average range of price movement is calculated for the number of periods you require.
For example, if you are trading the hourly chart, and you want the ATR for the last 100 hours, you set the ATR on your chart settings for that amount.
Advantage of the ATR
By knowing the average range of price movement in the past 100 hours, you can set a better stop loss level and limit the risk on your trade. This will give you enough breathing room so that you don’t get stopped out too soon. For example, if you are trading EURUSD and the ATR was 200 pips in the last 100 hours, you would know that you should set your stop loss for more than 200 pips. If you set it at 50 pips you could get stopped out sooner.
In the EURUSD hourly chart below, we see that for ATR (100 periods) the ATR was about 14 pips.
Average Directional Index (ADX)
One of the dilemmas that traders will often face is trying to decide how strong the trend is. This is when we can use the Average Directional Index (ADX), to help us decide. The ADX is an oscillator that shows us whether a market is trending or not. It will not show us whether we are seeing an up-trend or a down-trend, but it can help us see if there is really any trend at all and if so, how strong it is. Therefore, its main purpose is to determine the strength of a trend and not if the market is bullish or bearish.
The ADX indicator fluctuates between a minimum of zero to a maximum of 100. The higher the reading of ADX the stronger the trend will be.
Referring to the chart above, we can see prices are initially in an uptrend before fading into a range. Since ADX only measures the strength of the trend, we can see that as prices rose the ADX reading strengthened to as high as 66. Once prices traded sideways, and there was no longer a trend, the ADX fell and hovered at around 20.
The ADX is good for checking if the market is ranging or starting a new trend. Usually if the ADX is below 20, this signifies a non-trending market. Once the ADX crosses above 20, this indicates that a trend might be emerging. If the ADX indicator is increasing between 20 and 40, then it is further confirmation of an emerging trend. So we could consider initiating a buy or sell in the direction of price movement. If the ADX crosses above the 50 line, this indicates a strengthening in the trend.
Trading with the ADX Indicator
You probably noticed on the chart, the ADX line was actually accompanied by another two lines, called the +DI and the -DI lines. These DI lines are used for spotting entry signals by observing the crossover between +DI and –DI. Once the ADX peaks above 20 a buy signal occurs when +DI (green) crosses upwards and above -DI (red).
A sell signal occurs when the opposite happens and +DI crosses -DI downwards. Note that when ADX remains below 20 all +DI and –DI crossovers are ignored and you should not trade. It is suggested to us the ADX indicator in conjunction with another trend following indicator to confirm trade entries.
Important to Know!
It is important to remember not to think that the ADX moves in the direction of the trend! So if the trend was down and strengthening, then the ADX would increase (not decrease) to show a strong downward trend! You can see this in the chart below:
while prices were ranging until early December, ADX hovered below 20. No trend, so we do not enter a trade. Once prices broke out of the range and a trend began to emerge to the downside, then ADX rose above 50, indicating a strong downtrend.
Best Way to use ADX in Trading
The best method for using ADX is to wait for a breakout in price first before deciding to buy or sell. Once a breakout happens then we can use the ADX indicator as confirmation whether prices will possibly continue in the current trend or not. ADX can also be used to determine when one should close a trade early.
For example if the ADX starts to cross below 50, it indicates that the current trend is losing strength. From then, prices might just trade sideways giving a range. Therefore, you might want to book profits before that happens.
Other Common Indicators
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