Many traders spend their time looking for that
perfect moment to enter the markets or a telltale sign that screams
"buy" or "sell". And while the search can be fascinating,
the result is always the same. The truth is, there is no one way to trade the markets.
As a result, successful traders must learn that there are a variety of
indicators that can help to determine the best time to buy or sell a cross rate.
Here are four different market indicators that most successful traders rely upon.
Indicator No.1: A Trend-Following Tool
It is possible to make money using a countertrend approach to trading. However, for most traders the easier approach is to recognize the direction of the major trend and attempt to profit by trading in the trend’s direction. This is where trend-following tools come into play. Many people misunderstand the purpose of trend-following tools and try to use them as separate trading systems. While this is possible, the real purpose of a trend-following tool is to suggest whether you should be looking to enter a long position or a short position. So let’s consider one of the simplest trend-following methods – the moving average crossover.
Here are four different market indicators that most successful traders rely upon.
Indicator No.1: A Trend-Following Tool
It is possible to make money using a countertrend approach to trading. However, for most traders the easier approach is to recognize the direction of the major trend and attempt to profit by trading in the trend’s direction. This is where trend-following tools come into play. Many people misunderstand the purpose of trend-following tools and try to use them as separate trading systems. While this is possible, the real purpose of a trend-following tool is to suggest whether you should be looking to enter a long position or a short position. So let’s consider one of the simplest trend-following methods – the moving average crossover.
A simple moving average represents the average
closing price over the number of days in question. To elaborate, let’s look at
two simple examples – one longer term, one shorter term.
Figure 1 displays the 50-day/200-day moving average crossover for the euro/yen cross. The theory here is that the trend is favorable when the 50-day moving average is above the 200-day average and unfavorable when the 50-day is below the 200-day. As the chart shows, this combination does a good job of identifying the major trend of the market - at least most of the time. However, no matter what moving average combination you choose to use, there will be whipsaws.
Figure 1: The euro/yen with 50-day and 200-day moving
averages
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Source: ProfitSource
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Figure 2 shows a different combination – the 10-day/30-day crossover. The advantage of this combination is that it will react more quickly to changes in price trends than the previous pair. The disadvantage is that it will also be more susceptible to whipsaws than the longer term 50-day/200-day crossover.
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Figure 2: The euro/yen with 10-day and 30-day moving
averages
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Source: ProfitSource
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Many investors will proclaim a particular combination to be the best, but the reality is, there is no “best” moving average combination. In the end, traders will benefit most by deciding what combination (or combinations) fits best with their time frames. From there, the trend - as shown by these indicators - should be used to tell traders if they should trade long or trade short; it should not be relied on to time entries and exits
Indicator No.2: A Trend-Confirmation Tool
Now we have a trend-following tool to tell us whether the major trend of a given currency pair is up or down. But how reliable is that indicator? As mentioned earlier, trend-following tools are prone to being whipsawed. So it would be nice to have a way to gauge whether the current trend-following indicator is correct or not. For this, we will employ a trend-confirmation tool. Much like a trend-following tool, a trend-confirmation tool may or may not be intended to generate specific buy and sell signals. Instead, we are looking to see if the trend-following tool and the trend-confirmation tool agree.
In essence, if both the trend-following tool
and the trend-confirmation tool are bullish, then a trader can more confidently
consider taking a long trade in the currency pair in question. Likewise, if
both are bearish, then the trader can focus on finding an opportunity to sell
short the pair in question.
One of the most popular – and useful – trend confirmation tools is known as the moving average convergence divergence (MACD). This indicator first measures the difference between two exponentially smoothed moving averages. This difference is then smoothed and compared to a moving average of its own. When the current smoothed average is above its own moving average, then the histogram at the bottom of Figure 3 is positive and an uptrend is confirmed. On the flip side, when the current smoothed average is below its moving average, then the histogram at the bottom of Figure 3 is negative and a downtrend is confirmed.
One of the most popular – and useful – trend confirmation tools is known as the moving average convergence divergence (MACD). This indicator first measures the difference between two exponentially smoothed moving averages. This difference is then smoothed and compared to a moving average of its own. When the current smoothed average is above its own moving average, then the histogram at the bottom of Figure 3 is positive and an uptrend is confirmed. On the flip side, when the current smoothed average is below its moving average, then the histogram at the bottom of Figure 3 is negative and a downtrend is confirmed.
