Indicators can help you trade by providing more information.
A stochastic is an oscillator that measures overbought and oversold conditions in the market.
Stochastics tells us when the market is overbought or oversold. Stochastics are scaled from 0 to 100. When the stochastic lines are above 80 (the red dotted line in the chart above), then it means the market is overbought. When the stochastic lines are below 20 (the blue dotted line), then it means that the market is oversold. As a rule of thumb, we buy when the market is oversold, and we sell when the market is overbought.
Lagging indicators will spot trends once they have been established, at the expense of delayed entry. The bright side is that there’s less chance of being wrong.
Some examples of lagging indicators are:
- Moving averages
If you put a 8 EMA (Exponential Moving Average) and a 50 EMA on your chart, you could enter bullish when the 8 EMA crosses above the 50 EMA. To see the long term trend, you could put a 200 EMA on your chart.
To trade using the macd, enter bullish when the histogram rises above the signal line and exit when the histogram falls below the signal line. Enter bearish when the histogram falls below the signal line and exit when the histogram rises abovethe signal line.
An oscillator is any object or data that moves back and forth between two points. In other words, it’s an item that is going to always fall somewhere between point A and point B. Think of when you hit the oscillating switch on your electric fan.
Think of our technical indicators as either being “on” or “off”. More specifically, an oscillator will usually signal “buy” or “sell”, with the only exception being instances when the oscillator is not clearly at either end of the buy/sell range.
Some examples of leading indicators are:
- Parabolic SAR
- Relative Strength Index (RSI)
Each of these indicators is designed to signal a possible reversal, where the previous trend has run its course and the price is ready to change direction.
A leading indicator gives a buy signal before the new trend or reversal occurs.
A lagging indicator gives a signal after the trend has started and basically informs you “hey buddy, pay attention, the trend has started, you’re missing the train.”
You’re probably thinking, “Ooooh, I’m going to get rich with leading indicators!” since you would be able to profit from a new trend right at the start. You’re right – you would “catch” the entire trend every single time, IF the leading indicator was correct every single time. But it’s not.
When you use leading indicators, you will experience a lot of fake-outs. Leading indicators are notorious for giving bogus signals which will “mislead” you.
The other option is to use lagging indicators, which aren’t as prone to bogus signals. Lagging indicators only give signals after the price change is clearly forming a trend. The downside is that you’d be a little late in entering a position. Often the biggest gains of a trend occur in the first few bars, so by using a lagging indicator you could potentially miss out on much of the profit.
Oscillators are leading indicators.
Momentum indicators are lagging indicators.
Relative Strength Index, or RSI, is similar to stochastics in that it identifies overbought and oversold conditions in the market. It is also scaled from 0 to 100. Typically, readings below 30 indicate oversold, while readings over 70 indicate overbought.
RSI is a very popular tool because it can also be used to confirm trend formations. If you think a trend is forming, take a quick look at the RSI and look at whether it is above or below 50. If you are looking at a possible uptrend, then make sure the RSI is above 50. If you are looking at a possible downtrend, then make sure the RSI is below 50.
MACD is an acronym for Moving Average Convergence Divergence. This tool is used to identify moving averages that are indicating a new trend, whether it’s bullish or bearish.
With an MACD chart, you see two numbers that are used for its settings. The default values are 12, 26, and 9.
- The first, 12, is the number of periods that is used to calculate the faster moving average.
- The second, 26, is the number of periods that are used in the slower moving average.
- And the third, 9, is the number of bars that is used to calculate the moving average of the difference between the faster and slower moving averages.
There is a common misconception when it comes to the lines of the MACD. The two lines that are drawn are NOT moving averages of the price. Instead, they are the moving averages of the DIFFERENCE between two moving averages.
The histogram shows the faster moving average, and the signal line shows the slower moving average.
When the histogram is above the signal line, that is a bullish signal. When the histogram is below the signal line, that is a bearish signal.
One indicator that can help us determine where a trend might be ending is the Parabolic SAR (Stop And Reversal).
A Parabolic SAR places dots, or points, on a chart that indicate potential reversals in price movement. From the chart above, you can see that the dots shift from being below the candles during the uptrend, to above the candles when the trend reverses into a downtrend.
When the dots are below the candles, it is a buy signal; and when the dots are above the candles, it is a sell signal.
This tool is best used in markets that are trending. You DON’T want to use this tool in a choppy market where the price movement is sideways.
Bollinger bands are used to measure a market’s volatility. Basically, this little tool tells us whether the market is quiet or whether the market is LOUD! When the market is quiet, the bands contract; and when the market is LOUD, the bands expand. Notice on the chart below that when the price was quiet, the bands were close together, but when the price moved up, the bands spread apart.
One thing you should know about Bollinger Bands is that price tends to return to the middle of the bands. That is the whole idea behind the Bollinger bounce.
The reason these bounces occur is because Bollinger Bands act like mini support and resistance levels. The longer the time frame you are in, the stronger these bands are. Many traders have developed systems that thrive on these bounces, and this strategy is best used when the market is ranging and there is no clear trend.
A moving average is simply a way to smooth out price action over time. By “moving average”, we mean that you are taking the average closing price of a currency for the last ‘X’ number of periods.
The candles are in a downtrend, but the MACD is making higher lows. This means there is divergance and there is a good chance the candles will be going bullish soon.
Voila, the candles have turned!
To summarize, we have divergence:
- If the price is making lower lows,
but the oscillator is making higher lows.
- If the price is making higher highs,
but the oscillator is making lower highs.
- If the price is making higher lows,
but the oscillator is making lower lows.
- If the price is making lower highs,
but the oscillator is making higher highs.
Do not use the divergence on time frames smaller than the 1 hour. The longer the line of divergance the stronger the indicator. The larger the time frame showing the divergence, the stronger the indicator.