How do trading indicators work, and what are their types?
Trading indicators play an important role in technical analysis. Technical analysis studies how assets perform and predicts that patterns and behaviors of the past will likely be repeated in the future. Technical indicators help traders better visualize and digest current market information.
It’s essential to note that each indicator is different and is made for a certain purpose. You can not use trend trading indicators in ranging markets or range trading indicators in trending markets. Every indicator should be used accordingly.
In terms of trading signals, there are two types of indicators, leading and lagging. Let’s discuss what they indicate and how they differ from one another. But firstly, let’s talk about volume.
High volume brings good liquidity and therefore low spreads. In addition, volume is what moves the markets. FX indicators that measure volume are highly useful for determining entries and exits in a market. When the market is trending and traders have already opened a position in the market direction, the increase in volume is good. High volume means that other traders are interested in the asset. Similarly, decrease in volume might indicate the loss of interest and the price might start reversing.
Below, you can see a simple volume indicator that is placed below the price chart. Green lines mean that price is moving upwards, and red ones mean that price is moving downwards. Volume indicators can be coupled with other indicators and strategies.
Leading indicators are predictive types. They signal traders on potential price reversals or establishments of brand-new trends. They help predict future price moves, which is why they are called leading indicators.
Some of the most popular leading indicators are:
- RSI (Relative strength index) – The RSI is an oscillator that shows overbought and oversold conditions. When the indicator’s value signals an overbought condition, it is likely that the market will reverse downwards. When value is in oversold condition, price is likely to start reversing upwards. Keep in mind that the RSI is a range trading indicator and if fails to produce reliable signals when the market starts trending.
- ADX (Average Directional Index) – ADX is a trend trading indicator. It measures the strength of a market trend.
- ATR (Average True Range) – the ATR measures volatility by decomposing the entire range of an asset price for a given period
- CCI (Commodity Channel Index) – is an indicator that measures the difference between the current price and the historical average price.
Lagging indicators follow prices and do not have a predictive nature. Instead, they help traders to get a clearer picture of current market conditions. Lagging indicators make visualization better and digesting information becomes easier, which, in turn, helps traders better plan their future trades.
Some of the most popular lagging indicators are:
- Moving Averages (MA), Both Simple Moving Average (SMA) and Exponential Moving Average (EMA) – Exponential moving average is very similar to the simple moving average. The only difference is that the exponential moving average puts more emphasis on current price changes. And SMA takes into account total data for a chosen period.
- MACD (Moving Average Convergence/Divergence) – MACD consists of two moving averages, and their divergence signals potential price reversal. MACD is a lagging indicator as its values follow price action, however, they can also be used as a leading indicator for determining overbought and oversold conditions.
- Bollinger Bands – Bollinger Bands is also a lagging indicator as it consists of 3 moving averages. This indicator helps traders better spot when markets are sleeping and start trending.
Trend trading and range trading indicators
Moving averages are usually used for trend trading. Markets go from uptrends to ranges to downtrends and vice versa. It’s critical for traders to first find out whether the market is ranging or trending and apply indicators later. Trending indicators can be coupled with range indicators to improve the accuracy. For example, traders can use moving averages to determine price direction and RSI to locate entry points. Keep in mind that you should avoid using many indicators at the same time. The reason is that when traders use too many indicators, they get mixed, controversial signals and become unable to place a trade. This phenomenon is known as analysis paralysis.
How to get more indicators?
Most popular indicators are already installed on your trading platform when you download them using your computer. However, if you are using MetaTrader platforms, you can use MetaMarket to purchase or get a free indicator or trading algorithm.
Limitations of using technical indicators
Indicators have their limitations. The first difficulty traders face when using indicators is that they each should be used in a certain way. It’s worth mentioning that indicators are purely technical, and they don’t take into account fundamentals such as interest rate decisions, unemployment numbers, trade deficit and other important economic and political factors. Which is wise to always keep an eye on the economic calendar when using the indicators. Many traders use both technical and fundamental analysis to determine future price. Those who trade purely technical, avoid placing orders during major economic announcements.