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Figure 3: Euro/yen cross with 50-day and 200-day moving
averages and MACD indicator
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Source: ProfitSource
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In essence, when the trend-following moving average combination is bearish (short-term average below long-term average) and the MACD histogram is negative, then we have a confirmed downtrend. When both are positive, then we have a confirmed uptrend.
At the bottom of Figure 4 we see another trend-confirmation tool that might be considered in addition to (or in place of) MACD. It is the rate of change indicator (ROC). As displayed in Figure 4, the red line measures today’s closing price divided by the closing price 28 trading days ago.
Note in Figure 4 that the sharp price declines
experienced by the euro/yen cross from mid-January to mid-February, late April
through May and during the second half of August were each accompanied by:
- The 50-day moving average
below the 200-day moving average
- A negative MACD histogram
A bearish configuration for the ROC indicator
(red line below blue)
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Figure 4: Euro/yen cross with MACD and rate-of-change
trend confirmation indicators
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Source: ProfitSource.com
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Indicator No.3: An Overbought/Oversold Tool
While traders are typically well advised to trade in the direction of the major trend, one must still decide whether he or she is more comfortable jumping in as soon as a clear trend is established or after a pullback occurs. In other words, if the trend is determined to be bullish, the choice becomes whether to buy into strength or buy into weakness. If you decide to get in as quickly as possible, you can consider entering a trade as soon as an uptrend or downtrend is confirmed. On the other hand, you could wait for a pullback within the larger overall primary trend in the hope that this offers a lower risk opportunity. For this, a trader will rely on an overbought/oversold indicator. There are many indicators that can fit this bill. However, one that is useful from a trading standpoint is the three-day relative strength index, or three-day RSI for short. This indicator calculates the cumulative sum of up days and down days over the window period and calculates a value that can range from zero to 100. If all of the price action is to the upside, the indicator will approach 100; if all of the price action is to the downside, then the indicator will approach zero. A reading of 50 is considered neutral
Figure 5 displays the three-day RSI for the euro/yen cross. Generally speaking, a trader looking to enter on pullbacks would consider going long if the 50-day moving average is above the 200-day and the three-day RSI drops below a certain trigger level, such as 20, which would indicate an oversold position. Conversely, the trader might consider entering a short position if the 50-day is below the 200-day and the three-day RSI rises above a certain level, such as 80, which would indicate an overbought position. Different traders may prefer using different trigger levels.
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Figure 5: Euro/yen cross with three-day RSI
overbought/oversold indicator
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Source: ProfitSource
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Indicator No.4: A Profit-Taking Tool
The last type of indicator that a trader needs is something to help determine when to take a profit on a winning trade. Here too, there are many choices available. In fact, the three-day RSI can also fit into this category. In other words, a trader holding a long position might consider taking some profits if the three-day RSI rises to a high level of 80 or more. Conversely, a trader holding a short position might consider taking some profit if the three-day RSI declines to a low level, such as 20 or less.
Another useful profit-taking tool is a popular indicator known as Bollinger bands. This tool adds and subtracts the standard deviation of price data changes over a period from the average closing price over that same time frame to create trading “bands”. While many traders attempt to use Bollinger bands to time the entry of trades, they may be even more useful as a profit-taking tool.
Figure 6 displays the euro/yen cross with 20-day Bollinger Bands overlaying the daily price data. A trader holding a long position might consider taking some profits if the price reaches the upper band, and a trader holding a short position might consider taking some profits if the price reaches the lower band.
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Figure 6: Euro/Yen cross with Bollinger bands
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Source: ProfitSource
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A final profit-taking tool would be a “trailing stop.” Trailing stops are typically used as a method to give a trade the potential to let profits run, while also attempting to avoid losing any accumulated profit. There are many ways to arrive at a trailing stop. Figure 7 illustrates just one of these ways.
The trade shown in Figure 7 assumes that a short trade was entered in the market for the euro/yen on January 1, 2010. Each day the average true range over the past three trading days is multiplied by five and used to calculate a trailing stop price that can only move sideways or lower (for a short trade, or sideways or higher for a long trade).
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Figure 7: Euro/yen cross with a trailing stop
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The Bottom Line
If you are hesitant to get into the market and are waiting for an obvious entry point, you may find yourself sitting on the sidelines for a long while. By learning a variety of indicators, you can determine suitable strategies for choosing profitable times to back a given currency pair. Also, continued monitoring of these indicators will give strong signals that can point you toward a buy or sell signal. As with any investment, strong analysis will minimize potential risks.
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