Although many traders don’t realise this, technical analysis is the most systematic approach to trading.

If you are into forex, be it a beginner trader, pro, or simple interested, you probably already know that technical indicators are a vital tool to your success.

Even traders who don’t use technical indicators apply technical analysis to forecast whether an asset will move in one direction more accurately. However, price only offers limited insight in identifying market trends.

Technical indicators offer more precision and are easier to extract trading signals from.

The definition

Forex trading with technical indicators refers to the use of technical indicators to predict future movements of the market.

A technical indicator uses some price data, if not price itself, and simple or complex mathematical formulas to transform price into a comparable series of data points represented in graphical form. This comparison allows technical analysis of charts and the derivation of trading signals from repeated observations over a period of time.

Technical indicators are a tool forex traders can apply to their charts to help demystify market conditions and make better trading decisions. They are not supposed to be used independently, but similarly, not combined with many others.

Types of technical indicators

There are really two types of indicators.

Depending on the series of data points used in the formulae, trading indicators can predict and confirm, or better said, provide signals before and after an event. These are known as the leading and lagging indicators.

Leading indicators can use more recent or fixed price data to provide trading signals, whereas lagging indicators use the average of historical prices. For example, imagine a bar ranging from $50 to $100, a leading indicator would use the $50 or the $100 in its calculation, whereas the lagging one would use its average, $75.

There are different indicators, be it leading or lagging, but generally speaking, momentum indicators lead price, whereas trend indicators lag price. The former class provides more accurate signals in sideways or somewhat exhausted markets while the former confirms them in trending or mean-reverting markets.

Momentum indicators such as Stochastic and RSI can identify overbought and oversold levels. On the other camp, trend indicators such as the MACD and the Moving Average show trends.

Benefits of using them

Both types of indicators help identify weakness and strength in or during market trends and improve traders’ performance. Although its accuracy improves on higher timeframes, technical indicators can determine a trend’s direction, duration, and change for the short and longer term. And sometimes, before they occur.

In addition, technical indicators can indicate support and resistance areas, especially when overbought and oversold levels are combined with Fibonacci and/or horizontal support and resistance levels.

Furthermore, several technical indicators give forex traders the ability to measure the strength of a trend and when it’s about to weaken. That way, traders can determine entries and exit and receive warnings about important changes in the direction of the trend ahead of time.

Although many won’t think that, multiple technical indicators aid traders in identifying chart patterns more effectively as they can be used to confirm a pattern. For example, the volumes indicator shows a spike during the left shoulder of a head and shoulders pattern, and a decrease after that until the neckline breakout.

Of course, all types of indicators have their limitations too.

Drawbacks

Despite leading indicators providing ‘early’ signals and can foretell trend reversals, the truth is this comes with a greater risk of false signals as breakouts often end up being fakeouts. Lagging indicators are much better at that, however, the prospect of higher returns can be diminished by ‘late’ entries.

On a different note, lagging indicators fail to provide key levels for any analysis as they are based on averages.

Tips

Since both leading and lagging indicators’ performance depends on how traders use them as they can be sensitive and inconsistent when set up or used wrong, they must be used in combination: one prepares the trader for an entry or exit, the other confirms the entry or exit.

As everything is visual, spotting sideways and trending markets adds an extra layer of predictability. Both drawbacks of early and late entries can be eliminated by simply trading with the trend. For example, spotting momentum breakouts in the direction of the longer trend after a sideways market, combined with an oscillator hidden divergence, often serves wonders.

Takeaways

Technical indicators are not supposed to react to your expectations but only to price. As a technical trader, it is your job to appropriately respond to the indicators’ signals and make the best use of price movements.

Success is in your hands. Or should I say in your eyes?

Find the best technical indicators for your strategy.

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