Building a credible forex technical indicator trading strategy
Technical analysis (TA) and technical indicators can work hand in hand to provide a highly credible method to trade financial markets, particularly FX markets.
When this combination gets underpinned with fundamental analysis and a comprehensive trading plan including a thorough understanding of risk and probabilities, you’ve covered all bases.
You can choose from tens of technical indicators to apply to your charts. Many come already programmed on your broker’s MT4 charting package, and you can effortlessly select the most popular listed on the platform.
Others are available for free through the various MT4 forums; you can access the code base section on MT4 to select and add other indicators to your chart.
Technical analysis doesn’t have to be complicated
Technical indicators form the basis of technical analysis. Some technical indicators are elementary to analyse. For example, a simple moving average is a technical indicator, and large ones like the 100 DMA and 200 DMA are often used to spot longer-term bullishness of bearishness. If a security’s price is above or below these lines, traders might decide to trade long or short.
Another simple TA method involves identifying price-action using bars or candlesticks. If price forms a distinct pattern over a select period, traders will make a trading decision; to enter, exit or modify their current live trades.
Some traders might combine using bars or candlesticks with support and resistance levels only on their charts and little else. Other traders use various technical indicators to make all their decisions. Some were designed back in the 1950s to trade markets; they have stood the test of time.
The four-indicator trading method/strategy
There is a popular method to apply technical indicators on your charts, and it involves selecting a combination of one only from each of the four key groups. These groups are
- Trend-following
- Trend-confirmation
- Overbought/Oversold
- Profit-taking
The theory is that you select one indicator from each group and place it on your chart. Using these four indicators, you wait for them to align and generate a signal to justify your decision.
Let’s walk through a simple combination using one element from each group and build a technical indicator trading method and strategy. We’ll consider our approach from a swing-trading viewpoint; we’re making decisions from a daily timeframe—many of the maths experts who invented these indicators designed them to generate daily and weekly information and confirmation.
Our trend-following technical indicator could be a simple moving average (SMA) crossover. You could use a 50-day moving average and a 200-day moving average. The trend is bullish when the 50-day moving average is above the 200-day average and bearish when the 50-day is below the 200-day. The cross is often referred to as the “golden cross” when bullish and the “death cross” when bearish. The crosses often get used to either enter or exit trades.
A popular trend confirmation tool is the MACD (moving average convergence divergence). This indicator measures the difference between two exponentially smoothed moving averages.
This difference gets smoothed, creating a unique moving average. The MACD is a brilliant visual tool, and you can see when the histogram indicates positive and negative readings; bullish or bearish.
The RSI (relative strength indicator) is a respected overbought/oversold technical indicator. This type of technical indicator (in theory) tells you how close to exhaustion the sentiment and momentum is. In relative terms, the bullish or bearish movement’s strength measured over a certain period.
The RSI indicator calculates the cumulative sum of up days and down days over the time frame period and calculates a value ranging from 0 to 100. The level of 50 is considered neutral, readings above 80 can be considered overbought, and readings below 20 are considered oversold. Traders might exit their long trade if the RSI reading rises above 80. They might close their short position if the RSI falls below 20.
Bollinger Bands (BB) are respected profit-taking tools, and they work in a similar method to the RSI if used to close profitable trades. Some traders also use BB to time their market entries.
The BB is a calculation of standard deviation price-data changes over a period. This metric is then gets added and subtracted from the average closing price over that same period to create trading bands.
Like the MACD, the bands are a superb visualisation of price behaviour. There are three bands in the BB configuration. A trader holding a long position might consider taking some profits or closing the trade if the price reaches the upper band.
In contrast, a trader holding a short position might consider taking some profits or closing their trading-position if the security’s price falls to the lower band.
When the BB narrows, it indicates the trading range is tightening. The market could be stuck in a trading range and not a trend, and swing traders need trending markets to profit.
How to combine the four technical indicator tools
We’ve given you an example illustrating how you could combine several indicators to develop a strategy. For example, as a swing-trader, do you go long when the moving averages, MACD, and RSI indicate bullish sentiment and a trading opportunity? Do you then close when the BB bands narrow? Do you wait for all four to align before committing to a decision?
Remember that this suggestion is not 100% effective. There will be times when you get false signals, and the market will demonstrate chaotic whipsawing conditions making your TA and use of indicators challenging to apply. Hopefully, we’ve piqued your interest with this example, and you can experiment with tens of other combinations from the four main groups. It’s up to you to get curious regarding the four-tool method and strategies’ potential to see which (if any) fit in with your trading style and goals.
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