Moving Average Convergence/Divergence (MACD)

What is it?

The MACD is one of the most popular oscillator used by currency traders. This is a momentum indicator can be used to confirm trends, while also indicating reversals, or overbought/oversold conditions. The MACD is calculated by taking the difference between the 2 exponential moving averages. The two that is usually used are the 26-day and 12-day moving averages.

How can MACD be used for trading?

Crossovers

The most common way to use the MACD is to buy/sell a currency pair when it crosses the signal line or zero. A sell signal occurs when the MACD falls below the signal line, while a buy signal occurs when the MACD rallies above the signal line.

Overbought/Oversold

The MACD can also be used as an overbought/oversold indicator. When the shorter moving average moves away significantly from the longer moving average (i.e. the MACD rises), it is likely that the currency prices movements are starting to exhaust and will soon return to more realistic levels.

Divergences

When the MACD diverges from the trend of the currency price, this may signal a trend reversal. In addition, if the MACD makes a new low while the currency pair does not also make a new low, this is a bearish divergence, indicating a possible oversold condition. Alternatively, if the MACD is making new highs while the currency pair fails to confirm these highs, this is a bullish divergence, indicating a possible overbought condition.

Stochastics

What is it?

The stochastic oscillator is a commonly used momentum indicator that measures the current currency price compared to its historical price for a given time period. It looks to gage the strength and momentum of a currency pair’s price action by measuring the degree by which a currency is overbought or oversold. The scale for the indicator is 0 to 100. Readings above 80 indicate overbought conditions, as it reflects the fact that the currency is strong and the price is closing near the high of the trading range. Readings below 20 indicate oversold conditions and reflects the fact that the currency is weak and is closing near the low of the trading range.

How can stochastics be used for trading?

Detect Overbought and Oversold Conditions

The most common way to analyze stochastics is to sell when the reading is above 80, which implies overbought conditions and to buy when the reading is below 20, which implies oversold conditions.

Divergence

Buy and sell signals can also be given when stochastics show divergence, indicating a possible trend reversal. Divergence occurs when the stochastic values are moving in one direction and the price values are moving in the opposite direction.

Relative Strength Index (RSI)

What is it?

The relative strength index or RSI is probably the most popular oscillator used by the FX trading community. It was developed by J. Welles Wilder Jr. to gage the strength or momentum of a currency pair. This indicator is calculated by comparing a currency pairs current performance against its past performance, or its up days versus its down days. RSI is on a scale of 1-100, where any point above 70 is considered overbought, while any point below 30 is considered oversold. The standard time frame for this measure is 14 periods, although 9 and 25 periods are also commonly used. Generally, more periods tend to yield more accurate the data.

How Can RSI be Used for Trading?

RSI Can be Used to Identify Extreme Conditions or Reversals.

RSI above 70 is considered overbought and indicating a sell signal. RSI below 30 is considered oversold which would imply a buy signal. Some traders identify the long-term trend and then use extreme readings for entry points. If the long-term trend is bullish, then oversold readings could represent potential entry points.

RSI Can be Used to Indicate Divergence

Trade opportunities can also be generated by scanning for positive and negative divergences between the RSI and the underlying currency pair. For example, a falling currency pair where RSI rises from a low point of 15 back up to 50. With RSI, the underlying pair will often reverse its direction soon after such a divergence. Consistent with this example, divergences that occur after an overbought or oversold reading usually provide more reliable signals.

Bollinger Bands

What is it?

Bollinger bands are very similar to moving averages. The bands are plotted at two standard deviations above or below the moving average. This is typically based off of the simple moving average, but an exponential moving average can be used to increase the sensitivity of the indicator. A 20-day simple moving average is recommended for the center band and 2 standard deviations for the outer bands. The length of the moving average and number of deviations can be altered to better suit trader preferences and volatility of a currency pair. In addition to identifying relative price levels and volatility, bollinger bands can be combined with price action and other indicators to generate signals and be a precursor to significant moves.

How can Bollinger Bands be Used for Trading?

Bollinger bands are typically used by traders to detect extreme unsustainable price moves, capture changes in trend, identify support/resistance levels and spot contractions/expansions in volatility. There are a number of ways to interpret Bollinger Bands.

Breakouts

Some traders believe that when the prices break above or below the upper or lower band, it is an indication that a breakout is occurring. These traders will then take a position in the direction of the breakout.

Overbought/Oversold Indicators

Alternatively, some traders use Bollinger Bands as an overbought and oversold indicator. As shown in the chart below, when the price touches the top of the band, traders will sell, assuming that the currency pair is overbought and will want to revert back to mean or the middle moving average band. If the price touches the bottom of the band, traders will buy the currency pair, assuming that it is oversold and will rally back towards the top of the band. The spacing or width of the band is dependent on the volatility of the prices. Typically, the higher the volatility, the wider the band and the lower the volatility, the narrower the band.

Pulling it All Together

Alone, none of these indicators yield great results. However, when combined and used in unison, they can give traders the extra edge needed to better understand short term trading dynamics. Therefore it is important for traders to look for relationships between the different indicators as multiple signals can provide the most accurate trading predictions.

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