Forex (FX) traders use a variety of macro and technical aspects of price to try and determine the direction of forex prices. The focus of this article is on forex indicators, and the most popular ones you may find among new forex traders. Even if you, or other forex traders, are unable to make these strategies work, it is a good foundation to learn about different perspectives in forex markets.
And even though numerous automated algorithms by high-frequency firms can make microsecond decisions in a competitive landscape, it’s useful to know how to make these calculations as they can set the foundation for more advanced topics.
In this article, we cover forex indicators in more detail, including five popular ones that every forex trader should know.
What Are Forex Indicators?
Forex stands for foreign currency exchanges, and forex indicators are mathematical and statistical models used by traders and investors to analyze currency movements so they can buy or sell at the right time.
For traders, the “right time” is when indicators tell them it’s time to buy or sell two currencies valued against a third, known as the forex cross rate.
Most other currencies are compared against the U.S. dollar (USD) because of its dominant position as a global currency. As a base currency, USD always has a value of 1 in any forex indicator or cross-rate comparison — e.g., when trading the euro (EUR) and yen (JPY).
In any cross-currency pair transaction, a trader exchanges one currency for USD, and the value of that trade is exchanged for the other currency. So, it’s a two-transaction process and often happens in a matter of seconds because you’ve got to move fast when making forex transactions.
Even if you’ve switched to or mainly rely on automatic forex algorithms to make trades, as an investor or analyst you still need a clear grounding in the fundamentals. Forex indicators are an integral part of these fundamentals. The wider range of mathematical and statistical models you know will ensure you’ve got a more versatile, agile, and robust mental toolkit for making smarter, faster, and more profitable forex trades.
How Do Forex Indicators Work?
Forex indicators are the name for the outputs from technical analysis that traders use to to assess cross-pair volatility
Trading signals come in many forms, such as:
- Profit-taking indicators: Spot the right moment to maximize your profits (e.g., using Bollinger Bands).
- Overbought or oversold indicators: Calculate when a forex market currency pair (e.g., yen/euro with a U.S. dollar baseline) is bullish or bearish and whether to buy or sell using a forex trading strategy calculation such as the relative strength index (RSI).
- Trend-following indicators: Notice which way trends are moving — whether currencies you’re tracking are going through an uptrend or downtrend.
- Trend-confirming indicators: If you’re aware of a trend, then you need to confirm it. One way to do this is to apply the moving average convergence divergence indicator.
Pro tip: Watch out for whipsaws — when currencies are moving one way and then suddenly pivot in another direction.
5 Forex Indicators Every Investor Should Know
Here are five of the most popular forex indicators that every currency trader and investor should know.
1. Bollinger Bands
Bollinger Bands is a technical analysis tool developed by John Bollinger, a technical stock market trader, author, and financial analyst. He created this solution in the 1980s and changed how investors saw the market, realizing that volatility is dynamic rather than static.
According to Bollinger Bands, the tool is designed to answer this question: “Are prices high or low on a relative basis?” Additionally, the Bollinger Bands website explains, “By definition price is high at the upper band and price is low at the lower band. That bit of information is incredibly valuable. It is even more powerful if combined with other tools such as other indicators for confirmation.”
Traders can apply this knowledge to forex and almost every other kind of commodity and security, including crypto. Bollinger Bands can be applied from hourly to monthly timescales.
How Do Bollinger Bands Work?
As John Bollinger explains, the formula is an “n period moving average with bands drawn above and below at intervals determined by a multiple of standard deviation.”
It’s a way of drawing curves around a price structure with the moving average in the middle (middle band) and then an upper and lower band to assess whether prices are relatively high or low.
How to Use Bollinger Bands?
Traders can use a 20-day simple moving average of two currency pairs as the first data point in a Bollinger Band calculation.
Now you need the standard deviation of the two currencies: calculate the square root of the variance using the squared difference of the mean.
After that, multiply the standard deviation by two and then add and subtract that value from each day’s (in the 20-day moving average) currency price. This will give you the upper and lower bands.
Forex traders can use this calculation to assess whether a currency pair is overbought or oversold. When prices are close to the upper band, it’s an overbought indicator and lower means it could be oversold.
2. Stochastic Oscillators
Stochastic oscillators are another popular price momentum indicator first developed in the 1950s.
Stochastic oscillators are range-bound between zero and 100. Prices over 80 are usually considered overbought, and those under 20 are oversold.
How Do Stochastic Oscillators Work?
Stochastic oscillators apply two lines (80 and 20 within the zero to 100 range) to the moving average of the evaluated currencies. It’s a simple way to see whether currency movements are bullish or bearish.
How to Use Stochastic Oscillators?
Currency traders can use stochastic oscillators to decide whether a forex currency pair is worth buying or selling. Most forex trading tools can automatically apply these oscillator momentum thresholds for any moving average period.
When analyzed alongside other trading tools and calculations (such as MACD and Fibonacci retracements), it could help provide clarity as to whether it’s a good time to buy, sell, or hold a currency pair.
3. Fibonacci Retracements
Fibonacci was the name given to an Italian mathematician known as Leonardo Bonacci from the Republic of Pisa. He was the most talented mathematician of that era, and his work has influenced Western mathematics and statistical calculations ever since. His work, including one of his most notable books, Liber Abaci is one of the reasons Roman numerals were replaced with our modern numerical sequence (1, 2, 3, etc).
A Fibonacci retracement is a way to apply technical analysis to anything with moving prices (such as a forex pair). Fibonacci sequences are even found in nature for reasons many people don’t understand. And yet they’ve proven useful in analyzing the stock market and other types of financial data, including forex trading currencies.
The retracement is based on the Fibonacci sequence, a set of numbers that start at zero and increase through to infinity, whereby each number is 1.618 times greater than the one before. Because of this, the key ratio is 61.8%, which is found by dividing any number in the sequence by the one that follows after it.
How Do Fibonacci Retracements Work?
Fibonacci retracements work by taking two extreme points on a chart, such as a currency’s highest price in a 20-day moving average and its lowest price.
Once you’ve got these numbers, you can divide them using the Fibonacci ratios: 23.6%, 38.2%, 50%, 61.8%, and 100%.
How to Use Fibonacci Retracements?
Fibonacci retracements are one of many Fibonacci-based tools that analysts can use to decide on the best time to buy or sell currencies.
Most trading tools have functions that automatically input the horizontal lines at the various Fibonacci ratios. You can use this to decide whether a currency pair is approaching a support or resistance level and whether it’s a good time to buy or sell. If you use this with other technical analysis tools, you could be onto a winner in the forex market.
4. Moving Average Convergence Divergence (MACD)
The moving average convergence divergence (MACD or MSC-D) is a trend-following and trend-confirming indicator that analyzes a currency pair’s exponential moving averages (EMAs). Investors also use this when buying and selling other stocks, securities, and commodities.
You can calculate the MACD indicator by subtracting the 26-period EMA from the 12-period EMA of the currencies you’re tracking.
How Does MACD Work?
The signal line is the nine-period EMA. Traders use this to identify the buy or sell technical signals and determine whether a currency is overbought or oversold. MACD is often used with daily time frames, with 26, 12, and nine days as the comparative norms.
How to Use MACD?
Exponential moving averages are another moving average with more weight on recent data. Compared to a simple moving average (SMA), where equal weight is applied to every data point in the timescale an investor is looking at.
MACD charts track the moving average of currency pairs. Analysts and traders usually apply a histogram to MACD charts to clarify the divergence or convergence, making it a useful technical indicator.
Traders use the MACD line to spot when to buy or sell — e.g., if a currency pair goes above the signal line, it could be time to buy. Or when it falls below, it could be time to sell. You can also use these signals to potentially identify bullish and bearish currency movements or when a currency is overbought/oversold. It’s equally valuable for trying to see when there’s going to be a reversal.
Tapping into real-time forex data will help you stay on top of these indicators, making moving on to positive or negative MACD signals easier.
5. Relative Strength Index (RSI)
Relative strength index is a technical indicator analysis method first introduced in 1978 by J. Welles Wilder Jr. in his book New Concepts in Technical Trading Systems.
RSI is a momentum oscillator that’s most effective when analyzing trading range price movements, so it’s ideal for forex currency pairs. RSI can compare both currencies’ relative strength when prices go up and down. Traders can use this as a standalone approach or combine it with other technical indicators within their forex trading strategy.
How Does Relative Strength Index (RSI) Work?
Calculating RSI is a two-step process requiring a minimum of 14 data points. You could take the end-of-day trading price for the two currency pairs you’re buying or selling.
The calculation involves inputting days with an average gain and an average loss. RSI works this way:
- Days/periods with a price loss are given a positive value.
- Days/periods with a price gain are assigned a value of zero in average loss calculations.
- Days/periods with a price loss are assigned a value of zero in average gain calculations.
When you’ve gathered the data points for the timescale you’re going to calculate, it can either be worked out long-hand or using an RSI calculator.
Once you’ve done the calculation, the RSI can be used as one tool to help assess the relative strength of the two currencies using the moving average chart.
How to Use Relative Strength Index (RSI)?
An overbought indicator is when the RSI is above 70. Going above this line could be a positive buy signal.
An oversold indicator is when the RSI is below 30. Going under this line is usually when traders decide to sell.
However, as with any technical indicator, it’s useful to apply it in the context of other forex price movement calculations, charts, global events, and tools, and have access to a pipeline of accurate tier-one market data.
Make Smarter Forex Trades With High-Quality Data
As we mentioned at the start, no one way works universally and helps forex traders get it right every time. Experience as to the best time to buy or sell, using the average price, spotting uptrends, downtrends, trend indicators, trendlines, and sell signals, and numerous other approaches are often personal preferences.
Forex traders normally need to try multiple approaches every time they trade to make the best choices. Various tools exist to help with this, including automated real-time instant trading platforms.
In order to determine the most effective forex indicators, you first need access to high-quality, clean, enterprise-grade forex data, which you can get from Tiingo.
Tiingo is an enterprise-grade financial API with generous usage limits, cost-effective access for small and midsize firms in the financial sector, and support for business customers. With Tiingo, you can tap into forex data for over 140 currency pairs.